Emerging Markets

For much of the most recent phase of the rolling global crisis, the dollar and the yen rose against the euro, the pound and most emerging market currencies. Some of that was a reaction to the euro’s extreme strength going in to the crisis; a $1.55 euro amid a European recession would have made life very uncomfortable for many European manufacturers. But some of the dollar’s rise also reflected a global scramble for dollar liquidity, whether as a safe have (compared say to the ruble, the dollar looks good .. ) or to repay dollar-denominated debts. John Authers of the FT: On a trade-weighted basis, the dollar rose 22.7 per cent from July until its peak last month. This was not, evidently, due to any great strength in the US economy. Instead it was largely a perverse phenomenon – as traders sold assets to pay down debts (deleveraging), they often had to buy dollars. So as the crisis intensified, so the dollar strengthened. The only exception to this was the yen, which does even better than the dollar when investors are anxious. Over the past two days, though, the dollar has fallen against both the euro and the yen. The US trade data surprised on the downside -- and while it is far too soon for the dollar’s recent rise to really have an impact on the trade data, the rise in the deficit perhaps did remind the market that over time a rising dollar would tend to maintain the still large trade deficit not bring it down. Macro man was far more surprised by the rise in the non-oil deficit than I was; it was always going to be race down between imports and exports. And last month exports fell by more ... The collapse of Madoff’s investment fund presumably hasn’t done wonders for the United States image as a financial safe haven either. His stable, predictable returns turned proved too good to be true. See Cassandra (hat tip Naked Capitalism). And the apparent collapse of Detroit’s bailout hasn’t helped. The risk that the much of the US auto sector might be pushed not just into Chapter 11 (I sure hope they have contingency plans ... so any restructuring is fast) but could spiral into liquidation cannot be good for the dollar. Ford, GM and Chrysler still do make significant numbers of vehicles for sale in the US. If a couple of them end up liquidating, the US will either end up buying fewer cars or importing more cars. And over the longer-term, a weaker dollar would be needed to induce European and Japanese manufacturers (or any new electric car start-up) to produce vehicles for the US market in the US -- or to generate the additional exports the US would need to pay for additional automobile imports. Many emerging market currencies have slid too. But at least one emerging currency also did reasonably well this week: Korea’s won. Korea has secured $48 billion in swap lines from Japan and China, adding to the $30 billion swap line it now has with the US. I rather suspect that when the network of Asian swap lines was first created, Korea viewed itself as a likely lender to weaker Asian economies not a likely borrower. But times have changed. Korea has managed to secure more cash through swaps this time around than it got from the IMF last time. China and Japan weren’t acting entirely altruistically though. The large northeast Asian economies don’t trade among themselves to the same degree that the large European economies do. But they do compete against each other in global markets. Won weakness wasn’t good for either Chinese or Japanese exporters. Pulling the won back up consequently will help reduce the yuan and the yen’s effective strength. The fact that Korea was able to obtain large quantities of dollars from others in Asia -- and that it did so with having to turn to the IMF -- illustrates how much the world has changed. At the same time, it is striking to me that the US provided more than either China or Japan and, well, the US doesn’t have many formal foreign currency reserves. So long as the world needs dollars in pinch, the US doesn’t need to hold all that many foreign currency reserves. The Fed has an unlimited ability to provide dollars against won (or other) collateral if it decides too. And that has meant that the US has played a far more central role managing the global aspects of this crisis than I would have expected six months ago -- At the same time, the US isn’t the world’s only large source of dollar liquidity. Korea has obtained almost $50 billion -- far more than it ever actually borrowed from the IMF and the World Bank in 1997 and 1998 -- without going to Washington. And that is an important change. UPDATE: The Treasury isn’t going to let Detroit fail, at least not just yet. The TARP will undergo yet another incarnation.

Vietnam’s stock market has plunged and its economic growth has dwindled since 2006, when it was seen as a model for emerging country growth. The country’s experience highlights the problems confronting emerging markets in the 2008 financial crisis.  

