Will the world’s macroeconomic imbalances soon reduce to China’s surplus and offsetting deficits in the US and Europe?
The recent fall in oil prices, if sustained, should bring down the external surplus of the oil exporters. $80 a barrel is well above the average price of oil for most of the 1990s – or for that matter 2003, 2004, 2005 and 2006. But the oil exporters are spending and investing (and thus importing) a lot more as well. By next year, a $80 a barrel oil price won’t generate a big surplus to be managed by the oil exporters central banks and sovereign funds.
The yen has long looked very weak relative to the euro. But that too has changed. The yen’s recent rally – if sustained – should, over time, work to reduce Japan’s surplus (though the fall in commodity prices works the other way).
That more or less leaves China’s surplus – and the offsetting deficits in the US and Europe. There is good reason to think China’s export growth should slow over the next year. Neither the US nor the European economy looks likely to expand much in the near future. The dollar’s recent rally has led to a much more significant broad appreciation of the RMB than the RMB’s appreciation against the dollar ever did. Back then, the RMB never appreciated enough against the dollar to make up for the dollar’s fall. This broad appreciation should make it more difficult for China to offset weak growth in its exports to the US with strong growth elsewhere.
But there isn’t much evidence of a slowdown in China’s exports yet. Nominal export growth is chugging along at about 20% y/y – which implies the China is on track to export about $250 billion more this year than last year. That has kept China’s overall trade surplus more or less constant even as China’s (commodity) import bill soared in the first few quarters. China’s q3 2008 trade surplus ($83.3b) was about $10b more than its trade surplus in q3 2007 ($73.2b). Yes, the pace of real export growth has slowed. But at something like 10%, China’s real export growth is still comparable if not stronger than US export growth. Net exports contributed positively to China’s GDP growth in q1. The World Bank’s economists believe that they will contribute to q2 GDP growth – and I would be shocked if they don’t contribute positively to China’s GDP growth in q3 as well.
Looking forward, export growth should slow – in both nominal and real terms. But nominal import growth should slow as well, as China’s commodity import bill falls. I don’t yet see much evidence that China’s overall surplus will fall. And lest we forget, China has by far the largest surplus of all the major economies. The great boom in China’s exports that started in 2002 or 2003 looks – at least to me – to be continuing.
China is an outlier when it comes to reserve growth as well. In q3, many emerging economies saw their reserves fall. Not China. It – along with Saudi Arabia – likely will keep global reserve growth from turning negative. China’s stated reserves increased by $96.8b in q3, bringing total reserves to just over $1.9 trillion.
Both numbers are deceptive.
China’s state banks hold about $200 billion of foreign exchange as part of their mandatory reserves requirement, foreign exchange that – per China stakes – is on deposit at the PBoC and is managed by the SAFE (See Xu Yisheng of China Stakes). That implies that SAFE already manages an external portfolio of $2.1 trillion – far more than anyone else.
And the $96.8b in headline increase understates the “true” increase in China’s reserves. China has some euros and pounds – and those euros and pounds fell in value. If China has about 67% of its portfolio in dollars (and if it has a fairly low yen share), the falling dollar value of China’s euros and pounds subtracted about $70b from China’s reserve growth in q3 — implying that China actually bought about $165b in the fx market to keep its currency from appreciating.
That is a bit less than in q1 and q2 once adjustments are made for funds shifted to the CIC – but it is still a large number.
Now in the past the growth in China’s stated reserves has been misleading, as foreign exchange was shifted to the state banks in ways that held down overall reserve growth. There is at least a possibility that the opposite was true in q3 – and that China’s true foreign asset growth was less than $165b. In July and August, Logan Wright reports that PBoC’s other foreign assets – a line item that seems to correspond with the dollar reserves of the state banks held to meet a portion of China’s reserve requirement — fell by $7.5b. That brings the total increase in q3 below $60b.
But it doesn’t answer one key puzzle: almost all the valuation losses came in August (an estimated $40b) – which implies that China’s “true” August reserve growth was $80b. Frankly, that is a bit suspicious.
Maybe China’s state banks – contrary to what China Stakes reports – reduced their dollar reserves when the reserve requirement was reduced? Or maybe they otherwise reduced their foreign holdings, basically paying back funds that they had previously borrowed from the PBoC to invest abroad? Until the details of the foreign currency balance sheet of China’s state banks are released we won’t know.
But we do know that China’s trade surplus remains very large – and that it is still adding to its reserves at a fast clip. Over the last 12 months (q3 2007 to q3 2008) I estimate that China’s government added roughly $700 billion to its foreign assets (counting the increase in the CIC’s foreign assets as well as the dollar reserve requirement managed by the PBoC) to keep its exchange rate from appreciating.
And while there is good reason to think that the growth in Russian and GCC foreign assets is poised sharply, evidence that China’s surplus is about to fall remains, for now, rather thin.
No one paid much attention – in part because the IMF writes in code – but the chapter of the IMF’s WEO that examined the current account balances of emerging economies documented both that China’s real exchange rate has been unusually weak and that China’s external surplus has been unusually large. It doesn’t take much of a leap to think that those two facts are related.
This doesn’t just matter to the US and Europe either. China’s exports to India have absolutely soared over the past two years – and I suspect that the combination of competition from China in export markets and rising commodity prices helps to explain why other emerging Asian economies weren’t able to sustain their appreciation against the dollar for long.
UPDATE: After looking at the analysis of Michael Pettis (which draws on the work of Logan Wright), I realized that something was off in my valuation adjustment function. It turns out that I had end-July exchange rate data in the end-August file. As a result, I initially attributed all the valuation changes to September when most were in August. My valuation-adjusted reserve growth now is $43b for July, $79b for August and $40b for September. The graphs are consequently a tiny bit off — I’ll update them later today.
