Brad Setser

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Cross border flows, with a bit of macroeconomics

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The lunch may be free, but how much is it worth?

by Mark Dow

This is Mark Dow. Brad is still away.

Diversification is the only free lunch in investing. But the way many investment managers sing its praises, one can’t help but wonder if its value is overstated (much the way all portfolio managers are programed to say in interviews that “it’s a stock picker’s market”, no matter what the underlying market conditions). Here’s a graph below that speaks a thousand words.

Brazilian Real vs Turkish Lira, over the past year

This is a chart of the Brazialian Real (BRL, in white) vs. the Turkish Lira (TRY, red), over the last year. They have been nomalized to facilitate comparison. Brazil is well known as a commodity exporter, and Turkey as a commodity importer (oil is a huge component of Turkey’s import bill). Keep in mind that over this same period, the front contract on West Texas crude oil fell from USD 136 per barrel to today’s price of 60, and other commodities–both soft and hard–fell by similar amounts.

You will note the one period of divergence in the performance of these two fundamentally distinct countries came in December of last year. This is due to the unwinding of TARKO (Target Knock-Out) contracts that were sold to Brazilian companies ostensibly as pre-hedging vehicles for future dollar export proceeds. However, once they started “working”, these contracts proliferated and quickly became vehicles for specualtion, often by companies that lacked the necessary sophistication in complex derivatives. And had it not been for the coordination of the hedging of these contracts by the Brazilian Central Bank, the December divergence would have been greater. Once this demand for dollars cleared, however, BRL returned to correlate very closely to TRY.

This notwithstanding, the overall similarity of performance over the period would, I think, come as a surprise to most people–given the fundamental backdrop. I know it took the veteran traders I work with by surprise. And while it is true that all correlations “go to one” when markets are under stress, one would still expect to have seen a greater degree of differentiation over the period shown.

A lot of it has to do with fund flows. Funds flows tend to be trendy, with investors getting into and out of strategies–such as emerging market currencies–roughly at the same time. This makes it tough for investors who do their homework and are counting on markets to be rational and efficient. It also makes risk management at least as important as the investment theses themselves.

Once the fund flows come in, the stories that justify the investment follow. Turkey was a great example. Investors at first expressed reluctance to buy TRY with oil going up through USD 100 per bbl. But the story soon followed that made it okay. Strategists and traders started whispering “with oil at these levels there will be large investment outflows from oil producing states, many of which are Muslim. Muslims will feel more comfortable investing their windfalls in other Muslim states, from which Turkey will be a main beneficiary. This will be good for the country and lead to appreciation of TRY”. And thus it was so. An investment thesis was born. Later, after markets crashed and oil had fallen to $40 per bbl., TRY started appreciating again. The story then reverted to the old one we all know and love: lower oil is good for Turkey and for TRY. The Muslim investment thesis had disappeared. In short, when prices go up, a good story will follow.

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The Monkey Multiplier

by Mark Dow

This is Mark Dow. Brad is still away.

There has been a lot of response to the assertion I made the other day that base money has not been growing since December, and that the money multiplier is not passing much of anything on to the broader economy or markets. The story that the Fed is printing money is just too strong to kill with a few facts. But, let me try again with a picture.

Here’s a chart I stumbled onto. It was Bloomberg’s chart of the day a couple of weeks ago. I do not know the research analyst from Westpac, an Austrialian bank, who put it together, and though I can verify his base money numbers, I cannot verify his M2 numbers. Nonetheless, the data fit what I know. Here’s the chart:

The M2 Money Multiplier vs Base Money, last 16 months

Muito Forte

by Mark Dow

This is Mark Dow here. Brad’s still on vacation.

Here’s a quick chart  for anyone questioning the conditional convergence growth hypothesis in emerging markets. In English, the hypothesis loosely posits that you can’t commit suicide jumping out of the basement window (ie. those who start from a much lower base will tend to grow faster until thier growth rate converges with that of more developed countries.)

This chart was brought to my attention by Marcio Ferreira, one of my colleagues at Pharo.

The red line is Brazilian vehicle sales going back to 2001. The white line is the vehicle sales in the US. The two time series are normalized to Dec 2001 so we can see the contrast in growth rates. It paints a powerful picture.

Brazilian vehicle sales vs US vehicle sales, 2001-2009, normalized

The Dollar: It’s an Overhang, not a Hangover

by Mark Dow

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Dollar Index 2004 -2009

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

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The central bank panic of 2008

by Brad Setser

Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion.

Central bank sales of Agencies in 2008: close to $100 billion.

That is a one-year swing was close to $400 billion.

It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market.

Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

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Sign of strength or evidence of weakness? China’s dollar reserves

by Brad Setser

On Friday, Paul Krugman interpreted China’s call for a new reserve currency as a sign of weakness:

“But Mr. Zhou’s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”

China is, according to Krugman, hoping for a magical solution that will “rescue China from the consequences of its own investment mistakes.” I agree.

Krugman rather provocatively argues that “China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind.”

I agree, at least in part.

I would be surprised if the State Council received a memo from the PBoC back in 2004 saying “$500 billion in reserves isn’t enough for a country with a closed capital account; let’s aim for $2 trillion by the middle of 2008.”

At the same time, China’s leaders made a series of choices that resulted in the accumulation of huge quantities of reserves. Even if China’s leaders didn’t plan to hold so many dollars, they weren’t willing to make the policy changes needed to avoid accumulating their current stash.

No doubt the Asian crisis led most Asian countries to conclude that they wanted more not fewer reserves. At the same time, it is hard to attribute the buildup of China’s reserves simply to the Asian crisis. China — like other emerging Asian economies — actually didn’t build up its reserves immediately after the Asian crisis. If China’s only priority was building up its reserves, it should have devalued the RMB in 1998 – not maintained its peg to an appreciating dollar.