Tracy Alloway of the Financial Times’ Alphaville blog -- echoing Robert Sinche of the Bank of America -- thinks that spending reserves to defend your own currency and support your own banks is a form of economic nationalism. Funnily enough, I always thought that building up reserves through thick and thin -- and accumulating more reserves than a country ever needed for its own financial stability -- was a far more egregious example of economic nationalism. A country that only adds to its reserves is presumably pursuing a policy of intentionally holding its currency below its equilibrium value in order to support its export sector. A country like China isn’t just accumulating reserves because it enjoys financing the US, UK and many European governments at low rates .... The tone of the the FT’s excerpts of the Bank of America report suggest that a country that sells its reserves to support its own economy hurts the global economy. Not true. It may drain liquidity from some parts of the financial market, but the sale of reserve assets finances policies that add liquidity (so to speak) to parts of the goods market. Reserves are meant to provide a buffer against external shocks. And right now a host of emerging economies are facing a major shock. Remember, a country that is selling its reserves is trying to keep its currency from falling. That means it is trying to keep the price of the world’s goods in its market from rising -- and in so doing, it is keeping demand for the world’s exports up. And a country that draws on its reserves to make up for shortfall in export revenue is substituting the sale of foreign assets for a fiscal contraction -- a contraction that would subtract from global demand growth. Suppose for example Russia stopped intervening, let the ruble depreciate, didn’t bailout its banks (so they defaulted on their foreign debt and couldn’t finance domestic firms) and budgeted for $40 a barrel oil next year. Russian imports would collapse. That would have a big impact on Europe’s exports. The UK doesn’t make all that much these days, so this shift would hurt Germany more than the UK. But just because it helps some countries (and sectors) more than others doesn’t meant that the world doesn’t gain when a country draws on its own reserves to avoid a major contraction in demand. Indeed, if -- and it is a huge if (see below) -- private savings and investment do not change as a result of the government’s decision to run a bigger fiscal deficit, selling foreign assets to make up for a shortfall in say oil export revenue and to finance a budget deficit leads directly to a larger current account deficit and more demand for the world’s goods. It isn’t a beggar-thy-neighbor policy. Nor does it necessarily mean that the US and others won’t be able to finance large fiscal stimulus. Remember, the big if -- a rise in the fiscal deficit only leads to a rise in the external deficit if private savings and investment do not change, so the extra call on savings from the deficit has to be met by the world. And right now private savings and investment patterns are changing -- particularly in the US. Goldman forecasts private sector in the US will go from rough balance in q2 2008 to a large (10% of GDP) financial surplus by the end of next year. That means private savers in the US will be in a position to lend to the US government. Some money that say would have been spent on a Toyota instead will be lent to the US Treasury. In this case, the rise in the fiscal deficit will offset a rise in private savings and fall in private investment, allowing the US current account balance to improve even as the fiscal deficit expands. And in the off chance the emerging world spends so much that demand for US exports prevents a large US slump, the US wouldn’t need such a large stimulus in the first place. Bottom line: the US and Europe need emerging markets to buy their goods at least as much as they need emerging markets to buy their bonds. Consequently, a fall in central bank demand for US Treasury bond is no bad thing if it is the product of a set of policy choices that increase demand for US exports. Changing the basis of global growth requires, well, change. One technical note: foreign exchange reserves cannot directly be sold off to finance a fiscal deficit most of the time. Fiscal deficits are usually financed by selling off domestic bonds -- and only indirectly put pressure on the balance of payments as higher spending (or lower taxes) leads to more demand for imports. Foreign exchange reserves can only directly be used to cover an external financing need. But if a country has grown accustomed to financing a high level of domestic spending (and an associated high level of imports) with the government’s revenues from commodity exports, reserves can substitute for a shortfall in the government’s export revenues. This gets to the difference between central bank reserve purchases through intervention in the foreign exchange market (China) and Treasury reserves accumulated through saving the revenue from a commodity windfall. If the Treasury has lots of foreign assets on deposit at the central bnk, the Treasury can withdraw some of its foreign exchange, sell it to the central bank for domestic currency and draw on its external assets (rather than issue domestic liabilities) to cover a fiscal deficit. Fiscal spending in turn leads to higher demand for imports, and thus a current account outflow that reduces the central banks foreign exchange reserves: for example, government employees looking to buy the world’s goods may sell domestic currency for foreign currency. The overall result is a fall in the country’s overall foreign exchange assets, not just a shift in ownership of the foreign asset from the Treasury to the central bank. Apologies if this is confusing; of all balance of payments concepts, the way Treasury foreign assets can be used to cover a fiscal deficit is one of the more difficult.

CFR’s Latin America Studies Program outlines the implications of the global financial crisis for Latin America.

CFR Senior Fellow Adam Segal writes that India may be better positioned for a quick recovery from the global financial crisis than many other developing countries.