The graphs have been updated — here is a bonus one showing estimated hot money inflows.
My analysis — which doesn’t incorporate all potential flows between the PBoC and the state banks, so it could be incomplete — suggests a large fall off in hot money flows. However, on a rolling 3m basis, money still seems to be coming in (or at least not leaving).
Brad,
A large part of the US CA deficit reflects imports from regions that are more or less pegged to the dollar – i.e. oil and China. There should be downward pressure on both of these components due to declining oil prices and oil demand, and the effect of US recessionary pressures on the demand for Chinese imports.
Both of these trends should be somewhat resistant to a dollar that is otherwise strong in the near term. Just how sensitive is the US deficit to these factors versus the dollar per se? Which do you think will be more important to adjustment? Will the relative importance flip long term versus short term?
Great work as always Brad.
Michael Pettis has some good info today on Q3 flows for China that are relevant here too.
http://piaohaoreport.sampasite.com/
–Q
I think the first thing to so is to figure out what the important questions are:
1) How will current events affect currency values and flows?
2) How will current events affect balance of trade?
3) How will the Chinese economy react to current events?
Europe to U.S.: Paulson messed up the rescue, too
http://money.cnn.com/2008/10/13/news/international/gumbel_eurobank.fortune/index.htm
PARIS (Fortune) — First you mess up the world’s financial system. Then you blow the rescue of it. Now let’s show you how to do it properly. That, in a nutshell, is the less-than-flattering message European governments are sending to the U.S.
They believe that the $700 billion bailout plan was badly misdirected. Rather than buying up toxic assets, as the Paulson plan initially intended, they believe the role of government intervention should be to recapitalize the banks directly in exchange for some control of operations. That’s at the core of the European plans announced Monday.
The initial Paulson plan involved the U.S. government buying up the problem securities of banks in a procedure that risked being anything other than prompt and transparent. “It looks as complex as the credit derivatives that caused the problem in the first place,” one top European finance official told me, on condition I didn’t quote him by name.
If our CA deficit decreases, doesn’t our deficit then need to also decrease proportionally? Will the vendor nations really use their excess reserves to purchase insane amount of US Treasuries?
Please comment on trichet comment for a return to discipline - bretton woods. Really a choking statment. Paulson, trichet, Bush must be shuddering at such a statement.
The risk is you push it too far. The US will almost certaionly act to devalue overnight if they see this as the likely outcome. It is the only rational thing to do. if that funding advanatge ends, the US would almost certainly move to maximize the advantage pre-emptivily
Another big blowup for China CIC investment in US money market fund default
http://www.bloomberg.com/apps/news?pid=20601087&sid=ancX7qXx0kXk&refer=home
Oct. 13 (Bloomberg) — China Investment Corp., the sovereign wealth fund that bought stakes in Morgan Stanley and Blackstone Group LP before their stocks plunged, may have as much as $5.4 billion frozen in a U.S. money-market account.
Stable Investment Corp., an affiliate of Beijing-based CIC, was the largest shareholder in Reserve Primary Fund on Sept. 1, according to regulatory filings. Reserve Primary suspended withdrawals last month after becoming the first U.S. money- market fund in 14 years to leave investors with losses. Stable Investment had about $6 billion in additional U.S. money-market funds earlier this year.
while the CAD is shrinking, it arguably(?) may have to go positive in order to fund a (unified) budget deficit approaching 9% of GDP, cf. http://www.econbrowser.com/archives/2008/10/the_budget_defi.html
The financing of the emergency actions against the financial crisis (the 700 billion and others) must come from somewhere. And the only place it can come from now is China. Does not that mean that whether the world wants it or not, they have to buy relatively even more Chinese goods to get this financing?
Paulson’s bankster bailout plans summarized
http://www.globalresearch.ca/index.php?context=va&aid=10541
When the government says that it is reviewing “all” the options, reality is not one of them. Treasury Secretary Henry Paulson’s first option was to buy packages of junk mortgages (collateralized debt obligations, CDOs) to save the wealthiest institutional investors from having to take a loss on their bad bets. When this was not enough, he came up with “Plan B,” to give money to banks.
But whereas Britain and European countries talked of nationalizing banks or at least taking a controlling interest, Mr. Paulson gave in to his Wall Street cronies and promised that the government’s stock purchases would not be real. There would be no dilution of existing shareholders, and the government’s investment would be non-voting. To cap the giveaway to his cronies, Mr. Paulson even agreed not to ask executives to give up their golden parachutes, exorbitant annual bonuses or salaries.
Plan A (the $700 billion to buy mortgage-backed junk that the private sector will not buy) failed partly because it let financial institutions avoid putting a fair value on the debt packages they were selling. Instead of telling the truth about their financial position by marking assets to market prices), they can “mark to model,” Enron-style.
We have seen the result: A solid week of plunging stock market prices. The public media call this a panic, but there is nothing irrational about it. Who in their right mind would buy securities or buy into a bank without knowing what the securities were worth? Faith in junk mathematical models has ended.
dunno if it represents the CW of policy makers but at least according to erh-fei liu, ML’s china chairman: “China is losing a bit of money investing in U.S. Treasurys, given the dollar is depreciating in a long-term trend. [The alternative is worse, if] China stops buying Treasurys, the U.S. will stop importing from China, and that’ll hurt China demand and that’ll be a loss-loss situation for both countries.”
Isn’t the major uncertainty over China’s trade balance how far Chinese consupmtion will expand/be expanded as export demand contracts?