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Revival of Credit?

by

Note: This is a guest post by Paul Swartz. Again, I appreciate Brad giving me the opportunity to fill in while he is on vacation.

 

A recent congressional hearing focused on where the money from the first part of the TARP went. Some representatives chose to communicate the challenges that their constituents faced in were having getting credit and inquire whether the banks were extending credit. As shown on the Center for Geoeconomics Studies homepage, banks were contracting home mortgage credit in the third quarter. Given that the first TARP funds were distributed in late October (well into the fourth quarter) the latest Flow of Funds data leaves us to wonder whether the banks are extending credit after the first step of recapitalization or not.

 

The Federal Reserve’s G19 Consumer Credit Report provides a credit picture on a timelier (monthly) basis. On a year over year basis consumer credit is growing.  Banks are carrying this segment, making up for the securitization sector’s credit contraction (note: government lending plays a trivial role in this sector). It is interesting to note that, up until now, securitization has been more consistent (i.e. it has not been the cause of total growth volatility) than the banks (look at 81 and 90).

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The case for a bigger IMF

by Brad Setser

The Wall Street Journal (Slater and Hilsenrath) reports that Brown Brothers Harriman estimates that Russia, Mexico, Brazil and India have spent $75 billion in the foreign exchange market defending their respective currencies so far this month.

The most the IMF ever lent in a year to the world’s emerging economies? About $30 billion.

Nor have emerging economies limited themselves to just intervening in the spot market. Brazil committed to doing $50 billion of currency swaps. Korea has guaranteed $100 billion of bank liabilities. Russia’s different commitments add up to something like $200 billion – though to be honest I have lost track.

The IMF’s total lending capacity (without drawing on its supplementary financing lines): roughly $200 billion.

Right now, the IMF is too small to meet the foreign currency liquidity needs of the larger emerging economies – those economies like Mexico, Korea, Russia, India and Brazil that have GDPs of around 1 trillion dollars and substantial financial ties with the rest of the world. At least if the IMF has to draw on its own resources. If Japan or China lends alongside the IMF, it could mobilize bigger sums than it can lend on its own.

The IMF clearly still has a role – whether supplementing the reserves of some larger countries in a modest way or supporting smaller countries. It is now lending — or soon will be — to Iceland, Ukraine and Hungary. But in a world where Dani Rodrik argues the IMF needs to be lending hundreds of billions rather than tens of billions (“What will be required now is more of the order of hundreds of billion dollars”), it lacks the resources* to be at the center of the international financial system.

In very broad terms, the dollar liquidity needs of borrowers outside the US have been met in three different ways.

— European banks effectively have been given access to the Fed. Not directly. But indirectly. European central banks can borrow dollars in the Fed in literally unlimited quantities by posting euro or pound or Swiss franc or Swedish krona collateral. And European central banks can then onlend the dollars they borrowed from the Fed to their own (partially nationalized) banks.

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More extraordinary moves: $620 billion is real money, and it isn’t even for American financial institutions …

by Brad Setser

Give the world’s central banks credit for using swap lines to cobble together a global lender of last resort:

The Federal Open Market Committee (FOMC) has authorized a $330 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide funding for U.S. dollar liquidity operations by the other central banks. The FOMC has authorized increases in all of the temporary swap facilities with other central banks. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank. As a result of these actions, the total size of outstanding swap lines is $620 billion.

All of the temporary reciprocal swap facilities have been authorized through April 30, 2009.

Dollar funding rates abroad have been elevated relative to dollar funding rates available in the United States, reflecting a structural dollar funding shortfall outside of the United States. The increase in the amount of foreign exchange swap authorization limits will enable many central banks to increase the amount of dollar funding that they can provide in their home markets. This should help to improve the distribution of dollar liquidity around the globe.

hat tip: Alphaville

Call this a consequence of the emergence of Europe (and London in particular) as an offshore banking center for the US. A host of European institutions (and probably some US institutions too) without US dollar deposits seemed to have dollar funds to buy dollar-denominated securities during the peak of the boom. And well the boom is turning to bust.

I suspect this activity explains all the risky bonds — including asset-backed securities — that the US sold to investors in the UK during the peak of the boom. And I also suspect the collapse of this activity explains the sharp fall in both inflows and outflows in the United States balance of payments data. Much of the “shadow” financial system was offshore.

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Where Is this U.S. Recession Already?

by

Note: This piece is by Christian Menegatti of RGE Monitor, where this piece first appeared.

So, good news on the real U.S. GDP growth front: 3.3% in Q2 2008. But is it really good news? Let’s dig a bit deeper, maybe past the headlines…

Personal consumption was revised slightly upward from 1.5% of the advanced release (adv) to 1.7%. Not a major change. Notwithstanding the stimulus package consumption failed to stay above 2% (in 2007 it averaged about 2.3%) and continues to grow at the slowest pace since 1991.

image004.gif

Gross private domestic investment was revised upward (from -14.8% to -12%), but remained a drag on GDP contracting at a pace consistent with the one seen in the two previous recessions (1991 and 2001) (the biggest negative contribution to GDP growth in Q2 -1.82%). The improvement is explained by the change in inventories that were less of a drag than previously estimated (their contribution to growth was revised from -1.92% up to 1.44%). Residential investment were basically unchanged with respect to the advance release, (-15.7% versus -15.6%), this is an improvement with respect of an average of about -24% in the previous three quarters.

image0021.gif

So, what explains the upward revision? Largely the external sector.

Is this really good news?

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