At least for Russia. And probably for a host of emerging economies. Russia’s reserves fell by over $30 billion during the third week of October -- tumbling from $515.7b on October 17 to $484.7b on October 24. Roughly $15 billion of the fall reflects the fall in the dollar value of Russia’s euros and pounds. But about $15 billion reflects Russian intervention in the currency market, as well as the drain on Russia’s reserves associated with the loans Russia’s government is making to Russian banks and firms seeking foreign exchange to repay their foreign currency debts. A $15 billion weekly outflow is rather large. $15 billion is as much as the IMF committed to lend Russia back in 1998. And the IMF actually only disbursed a third of that total. The most the IMF ever actually lent out to a single country in the past was roughly $30 billion (to Brazil, in 2002-03). At the current rate, Russia will run through that much in two weeks. The pace of decline in Russia’s reserves is partially a function of the fact that Russia had so many reserves back in July. Countries with less money in the bank tend to husband their scarce resources rather than spend them liberally. A lot Russia’s reserve buildup reflected private inflows rather than the oil surplus, so in some sense Russia’s government is just facilitating the reversal of those flows. In the process, of course, the Russian state is helping out some of Russia’s biggest businessmen. Russia’s state will likely end up controlling a broader swath of Russia’s economy at the end of the "deleveraging" process. But the pace of decline in Russia’s reserves is also evidence of the scale of the reversal in capital flows to emerging economies -- and the pace of the current outflow. More money is probably leaving Russia than is leaving other countries, as Russia has some uniquely Russian vulnerabilities that other emerging economies lack. But even if Russia is at one end of the distribution, it certainly isn’t atypical ...

Today the Federal Reserve indicated that it would swap US dollars for Brazilian real, Korean won, Mexican pesos and Singapore dollars -- effectively allowing a select group of emerging economies to borrow dollars on terms similar to those available to the G-10 economies. Or almost similar terms. The G-10 central banks can currently borrow dollars from the Fed without limit; the four selected emerging market central banks can only borrow $30 billion each. But $120 billion is real money -- and if need be, the the size of these swap lines conceivably could be increased. This move goes some way toward breaking down the line between the G-7 (really G-10) economies and emerging economies that emerged after the G-7 countries guaranteed that systemically important financial institutions in their economies wouldn’t be allowed to fail and the Fed expanded the scale of the swap lines available to European economies whose banks had a large need for dollars. Those moves reduced the risk of lending to another bank in the G-7 (or G-10), but increased the (relative) risk of lending to a bank outside the G-10. German banks needing dollars could get dollars from the ECB, which could get dollars from the Fed. Korean banks had no such luck. Change has come to the IMF as well. The IMF used to be in the business of providing tranched, conditional loans. And for a long-time the stated goal of fund policy was to return to the funds traditional lending limits (for geeks, 100% of quota in a year, 300% of quota over the life of the program). Now it is willing to lend to some countries unconditionally. And to provide up to 500% of quota upfront. Today’s IMF press release: The new facility, approved by the IMF’s Executive Board on October 28, comes with no conditions attached once a loan has been approved and offers large upfront financing to help countries restore confidence and combat financial contagion. "Exceptional times call for an exceptional response," said IMF Managing Director Dominique Strauss-Kahn. "The Fund is responding quickly and flexibly to requests for financing. We are offering some countries substantial resources, with conditions based only on measures absolutely necessary to get past the crisis and to restore a viable external position," he said. That’s change. There was a time when it was fairly standard to argue that the financing that the Fund provided was almost incidental to the success of a Fund program. The conditions were what really mattered. Now, for at least a subset of countries, the Fund thinks all that really matters is money. The Fund cannot be a true global lender of last resort so long as it only has $200 billion to lend. Arend Kapteyn of Deutsche Bank noted recently that emerging markets have about $1.3 trillion in short-term external debt (with over $800b owned by emerging market banks) -- a sum that far exceeds the Fund’s resources. But even if its lending is constrained, the Fund can provide financing in way that resemble the financing made available by a traditional lender of last resort. That is the right move. I agree with Dani Rodrik. The scale of the current crisis demands innovation. There are also a set of countries that need more than money -- as current account deficits that could easily be financed when leverage was readily available and leveraged players sought out risk are not going to be financed in today’s environment. That requires adjustment, not just financing. Deciding who belongs where will be a challenge. Demand for unconditional financing likely will exceed supply ... in part because some demand will come from countries that need conditional financing. One other point, or perhaps two -- on the potential geopolitics of today’s moves. First, all the countries that got access to the Fed’s swap lines are US allies, and all except Singapore are democracies. Russia may be part of the G-8 but it is outside of this club. Second, it has been fashionable to argue that the crisis would increase China’s financial influence -- as China sits on a ton of foreign exchange and potentially offered an alternative source of foreign currency liquidity. Indeed, China seems keen on doing a deal with Russia that would help Russian state-owned energy firms raise foreign exchange to help cover their maturing external debts -- and the in the process, help reduce the drain on the government of Russia’s foreign exchange reserves. But so far the crisis hasn’t had that effect -- in part because the US and Europe have moved quickly (by the standards of governments) to help a broad range of countries meet their foreign currency needs. That was driven first and foremost by the needs of the emerging economies -- and the ripple effect their deepening trouble would have on the US and Europe. But I wonder if the possibility that institutions like the IMF could be bypassed if they didn’t respond more quickly and creatively than in the past didn’t help to spur the recent set of policy changes. Those in the IMF’s Executive Board who normally would object to unconditional lending didn’t block the new short-term lending facility -- perhaps at least in part because of recognition that the IMF potentially isn’t the only game in town (or in the world). China’s rise, in effect, contributed to the a change in the political climate that helped to lift some of the political constraints that in the past limited the IMF’s scope. I certainly didn’t anticipate this. Three months ago I was among those thinking that the rise of the emerging world’s reserves would reduce the IMF’s future relevance.