One thing that I hope will change in the new era is that people will give government officials some more slack to actually try and fix problems, before screaming at them for being incompetent. People went from “constructive criticism” to “screaming at people for the sake of screaming.”
Paulson and Bernanke happens to be human beings. They don’t have absolute knowledge and then do make mistakes, but they are quite aware that their decisions have consequences. They are doing the best that they can, and I have a lot more respect for them than I do for the “know-it-all” pundits that probably would end up destroying the world if they were in charge.
The pundits are able to “know-it-all” because they really don’t suffer any bad consequences if they get it wrong.
I do find it interesting that after the huge drop in the stock market, many fewer people are complaining about the government bailout. People generally complain about bailouts up to the moment they realize that they are the ones getting bailed out, and then they shut up.
I’m actually looking forward to the recession. You become grateful for what you have when you realize how bad things could have been.
AC Says:
“The financing of the emergency actions against the financial crisis (the 700 billion and others) must come from somewhere. And the only place it can come from now is China. Does not that mean that whether the world wants it or not, they have to buy relatively even more Chinese goods to get this financing?”
There is one other source…it comes out of the stock and commodity markets. We would of course need something to convince investors of the wisdom of dumping stocks and oil contracts and buying treasuries. Like maybe deteriorating technicals and fundamentals in these markets. But I wouldn’t rule out the possibility that it could happen.
The other wild card is OPEC. They could decide to make relatively small cuts in production, which I couldn’t imagine would need to be more than high single digits even with more demand destruction than we’ve had so far, and get double digit percent price increases from current levels.
That would be bad news for US imports of Chinese stuff, assuming the US consumer can’t keep up the spending pace to keep OPEC and China happy.
I can’t help thinking this could be a problem for EM consumers as well. Asia rolled back oil subsidies substantially. Many like India depend on US outsourcing for jobs. Could have a tech wreak there.
But it would take a dartboard and a set of darts to accurately predict how this all turns out.
you are not alone
“In the middle of a financial crisis, ideology is sort of pushed to the side. You know, the government could do no wrong or the government can do no right.
“We forget about that, and we say we have an immediate problem, and we have to solve it.
“And so I think that we’re going to move maybe toward the center. It’s not going to be deregulate, let the market work, and it’s not going to be let the government take over the economy.
“We’re Americans. We’re pragmatic. We’re in the middle. And we’re going to work our way out of this problem.”
cf. zakaria
cheers!
Date: Wed, 15 Oct 2008 11:17:10 -0700 (PDT)
From: Chidambaram P
Subject: Getting Creative around the US Mortgage Crisis…
To: bsetser@cfr. org
The Sixty-Year Mortgage: (Mortgage Banker gets around 20% stake in the home equity)
Hello Dr. Setser,
Please go through this interesting proposed solution to the current global economic crisis!
This solution requires very little regulatory intervention and involves absolutely no cost to the tax payer. Yet it will ensure a rapid recovery of mortgage markets, solve the liquidity crisis and avoid a global recession.
Hopefully the product described here will actually enter the market and solve the current crisis.
Also, please post this on your very interesting blog if possible.
There are four policy objectives with respect to the U.S. mortgage crisis:
1) Ordinary people living in their own home need to be empowered to stay in their home without having to default their mortgage payment and have the bank foreclose on them.
2) The housing market needs to receive a stimulus to arrest the downward trend in home prices and avert further decline in economic growth.
3) Mortgage bankers who have either already booked losses or are likely to book more losses need to be recapitalized so that liquidity in the financial system can be ensured.
4) All of the above objectives need to be met without much of an impact on the U.S. taxpayer.
All of the above objectives can be easily met with the introduction of a new commerical financial product, largely within the bounds of the existing regulatory system; but with a couple of small innovations to the current structure of a typical mortgage product.
The new mortgage product required to solve the problem is a simple mortgage loan from any private mortgage banker or other relevant private financial institution.
Though the mortgage loan will be like any other existing mortgage loan product, there will be two modifications to the product:
1) Both the mortgage banker and the borrower will have the right to foreclose the mortgage with due notice. (While I believe this is currently the case from a legal perspective it is very rare for the mortgage banker to actually exercise their right to foreclose unless there is a default by the borrower. The new product will specifically stipulate that the mortgage banker can foreclose the loan at their option with due notice, irrespective of the borrower’s payment history)
2) In case the borrower should choose to foreclose their loan, or transfer it to another party, 20% of the proceeds of the sale will accrue to the mortgage banker and only 80% of the proceeds of the sale will be received by the borrower. The same would apply in case the mortgage banker should choose to foreclose from their side.
3) The term of the mortgage loan will be 60 years instead of 30 years.
a) In the event the borrower is deceased prior to the expiry of 60 years, the home will revert to the ownership of the mortgage banker.
b) The only exception to b) above would be that the borrower will have the right to bequeath the home, provided the person receiving the home continues to make the mortgage payments as usual.
c) The borrower will not be compelled by the mortgage banker to take out life & disability insurance to the extent of the mortgage principal and assign it to the bank only as a result of this increased term. The current practice on this will be followed.
4) One important change in the product will be that the mortgage banker will have norms enabling them to lend out the higher of the following two amounts:
a) The current market value of the home (as determined by a valuation, as happends right now)
b) The pay off amount on an existing mortgage loan on the home.
I request you to carefully evaluate the impact that the introduction of this new product or a similar product will have on the U.S. mortgage market and it’s beneficiary impact on the current global financial situation.
Expected Impact:
Consider a typical problem right now:
The borrower has an outstanding pay off amount of say $300,000/= on their mortgage. They are unable to afford the monthly mortgage payment and they have less equity in their home than the outstanding pay off amount. The market value of the home is only $220,000/=.