Alan Ruskin argues that the moves in the foreign exchange market today -- with the dollar and yen rising sharply against nearly everything -- reflect an unwinding of bets made on the assumption that the world economy would remain strong and market volatility would remain low even as the US slowed. The dollar’s rise since July is part of a reversal in longstanding investment trends that prevailed during years of plentiful borrowing, strong growth and low financial-market volatility. "Essentially, every large trade that built up a head of steam in the go-go years has blown up or is in the process of blowing up," wrote Alan Ruskin, chief international strategist at RBS Greenwich Capital, in a report to clients. "That goes for almost every asset class." That seems more or less right to me. Crises have a way of clarifying what happened in the past. I think it is now clear that the scale of emerging market reserve growth from the end of 2006 to q2 2008 should have been a leading indicator that a lot of investors -- probably too many -- were betting that emerging markets (and indeed the world) could continue to grow rapidly even as the US slowed. Reserve growth was running well in excess of the emerging world’s current account surplus, as private capital was flowing into the emerging world in a big way. The IMF data indicates that private flows to the emerging world in 07 and the first part of 08 ($600b a year in 2007 -- over twice the average pace of 04-06; see table A13 of the IMF’s WEO) were well above the levels seen before the 97-98 crisis. Those capital flows -- plus very low real interest rates, as many emerging markets followed the US rates down even though they were still booming -- helped fuel surprisingly strong global growth even as the US slowed. The US actually wasn’t driving global demand growth over the last two years. Europe and a few booming emerging economies were. The world did decouple. Energy prices certainly decoupled from the trajectory of US demand. But only for a while. In retrospect, large inflows to the emerging world - and expectations that emerging currencies were generally on an appreciating trend, making it safe to borrow in foreign currencies (or sell insurance against a large depreciation of an emerging market currency) led investors to take on a lot of risk. Consider for example the rise in borrowing from global banks by many emerging markets (documented by my colleagues at the Council’s Center for Geoeconomic Studies) over the past few years. The fuel for the current market fire was there. I still never would have experienced that the emerging world could experience a sudden stop like it is experiencing now while it was still running a large aggregate current account surplus. Particularly after most emerging markets had built up rather substantial reserves. Both should have helped to buffer against a huge swing in market sentiment, at least in aggregate. I haven’t done a detailed analysis, but my sense is that the scale and pace of recent market moves -- and in all probability the scale and pace of associated capital flows -- is comparable to the Asian crisis of 97-98. Faster perhaps. That is scary. The leaders of the G-20 countries will have plenty to talk about when they meet in the middle of November. UPDATE: I added Jim Reid’s line about the "globalization of the credit crunch" to the post’s title after posting it. I like the phrase. Reid is a credit strategist at Deutsche Bank.

Some emerging market central banks have noticed that they – unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank – don’t have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve. Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes: Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. “In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility” says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ. Think of Korea. There is "a shortage of dollars in the Korean banking system" – and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won. For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7’s importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks – dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed. Banks in emerging market countries have no such luck. Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn’t part of the G-7 (or G-10) and doesn’t have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves – and its government’s capacity to borrow dollars in the market – to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China. The old global architecture for responding to financial crises had, in my view, two essential components: First, the major countries themselves were responsible for acting as the lender of last resort (and the bail-outer of last resort) to their own domestic financial system. Since the advanced economies banks’ had liabilities denominated in their own countries’ currency (US bank deposits are in dollars, British deposits are in pounds, and so on) this wasn’t hard. And emerging economies had to turn to the IMF (sometimes reinforced with “second line” financing from the G-7) for dollar (or DM or pound or Euro) financing – whether to help meet their government’s own financing need, to help the emerging economies’ central bank provide a “hard currency” lender of last resort to its domestic financial system or to provide the emerging economy more foreign currency reserves to backstop its currency. And since emerging market governments often borrowed in dollars or euros rather than their own currencies – and since many emerging market savers held dollar or euro denominated domestic deposits – emerging economies often had a need for significant financing. This financing though was never unconditional – and was never unlimited. The $35b the IMF lent to Brazil in 2002 and the $20-25b the IMF lent to Turkey in 00-01 seemed big at the time, but it now seems small. That architecture has been extended in one key way in the crisis: European and Japanese banks facing difficulties refinancing their dollar liabilities now have (indirect) access to the Fed. The availability of $450b in credit from the Fed allowed European central banks to lend dollars to their banks without dipping into their (comparatively modest) reserves. Emerging market central banks generally haven’t been as lucky. Their ability to lend dollars to their own banks is still limited by their own holdings of dollar reserves, their ability to borrow reserves from the IMF in exchange for IMF policy conditionality and their ability to borrow dollars from other emerging market economies with spare dollar reserves. I am still trying to figure out how important a change this is – and to assess whether this new architecture makes sense for a global financial system that has changed fundamentally in some ways but not in others. At one level, the stark divide between banks regulated by a the G-10 countries -- which now have access to the Fed as a lender of last resort, albeit indirectly -- and the banks regulated by the rest of the world seems a bit anachronistic. The center of the world economy won’t always be in the US and Europe. On another level, a higher level of cooperation is possible among countries with broadly similar political systems than among more diverse group of countries with different political and economic systems. Similar forms of government, broadly similar (though changing) conceptions of the state’s role in the economy and a standing political alliance* facilitate the kind of cooperation among G-10 central banks that we have seen recently. Korea could presumably be drawn into the club without changing its basic character – Korea is a US ally and a democracy. Iceland could too, if it patches up its relationship with the UK – though the risk that Iceland’s government now has more debt than it can pay makes accepting Icelandic collateral in exchange for dollars a bit more of a problem. Adding emerging economies with different economic and political systems from the G-7 countries into the "swap line" club might fundamentally change its character. Among other things, the US and Europe basically agree that their currencies should float against each other -- and that they should regulate (or, until recently, not regulate) their financial systems in fairly similar ways. There is another key difference between European banks’ need for dollars and many emerging markets’ need for dollars. European banks need dollars to finance their holdings of US mortgages and other US securities. If they didn’t have access to dollar financing, they would either have to borrow euros and buy dollars – pushing the dollar up (and hurting US exporters) or they would have to dump their US assets (hurting US banks holding similar assets). By lending to European central banks who then lent to their own banks, the US kept some European banks from being forced sellers of risky US assets – and in the process putting pressure on US banks. The US wasn’t acting entirely altruistically. Emerging market banking systems by contrast often need dollar financing not to support their portfolios of US assets but to support their domestic dollar lending. And it is now clear that a broad range of emerging economies do need access to the international banking system to continue the kind of breakneck growth that they have experienced recently -- and have been caught up in the recent "deleveraging" of the global financial system. The FT’s Garnham again: Analysts said emerging market currencies were being hit as foreign investors pulled money out of developing regions, driven by liquidity pressures from the credit crisis. "There seems little now that the authorities can do to reverse the process of deleveraging that is taking place with financial institutions all contracting their balance sheets at the same time," said Derek Halpenny, at Bank of Tokyo-Mitsubishi. Hungary is scrambling for euros. Ukraine’s government is scrambling for dollars and euros – both to back its currency and to cover the maturing foreign currency borrowing of its banks. Pakistan’s government needs dollars. Korean banks are scrambling for dollars. As are Russian banks. And Kazakh banks. And Emirati banks. In many of the oil exporters, the government was building up foreign currency assets (reserves, sovereign wealth funds) while the private sector (including many firms with close ties to the government) were big borrowers from the international banking system. In the Emirates there is an added complication: Abu Dhabi was the emirate building up its external assets, while Dubai was the emirate doing the most borrowing. But across the emerging world, external bank loans have dried up – creating a scramble for foreign currency liquidity. And emerging markets (and Iceland) are looking for help from a range of sources. Their own central banks’ reserves (Korea, Russia, the Emirates) – or the foreign assets of their sovereign fund (Russia, China, Qatar, Kuwait, perhaps Abu Dhabi).*** The IMF, which is clearly back in business. European central banks (Hungary borrowed 5 billion euros from the ECB, the Nordics swap line with Iceland -- which was recently tapped for euro 400 million). Russia (if it lends to Iceland). Or China. Pakistan was certainly hoping that China would offer an alternative to the IMF; China though does not currently seem to be willing to hand Pakistan a sum that is equal to a couple of days of its reserve accumulation … . This frantic activity suggests another potential change to the global architecture for responding to crises: the IMF no longer necessarily has a monopoly on hard currency crisis lending to the emerging world. It is now one player among many. That is a fundamentally a reflection of the increased reserves of many large emerging economies. China clearly has more dollars than in needs to maintain its own financial stability, which means that it is an alternative source of dollar financing. Russia may be too – though the large dollar and euro liabilities of Russian banks and firms implies that its own need for reserves could be quite large. It isn’t in as comfortable a position as China. The diffusion of pools for dollar liquidity available to lend to troubled emerging economies seems at least to me to pose a fundamental issue for the G-7 countries that traditionally have been able to essentially decide on how the IMF’s funds are used among themselves: does the diffusion of financial power a major effort to bring the big emerging powers into the IMF’s fold – and thus to restore a de facto IMF monopoly on large-scale crisis lending? Or would the cost of any “deal” that would lead that countries like China and Russia and Saudi Arabia (which already has a large IMF quota) channel their lending through the IMF prohibitive? The right answer isn’t clear to me. On one hand, granting the new players significantly more votes might make it next to impossible to build consensus in the IMF – and even a generous increase in the voting weights of key emerging economies might not be enough to convince them to channel their “crisis” lending through the IMF. China might not want to give up on bilateral lending in exchange for say 15% of the IMF’s voting shares. On the other hand, China hasn’t been keen to throw its reserves around over the past few weeks – preferring the safety of Treasuries to Agencies (or a dollar deposit in Pakistan’s central bank) – and might prefer conditional IMF lending to the risk of losing its funds … For now it seems to me that the crisis likely has increased the gap between the G-7 (and G-10) countries and the rest of the world in a couple of key ways. Inside G-7 land, US banks could lend in euros (and European banks lend in dollars) secure that they had access to a lender of last resort – and the G-7 countries would still be in a position to offer hard currency loans to their “out-of-area” friends through the IMF. Outside G-7 land, countries would rely primarily on their own foreign currency reserves to cover the foreign currency liabilities of their banks – and potentially could use their own reserves to finance their crisis lending to other troubled countries.** In some ways, that is a world where the gap between the G-7 countries and the rest would gets larger not smaller … * Switzerland is an exception; it stands outside the “Western’ alliance but has access to the swap lines. But the Swiss have long been a big part of central bank cooperation – Basle and all. ** This leaves aside a key issue, namely the fact that countries outside the G-7 provide enormous quantities of unconditional dollar financing to the US through the buildup of their reserves. That reserve growth is partially a function of the need for countries outside the G-7 world of reciprocal swap lines to hold a lot more foreign currency – but it is also a function of these countries ongoing policy of pegging their currency to the dollar at an undervalued level. It also ignores the debate over whether sovereign funds investments in the US and European banks should be considered private investments for profit, or part of the global policy response to the crisis. *** SWF Radar has been invaluable in tracking the use of sovereign funds to support domestic banking systems; many of my links are drawn from there.

Iraq’s finance minister asserts his country does not have a surplus of funds and expresses concern about the potential impact of the global financial crisis, and falling oil prices, on Iraq.