A new lender might be willing to re-finance but the existing banker has to agree to book a loss for this to happen.
In either case, the borrower is not in a good situation to afford the payment.
A new lender can now come in and offer a Sixty Years’ mortgage product to this borrower. The lender is very motivated to do this because the lender will be able to
)
1) Charge a high interest for this product(say around 20% … 20% is becoming a favorite number here for me
2) Benefit from a future sale of the home at a higher price. It’s important to remember that according to the terms proposed here the lender has a 20% equity stake in the home.
For the borrower the benefit is that they will be able to stay in their home while making a much reduced monthly mortgage payment. In the longer term appreciation in the price of land will ensure that they will more than make up any losses from having to pay 20% of their home equity to the bank.
For the existing lender, there is absolutely no problem because they will realize the pay off amount from the new mortgage in case the market value is lower than the outstanding loan.
Questions and Answers:
1) If the mortgage term is extended to 60 years, will everybody want to move to this structure?
The answer is no, because taking this loan means that the borrower loses 20% of the value of the home to the mortgage banker.
Only somebody who is very serious about staying in their own home for a long term, and who is also currently distressed, will avail of this loan.
2) How long will the 60 year mortgage actually carry on?
Probably within a period of less than 2 years from now, all the 60 year mortgages will disappear from the market. This is because both the banker and the borrower are motivated to foreclose this mortgage as soon as the home values appreciate around 20%. The banker will want to book a high profit. The borrower will want to keep all of the home price appreciation as their own profit.
Please note that some changes to the 20% equity proposed for the mortgage banker might be needed. In any case the market will ensure an appropriate percentage is arrived at.
3) Will a renter want to take this mortgage?
A renter who plans to stay for a short while will not want to go for this. This is because they will be liable to go bankrupt or pay 20% of the home sale proceeds to the bank.
A long term renter will want to go for this, and afterwards they will have the motivations as any other borrower above.
4) Will owners of 2nd and 3rd homes, or speculative real estate investors go for this?
Some of them will, depending on their intention to wait for a sufficient time till the home values appreciate much beyond 20%. But somebody with a short term outlook will not go for this, again because the bank holds a 20% equity stake in the home, which reduces the speculative profits.
5) Will this product solve the global crisis?
Yes, because many lenders will be motivated to come into the market again, borrowers are a plenty and the value of the homes will increase in the short terms since the payments on a 60 year term will be around twice as affordable.
6) Should there be any regulatory or systemic changes related to the introduction of this product?
The only change might be that in future whenever the home underneath a Sixty Year mortgage is sold, it would have to be through an open auction where both the banker and the borrower are present; or to have some other mechanism to ensure mutual agreement that the home is being sold at it’s correct value.
Please add to this reasoning any further insights you may have. Also, please propose any modifications you might like to.
Best regards,
Chidambaram
Chidambaram:
Very funny, but now that I am a passive mortgage banker, thx to the USG, I like it.
I do suggest, however, that we do require the borrowers to take out a life insurance policy with the lender being the payee. Remember that AIG needs help too. But I would suggest a policy of twice the current home value to offset our risk of default on the part of insurance counter parties.
But other than that, looks like a plan and a really wonderful product to me.
BTW: Before the Japanese housing bubble burst, Japanese mortgage bankers did offer 100 year mortgages. This was done while the bubble was growing for some reason. And the Japanese sometimes have 3 generations under one roof. But I see no reason not to do it post bubble in the US. The part about it being assignable to the kids is a nice touch, and no one is going to have to move far away to get that good job anymore. And you never know, the medical industry may someday develop life extending drugs and procedures covered by our national health care plan, so many borrowers may be able to pay off all on their own.
Twofish,
All of the absurd bailout schemes don’t matter at this point. The United States as a nation is financially bankrupt thanks to the Wall Street banksters (ie. Paulson, Rubin, Dimon, Fuld, Geither, Bernanke, Greenspan, etc). When there are street riots across America, I am sure Paulson’s bankster cronies will fly off to the Swiss Alps or the French Rivera.
I think this is a bad idea. Dealing with a bad loan by extending terms doesn’t solve the problem and just makes the problem worse. Also assuming housing prices go up is a very bad idea. Finally, banks are in the business of lending money, they do not want to be in the business of managing property.
Quite frankly a lot of people would be better off if they just defaulted on a mortgage loan and declared bankruptcy. Bankruptcy will leave you clear of debt in about seven years, whereas agreeing to a new loan will leave you permanently in debt to the bank, and having people permanently in debt to the banks is a very, very unpleasant society to be in.
DJC: All of the absurd bailout schemes don’t matter at this point.
Yes they do. I don’t care about Paulson or Dimon or whatever. What I do care about is that *I’m* going to be the person at the wrong end of the rope if things go really bad, and I care enough about the United States do leave it in good shape for my kids.
If you have any constructive ideas for getting out of this mess, I’d be glad to hear them, but I have got very little tolerance for all of this “know-it-all” punditry that doesn’t offer constructive solutions and take some responsibility if those solutions go bad.
DJC: The United States as a nation is financially bankrupt.
So we go through a bankruptcy and reorganization process.
DJC: When there are street riots across America, I am sure Paulson’s bankster cronies will fly off to the Swiss Alps or the French Rivera.
Which is pointless since it’s a *global* crisis.
twofish
DJC: The United States as a nation is financially bankrupt.
So we go through a bankruptcy and reorganization process.
The idea of the US declaring bakruptcy and all clear is insulting. The only reason the US has been able to proceed as it has (and you kno well) is the funding mechanism gratis the rest of the world. That window is closing. So a bankruptcy is a very dangerous option especailly when you consider that funding growth with debt would be cut off at the knees henceforth. The US has been a biog talker about innovation and how hard people work etc. Well the time is coming when that will be the only way to drive real wealth creation. Something tells me the bark is a lot bigger than the bite. otherwise the powers that be wouldn;t be fighting so desperately to preserve a rotting corpse in the name of global systemic stability. Something tell me that as the US holds dollar devaluation gun to its head the rest of the world is praying it pulls the trigger.
Hello Twofish, Cedric, DJC, s, etc:
First of all, thanks a lot for reading my earlier post. Please consider the following example.
A borrower owes $200,000 on their home which is worth only $160,000 in the market.
There are already 50-year mortgages, interest only mortgages, etc freely available in the market.
http://www.bankrate.com
These products can help reduce the monthly payments on the $200,000 mortgage but they are not useful to solve the above logjam.
This is because the new lender cannot lend more than $160,000 on the underlying home, since their norms disallow that. Unless the borrower can raise $40,000 on their own, and then re finance, the logjam will continue, or result in a painful bankruptcy.
The product I’ve described above will provide the new lender with a 20% equity in the home. If the new lender provides $200,000 (the existing mortgage payoff amount is their maximum): After some time the home value will go up to, say, $250,000. Now the lender and the borrower are both motivated for a re finance. The lender receives $50,000 (20%) and books that as a profit. The borrower reverts to a normal 30-year mortgage on a $250,000 home in which they now own 100% equity.
Introduction of this product will introduce new lenders/capital as well as a large number of new genuine ‘rent savers’ who will be motivated to make a long term investment in creating a home as an asset.
The borrower will be much more motivated to save after going in for this product, mainly because accruals of increased equity to borrow more against the same home will be slow. Also they will want to exit this product as quickly as possible and go back to a traditional mortgage which gives them 100% equity.
Lenders will not prefer to keep these 60 year mortgages outstanding for long since they will want to book the profits from the 20% of the sale proceeds.
Not assigning a sufficiently large life insurance policy amount to the lender will also ensure that this new product is not misutilized for speculative purposes either by the lender or by the borrower.
The borrower should not be required to pay a lot of new life insurance premium for this and the lender should be scared of being left holding the ball (home) in case the borrower deceases without bequeathing the home to anybody!
The only difference between this product and the existing ones, as well as the Japanese ones is that this product ensures an equity return for the lender, apart from the interest.
My proposal of 20% equity stake for the lender is an approximate one as an example. It needs to be higher or lower depending on the difference between the mortgage pay off and the market value of the home.
It would also have to be worked out in such a way that the borrower is not motivated to stay in this new 60-year mortgage forever, paying very little every month for a long time, waiting for the ultimate high appreciation, borrowing more against their equity in this new structure and ending up in the same old crisis 20 years from now!
Best regards,
Chidambaram
David H — Yes, the one uncertainty is whether or not China can stimulate domestic consumption — tho perhaps the trajectory of CHinese investment is an even larger source of uncertainty, as it is not inconceivable to me that a fall in investment might really drag down Chinese growth. The other variable is how fiercely China fights for market share in a global environment marked by a shortfall of demand v supply.
Glory — Erh-fei Liu describes the current situation perfectly. that is the balance of financial terror from China’s point of view: continue long-term financing to the US at a loss, or take an immediate hit on the export side.
AC — actually, US demand for treasuries has spiked, so more of the bailout will be financed domestically than you imply. The US external deficit will almost certainly come down as oil prices fall and consumption growth slows (see the data flow from today).
The impact of the crisis on china is more ambiguous. Slower global demand, especially if offset by a successful domestic stimulus program, would tend to reduce China’s surplus and thus its net lending the world.
On the other hand, a fall in chinese investment would free up more funds to lend to the world (and reduce demand for imports), and the big recent fall in commodity prices will lower China’s import bill significantly.
What increasingly worries me is that we may be heading for a world where both US exports and imports fall — with the trade deficit falling but rather slowly as some of the gains on imports are offset by losses on exports. I.e. after the big one off gains from the fall in the oil import bill, the pace of improvement slows. in that world, the US would be borrowing from china - but it would be a world marked by a fight for shrinking market share and many accusations of unfairness.
Quarrel — thanks for noting that pettis had blogged on this. I am having some trouble with my home internet connection, so i missed it. reading it and noticing a couple of key differences helped me catch a major error (an exchange rate that was misentered) fairly quickly, which is important.
Brad,
If more Americans in large numbers default on their loans and walk away in bankruptcy, would that justify a speculative attack on the dollar, in favor of Euro denomination of global commodity trade, cleverly perpetrated as ‘a new world order’?
Changes in Chinese policy towards stimulating their domestic consumption will weaken the dollar, but this is decidedly a long term effect, and still seems uncertain.
Best regards,
Chidambaram
Cedric,
On second thoughts I’m not too clear on the life insurance part. It seems to make sense to assign a life insurance policy amount equal to the outstanding initial mortgage principal to the mortgage banker.
Best regards,
Chidambaram
Brad/others,
) reasoning powers can be useful to others in a crisis.
Request you to forward the earlier discussion about a new mortgage product to some folks you know in the mortgage industry/finance/economics areas, along with any modifications, comments, etc that you might have.
My only intention is to see if the creative use of my (limited
Best regards,
Chidambaram
I’ve seen the government’s plan to buy preferred stock referred to as “non-dilutive” in a number of this places. How can this be so?
Hello Dr. Brad,
We need to be very sure not to miss the geoeconomics subtext around the current crisis.