Joanna Slater of the Wall Street Journal notes that many countries that were resisting pressure for upward appreciation are now selling dollars to defend their currencies. I very much agree with the quote from Lisa Scott-Smith: Earlier this year, many governments in emerging markets were worried that their currencies were too strong, partly because foreigners kept plowing money into their economies. Since then, investor sentiment has shifted sharply. Fears of inflation have combined with worries over a world-wide economic slowdown. Commodity prices have fallen, bad news for countries that export everything from oil to metals, and the U.S. dollar has mounted a powerful rally. In some cases -- like Russia, Thailand and Pakistan -- turmoil at home or nearby has spurred further unease. As investors retreat from places they used to favor, many of them emerging markets, it creates a new worry for central banks in these countries. When too much capital was flowing in, their main problem was that such flows put upward pressure on their currencies. A stronger currency makes exports more expensive abroad, harming trade competitiveness. To curb currency appreciation, central banks would buy dollars, and that led to a large accumulation of reserves. Now "that is unraveling the other way," says Lisa Scott-Smith of Millennium Global Investments, a London currency manager with $13 billion in assets. With investors unloading local stock and bond holdings, central banks find themselves "on the other side of the trade, trying to smooth currency weakness instead of strength." As Slater’s article notes, I expect emerging market reserve growth to slow from a level that was well above the emerging world’s current account surplus to a level that is more in line with the emerging world’s surplus. It might even dip below the emerging world’s combined surplus for a bit, as some of the money that went in earlier comes out. In some cases the pace of the reversal in flows has surprised me: I would have thought that high levels of reserves in the periphery might damp down volatility a bit more. A couple of bits of data will be key to understanding how strong this shift is: China’s July and August reserve growth And Saudi Arabia’s reserve growth for those months. Both still have a large trade surpluses, so there should still be an underlying dynamic of reserve growth. But the pace of their reserve growth likely has slowed in line with broader moves in global markets. Speaking of Saudi Arabia, let me recommend Robin Wigglesworth’s reporting on Saudi Monetary policy. Wigglesworth reports that the unwinding of speculative bet on the riyal has created a cash squeeze in Saudi Arabia -- pushing up local interest rates. And it so happens that the Saudi Monetary Agency is quite happy to see rates rise, as they want to cool lending to help curb inflation. Earlier this year, funding costs in the interbank market were subdued by international capital inflows. Local currencies had slumped due to their peg to the dollar, and ambiguous comments from some central bankers around the turn of the year led international banks and hedge funds to bet on currency revaluations to help curb inflation. This helped to subdue borrowing costs for regional financial institutions, but also led local banks to ignore the need to build deposits to match hyperactive lending. The dollar’s rally this summer also increased the value of Gulf currencies such as Saudi’s riyal, cutting the cost of imports and easing pressure on authorities to revalue their dollar pegs.International banks therefore started to reverse speculative revaluation bets, withdrawing local currency deposits and draining away capital that had helped keep spreads between the money market and benchmark rates low. Subsequently, Gulf banks have had to turn to local money markets to finance lending, causing interbank rates to climb far above the central banks’ benchmark interest rates. Rather than try to ease the liquidity squeeze, authorities have welcomed more expensive funding costs in the fight against inflation, even abetting it in the case of Saudi Arabia. Interesting. Reports of capital outflows from the Gulf suggest that Saudi reserve growth won’t be quite as high as one might expect based on the price of oil in July and August. The Saudis also seem have a bit more monetary autonomy when money is going out than when it is coming in -- as they can allow the outflows to push up rates. Even so, I fully agree with an anonymous Treasurer at a Gulf bank: "the monetary policy appropriate for the faltering US economy is far from ideal in the Gulf, which has other concerns. Inflation and credit growth are soaring, but “we have monetary policies as if we were in a recession”, says the head of treasury at a top Gulf bank. Pegging to the dollar isn’t quite as painful when the dollar is rising, but the dollar is still a poor fit for the Gulf’s economy. The Gulf would benefit from a currency that moved in the same way as oil -- not one that often moves in the opposite direction.

Korea’s reserves fell by about $10 billion in July -- a bigger fall than in November 1998,* at the height of Korea’s crisis. Korea, of course, has WAY more reserves now. It can afford to intervene heavily -- as it clearly did earlier this month. The release of its reserves data just confirms something that the FT, among others, have already reported. Indeed, the reported fall in Korea’s reserves was a bit smaller than the $15 billion some expected. Some estimates even put Korea’s July intervention at close to $20 billion. The fall in Korea’s reserves though highlights an important shift: many Asia’s currencies have decoupled from the Chinese yuan. There is still pressure on the yuan to appreciate,and China is still buying a lot of dollars to keep the CNY from appreciating. But a lot of other Asian countries are now selling dollars (and euros) to keep their currencies from falling. This is a shift. In 2005, 2006 and 2007, most emerging Asian economies (Japan is different story) faced pressure to appreciate. Most were adding to their reserves. And many had currencies that appreciated faster than the Chinese