At the start of the Iraq war, public sentiment at that time seems to have largely missed the ‘petrodollar’ factor causing the war. Saddam Hussein was reportedly unwilling to have petro trading continue in USD denomination.
Much more recently, Argentina has reached some agreement to settle bilateral trade with Brazil without involving the dollar.
Iran has opened an oil bourse bourse which is again not USD denominated trade.
Could it be that some of the recent regulatory actions from the Fed and Treasury are partly motivated to defend the dollar against a speculative attack?
Best regards,
Chidambaram
Chidambaram — I am quite confident the US did not invade iraq to protect the dollar pricing of oil. And I among those who tend to think that the macroeconomic impact of a move away from dollar pricing would be modest.
As for your proposal — please note that I am not fond of long off topic comments.
Chidambaram: Unless the borrower can raise $40,000 on their own, and then re finance, the logjam will continue, or result in a painful bankruptcy.
Bankruptcies are indeed painful, but much less painful than perpetual debt. I think that is it important that we quickly figure out what debts are payable, which one’s aren’t, and then those that aren’t payable, we write down, and let people have a clean start. One big problem that I have with what you are suggesting is that in a lot of markets, there is no reason to think that home prices will increase past current values. It takes a long time for home prices to drop after a real estate bubble bursts, and the process has barely begun in a lot of places.
The reason that we got into this mess is that banks should not have on their books products whose values are tied to home prices. Banks are required to allow people to withdraw money, and backing demand deposits with fluctuating assets is a recipe for disaster. In your example, what do we do if house prices drop from $200,000 to $150,000, which they could very well do?
What do we do if the homeowner loses their job and can’t make the new reduced payments, which also could happen.
And don’t say house prices can’t drop. It was that idea that got us into this mess int eh first place. Also I’m very suspicious of complex new mortgage products, because that is also what got us into the current mess.
Also this requires that the owner put in a whole life insurance policy, and that’s another scam. If house prices increase then yes, everything is magically solved, but there is no reason to think that house prices will increase. One interesting graph that I’ve seen plots inflation adjusted house prices since 1870, and the last ten years have seen house prices go to levels that they’ve never historically reached.
To have people locked into situations in which they hope for some miracle which may never come is a waste of good capital and it’s value destroying. If someone has a house that is hopelessly underwater, it may be a good idea to just declare bankruptcy and have a clean start.
Also it’s unlikely that a financial crisis in the United States will change the dollar-euro exchange rate, since the US and European banking systems are so tightly connected that any problems in one will spread to the other. One needs to note that the unit of AIG which caused the near default was based in London, and one curious fact is that Europe is far more permissive about retail sales of derivatives than the United States for what I think are deep cultural reasons.
What long term impact of this is going to have on dollar-renminbi exchange rates is going to be interesting. The situation is still very fluid since what happens next depends on some decisions and interactions between decisions.
Judging from the headlines in the last few days, the Chinese Communist Party is planning on some massive fiscal stimulus in rural areas.
Soxfan Says:
“I’ve seen the government’s plan to buy preferred stock referred to as “non-dilutive” in a number of this places. How can this be so?”
I’ve been wondering the same thing. In fact in all the press releases the have even carefully not used the word “preferred”, which usually implies a dividend paying type of stock. I think Buffet and others have generally been going for upwards of 4%.
So it is non voting, non dividend paying, and non dilutive stock. Almost as if it didn’t exist !
Looking for an animal like that in my book of financial zoology, but none exists !
I’ve even heard they would like to cash it in as soon as possible. Maybe when we see DOW 5000? Wonder what our stock will be worth then?
So I have been curious about what the effect this all would have on macroeconomic imbalances, which is of course what this blog topic is about.
Twofish:
Taking a cue from terminology used by George Soros, my contention is that there are several ‘prevailing biases’, ‘misconceptions’ and ‘reflexivities’ right now! Your basic contention is that due to complex financial engineering products, lax lending standards, etc the mortgage crisis has come up.
If that’s the case how do you explain the stagnation or decline of real estate prices around the world, including stagnation in countries which have a very traditional banking system, and don’t have even LEAPS, let alone depositories to register OTC CDS instruments?
Even a few weeks back everyone was discussing the high oil prices. Now that oil prices have dropped below $80, that factor is almost forgotten in public discourse.
Twofish, how about creating a model to determine the current value of a home, using time value of money, mortgage interest rate, expected rent, risk free rate, inflation, etc?
That would tell you that there is a relationship between the price of oil and the price of a home in any economy.
Oil is a commodity which as we know goes into most activities as an input and it’s price is a reflection of the level of inflation.
What I find is that both a home and oil are basically commodities and with a general increase in the price of oil, the price of a home also increases.
However, an inflection point is reached where the price of a home no longer elastically increases with increasing levels of inflation in general.
This is also affected by interest rate policy.
There has been a global downturn in the real estate market since around April 2007 or so.
In the US the effects of reduced home prices have perhaps been more visible and pronounced due to underwriting norms, valuation practices, structured financial products, leverage, etc.
My point here is that those factors did not CAUSE the real estate downturn.
What caused the real estate downturn is speculation in oil futures, and the reaching of an inflexion point beyond which upward elasticity of home prices was not possible.
Best regards,
Chidambaram
ot, but amusing! http://gawker.com/5063337/the-secret-pleasures-of-dr-doom and bsetser may be the only one who can confirm or deny whether roubini’s apt walls are “indented with plaster vulvas”
Twofish:
“Also it’s unlikely that a financial crisis in the United States will change the dollar-euro exchange rate, since the US and European banking systems are so tightly connected that any problems in one will spread to the other”
It’s been a theory among FX traders for many months that the US is much farther ahead than Europe in ‘fessing up to bank problems, farther ahead in writedowns, and farther ahead in re-capping them. That plus the euro was trading well above fair value estimates ,ranging from 1.10 to 1.35, probably had a lot to do with the upward dollar move so far. And the yen beats all move confirms that it’s not because something is going right in the US. Imagine the strongest currency in the world comes from a country with 140% debt/GDP(Japan). Boy are we messed up.
It would be ironic if China actually decides to weaken the yuan, to maintain world competitiveness. Maybe we get all their reserves next year afterall?
Twofish,
“So we go through a bankruptcy and reorganization process.”
That’s the best statement of the only realistic solution to the unfolding credit contraction (called “the credit crisis” because the contraction destabilizes the over-leveraged prior condition).
The reason it’s the best is because the U.S. Government, as well as a majority of the financial sector, much of the household sector, and a non-tivial portion of the commercial non-financial sector, are all insolvent (i.e., they have more current liabilities than currently marketable assets, and insufficient cash flow to make their current or coming debt payments).
The “solution” of having the government create more liabilities on its own books in order to “remove” liabilities from everyone else’s books (while also increasing its own liabilities for governmental operations) is a straightforward statement of intent to debase the currency (i.e., admit the insolvency). We WILL go through the credit contraction/bankruptcy one way or the other.
What bothered me most about Bernanke’s speech today, was his repetition of the monetarist dogma that the credit contraction of the Great Depression was “caused” by the failure of the Fed to rapidly and sufficiently expand the monetary supply and to re-capitalize the banks. His point was, since the current leadership is doing that, there will be no such credit contraction and economic depression. If only the dogma fit the facts.
The Fed cut the Fed Funds rate to 1.5% (sound familiar) early in the credit contraction process. It raised the rates a couple of years later because 1) it had no effect on the contraction of credit, and 2) the dollar started devaluing immediately (a run on U.S. gold reserves backing the dollar was accelerating). Solvent banks WERE re-capitalized through mutliple processes, some of which were very similar to what we’re seeing right now (though through transparent, public, congressionally controlled processes instead of the “weekend secret meetings with cryptic announcement process we’re now experiencing) - it didn’t stop thousands of banks from closing, and it didn’t stop the unfolding of the credit contraction.
Once this cycle is completed and we’re recovering, and although it will have been obvious that the credit contraction had to run it’s course no matter what anyone did, the monetarists will insist that MORE LIQUIDITY would have prevented the Second Depression.
micheal:
My economic plan that I developed a year ago is to first default on treasuries and GSEs, then nationalize(republican word for invade and occupy) Canada so someone will still sell us oil.
Then we can just give away all those subprime houses to the owners since that’s about all they will ever be worth anyway.
Then we still need toaster ovens. But that’s what Mexico is for. I’m confident the peso will go where it needs to in order to re-vitalize NAFTA. Tho we do need to be careful not to nationalize Mexico, even if they request it. Their big oil field is slated for a 30% reduction in output, and that would just put us deeper in a hole.
Who is chidambaram. Finance minister of india or fake fm of india
Michael: His point was, since the current leadership is doing that, there will be no such credit contraction and economic depression. If only the dogma fit the facts.
We have to distinguish between a recession and a depression. The prevailing economic believe is that in 1929 as now a nasty economic contraction is inevitable. However, the choice is between a painful recession similar to what we saw in 1981-1983 and a decade long depression which we saw between 1939 and 1941 or 1972-1975. Bernanke’s belief is that between 1929 and 1932, things contracted so hard that it damaged the economy so that when things did hit bottom in 1932, there was no ability for the economy to recover until you had massive government spending associated with World War II. One thing that you do see around the workl is that when people end up losing their life savings whether through bank failure or hyperinflation, it scars them for the rest of their life, and it takes a generation to undo the damage.
If Bernanke is right then there *will* be a nasty credit contraction, but it will have worked its way through the system by 2012 rather than by 2022.
Michael: it didn’t stop thousands of banks from closing, and it didn’t stop the unfolding of the credit contraction.
There will be a credit contraction. However we will know whether we are looking at something bad or horrific if we see people lose their savings through bank failures which is what happened in 1930, and I don’t think this is likely, if for no other reason that we have FDIC.
The other big question that I’m think about is what happens if the stock market goes down and then stays down. It’s possible that the Dow will go to 5000 and stay their for a few years. If this happens then you have lots of people whose 401(k) is completely shot. You then have a very big problem of aging baby-boomers with no retirement savings counting on a government who owes lots of money to China to address it’s aging population problem.
[...] Recession versus depressions Filed under: china, finance — Tags: china, finance — twofish @ 3:14 am http://blogs.cfr.org/setser/2008/10/15/will-the-world%e2%80%99s-macroeconomic-imbalances-soon-reduce... [...]
Hi Dr Brad/Satish,
I just happen to share my first name with the Indian finance minister.
What’s more interesting is how I came across Dr. Brad. In February/March 2007, many global markets were crashing and Brad had explained in a lucid set of blogs on RGE the reasons for it. Especially I recollect one article on RGE on which he’d elaborated the 5 steps normally used to execute a yen carry trade against USD, in the absence of forex swaps’ availability and regulatory restrictions on direct yen borrowings.
Best regards,
Chidambaram
Yikes, Japan wants to sic the IMF on us!
There goes the national health care plan.