yuan. That was even true in the first couple of months of this year, when countries like India and Thailand were all buying dollars to keep their currencies from going up. Now, these countries -- and countries like Korea that didn’t face the same pressure to appreciate earlier in the year -- are all intervening to keep their currencies from falling. And for the first time in a long time, their currencies aren’t going up faster than the Chinese yuan. Indeed, many emerging Asian currencies have depreciated against the dollar this year even as the yuan has appreciated. In 2006 and 2007, the slow pace of CNY appreciation was a constraint on faster appreciation elsewhere in Asia. Now, the depreciation of other Asian currencies seems to have become, if anything, a constraint on further appreciation of the yuan. So why have the fortunes of China’s currency and many other Asian currencies diverged? First, the appreciation of other Asian currencies over the past few years had real consequences. China has become India’s largest trading partner, largely because Indian imports of Chinese goods have soared. Second, and no doubt more important, the sharp increase in the price of oil has created far more strain on Asia’s "deficit" economies and on its "surplus" economies. Countries whose current accounts were balanced -- as well as countries that ran small deficits -- with oil at $70 a barrel are now running significant current account deficits. China will still run a large current account surplus even with oil at $120. The runup in the price of oil and other commodities has kept China’s trade surplus from expanding, but it has yet to bring it down in a significant way. Right now, China’s nominal current account surplus looks likely to be roughly constant in 2008. That could change if Europe slows dramatically, leading to a big slowdown Chinese export growth in the second half of the year and if -- even in those conditions -- commodity prices remain high. But as of now, other Asian economies have been squeezed far more than China by the rise in commodity prices. * Korea’s reserves would have fallen significantly in December 1997 as well if not for loans from the IMF and World Bank

Many emerging Asian economies -- Korea, India, perhaps some others -- are now intervening to keep their currencies up rather than trying to hold them down. Raphael Minder of the Financial Times reports: South Korean authorities on Tuesday sold as much as $1bn to shore up the won, according to currency traders in Seoul, underlining concerns in several Asian countries about weakening currencies in the face of oil-fuelled inflation ... South Korea’s predicament is shared by other Asian nations that have seen an abrupt currency reversal compound inflationary pressures as oil and food prices remain near record highs. Other Asian central banks likely sold dollars as well. An Indian newspaper reports: " Central banks across Asia region likely to have intervened in the foreign exchange markets. The Bank of Korea, Bank of Thailand, Banko Sentral ng Pilipinas and Reserve Bank of India are all suspected to have sold US dollar to boost domestic currencies in order to contain inflation," Sherman Chan, Economist, Moody’s Economy.Com said." China, like many other emerging Asian economies, imports oil. but it otherwise is in a rather different position than many other Asian economies. The hike in oil prices has yet to put much of dent in its trade surplus. Its larger current account surplus is expected to remain constant in dollar terms this year. And its central bank is still buying dollars, not selling dollars. If the latest leaked data is accurate, China reserves increased by $40 billion in May. I would estimate that China bought about $44 billion in the market, after adjusting the $40 billion total to reflect a slight fall in dollar value of China’s exiting holdings of euros in May. $44 billion (over $500 billion annualized) is a huge sum. But it likely leaves out another $22 billion that China’s banks accumulated, as China’s central bank continues to ask China’s state banks to meet their (rising) reserve requirement by holding dollars rather than renminbi. $66 billion -- almost $800 billion annualized -- is a very big number. It is a smaller than the $75 billion increase in China’s reserves in April -- a number that rises to $80 billion after adjusting for valuation gains and rises to above $100 billion if the April rise in China’s reserve requirement is factored in. Slowing down the pace of RMB appreciation in April (it has subsequently picked up somewhat) may have helped slow the pace of hot money inflows -- or China’s efforts to tighten the enforcement of its capital controls may have had an impact. But Michael Pettis is right. The overarching story is that China’s reserves and foreign assets continue to increase at a stunning pace. Throw in another $45 billion in June reserve growth, and the increase in China’s reserves -- after adjusting roughly for valuation effects -- in the first half of 2008 could approach $290 billion. I would round that up to $300 billion. That is roughly as much as India, the emerging Asian economy with the second highest reserves, has in the bank. Michael Pettis -- drawing on work by our mutual friend Logan Wright -- has estimated that China’s adjusted reserve growth in the first five months of 2008 was about $435 billion. To get that total, he assumed China transfered $75 billion to the CIC in q1 and that the banks have added $90 billion to their dollar holdings to meet their reserve requirement. China hiked its reserve requirement again in June. My own projections would net out some valuation gains in a way that would reduce the increase over the first five months of 2007 to around $410 billion. But that is still an absolutely huge number. It consequently isn’t unrealistic to project that China’s adjusted reserve growth for the first half of 2008 could be close to $500 billion. Then double that number. The 2008 increase in China’s reserves, bank reserves and CIC could match Japan’s total stock of foreign exchange reserves. And not so long ago most people thought Japan had a ton of reserves.