===========================================
Japan’s PM says US bank bailout is ‘insufficient’
Thursday October 16, 12:29 am ET
By Shino Yuasa, Associated Press Writer
Japan’s prime minister says US bank bailout is ‘insufficient’ and leading markets lower
TOKYO (AP) — Japanese Prime Minister Taro Aso said Thursday the U.S. bank bailout is “insufficient” and is contributing to the renewed plunge in global stock markets.
“Since it was insufficient, the market is again falling sharply,” Aso told lawmakers at the upper house budget committee in parliament. The committee was wrapping up talks on a supplementary budget aimed to help struggling small- and mid-sized firms amid an economic downturn.
ADVERTISEMENT
Aso made his comments as Japan’s key stock index plummeted 10 percent in early Thursday following another dive on Wall Street amid growing fears of a global recession.
The U.S. Congress earlier this month approved a plan to use $700 billion of public money to buy bad mortgage-related securities and other assets from troubled financial institutions. Some $250 billion of that will be used to buy shares in leading U.S. banks.
Aso said that the continued market volitility suggests that more action is needed. He did not elaborate.
Japan has said that it is willing to offer funding to help prop up crumbling financial companies around the world.
Japan is sitting on more than $950 billion in foreign exchange reserves, second only to China’s $1.9 trillion. Together, they control a major pool of funds that could come to the rescue of the West’s severely strained financial industry. Options range from helping to provide credit to strapped financial institutions to cash infusions in return for ownership stakes in them.
Finance Minister Shoichi Nakagawa said Tuesday that Japan would be willing to contribute to a rescue led by the International Monetary Fund. He said that at a Group of Seven meeting in Washington last weekend that brought together finance ministers from Japan, the United States and five other major economies.
Glory — I didn’t notice anything in the Gawker article that seemed inaccurate.
Cedric — I never quite understood the fair value models of the fx world. they seem to assume some mean reversion — but I would think that the United STates trade deficit (much larger than Europe’s by any measure) would imply a trend depreciation rather than mean reversion.
that isn’t to say the Euro wasn’t somewhat overvalued at 1.55 — it was. that was a price that assumed a strong europe/ weak US. at the same time, 1.20 is a $/ euro that doesn’t provide much impetus for adjustment. and then there is whole question of the emerging world v the US and Europe.
Wow, FDIC Chairwomen attacks Paulson’s $700 billion bailout scheme as corporate welfare for Wall Street.
http://finance.yahoo.com/tech-ticker/article/96631/FDIC-Head-Bair-Rips-Bailout-Where%27s-Love-For-Consumers?tickers=%5Edji,%5Egspc,%5Eixic
The Bush Administration’s bailout plan bails out Wall Street but ignores demolished consumers, FDIC head Sheila Bair says–and she blames politics. Her criticism gets at the reason why the bailout plan has so far failed to unlock the credit markets: because banks are now unwilling to lend money to people who can’t pay them back.
“Why there’s been such a political focus on making sure we’re not unduly helping borrowers but then we’re providing all this massive assistance at the institutional level, I don’t understand it,” [Bair] said. “It’s been a frustration for me.”
Brad:”I never quite understood the fair value models of the fx world. they seem to assume some mean reversion”
Ditto, which is why I have been generally ignoring them. I’ve never bothered to research how they model these. I have heard they ignore a lot of hard to quantify factors, and maybe it has something to do with corporate profit levels, or maybe partly purchasing power parity.
But like you say, those factors are counter intuitive no matter which countries you compare.
I will be interested in end of 2009 OECD numbers on debt/gdp ratios of the developed world. Especially since Occam’s Razor says credit contraction causes GDP contraction.
Chidambaram writes: Your basic contention is that due to complex financial engineering products, lax lending standards, etc the mortgage crisis has come up.
Really no. The root cause was that the US kept interest rates very low which resulted in money lent to people it probably shouldn’t have been lent to.
Chidambaram writes: Twofish, how about creating a model to determine the current value of a home, using time value of money, mortgage interest rate, expected rent, risk free rate, inflation, etc?
Even creating that model tells you that something is very wrong. At one point a house was *some place you lived in* and you were willing to pay a certain amount of money for a house because it had a nice yard, a good location, and large living room.
When people started looking at houses and real estate mainly as *financial instruments* and not as *places to live in*, then we really started to have problems, because at that point people just started to make fake wealth by flipping houses to each other.
Chidambaram writes: What caused the real estate downturn is speculation in oil futures, and the reaching of an inflexion point beyond which upward elasticity of home prices was not possible.
No. What caused the real estate downturn was that at some point someone realized that to generate real wealth, someone would actually have to buy a house and live in it, and not just flip it to someone else.
It’s your classic bubble. The good thing about this real estate bubble is that economic bubbles have happened hundreds of times before, and there is some experience in what to do and what not to do when one pops.
You need to deflate the bubble in a way that minimizes collateral damage.
If Bernanke had said this back in the day instead of sucking up, he would not be Fed chairman now.
http://www.bloomberg.com/apps/news?pid=20601068&sid=a_EGuB7kQmyo&refer=home
“Federal Reserve Chairman Ben S. Bernanke said the central bank will consider discarding its long- standing aversion to interfering with asset-price bubbles and warned that the banking business may be concentrated in too few companies.”
“Officials should review how supervision and interest rates can minimize the ‘dangerous phenomenon’ of bubbles in housing, stocks and other assets that risk bringing the financial system and economy down with them when they burst, Bernanke said.”
I am a layman in economics. But I surely have enough common sense to think that in times of crisis Gold and Silver would act as the saviour. But it just seems to act in the opposite direction violating all laws that govern it. This is not a bubble but a high tension spring highly compressed which when released would surely sent shockwaves. I really doubt anyone can dispute this theory.
Test:
Test 2: Reserves Control