Emerging Markets

Or, for that matter, Icelandic krona and Turkish lira … Borrowing at 1%, maybe less, in a depreciating currency, and buying an appreciating currency that pays 12.4% or so is pretty good business.  The Turkish lira pays more 20% , as does the Icelandic krona (14.25% -- Kaupthing Bank has a nice description of the yen funded krona carry trade).  But they are a bit more volatile – for a comparison of BRL and YTL volatility last year, see the last two charts of this presentation.    And since last July, it is has been really good business.     The 2 and 20 crowd doesn’t even need to use that much leverage on yen funded carry trades in the Brazilian real, Turkish lira or Icelandic krona to maintain their position at the top of the income distribution.    That kind of spread works with real money.  Or if you finance it with low-yielding Latin currencies rather than yen ... My colleague Victoria Saddi has noted that Brazil seems to have attracted $10b in portfolio inflows in January alone, judging from the balance of payments data.  It attracted $14b in all of 2006 (There was a little sell off in May and June that slowed things down). Brazil’s reserves increased by over $5b in January.   That is a $60b annual pace.   $60b is huge.  It is about twice what the IMF provided back in 2002 - funds that in all probability kept Brazil from a messy default. Moreover, the pace of reserve growth seems to be accelerating.  There are press reports (in Portugese) that Brazil bought $2.5b in three days at the end of last week.  That is real money – almost China style money.    China has to buy about $1b a business day to keep the RMB down.    In the past couple of days, Bloomberg reports that Brazil's central bank bought around $0.5b a day.  That isn't quite China's pace, but relative to Brazil's economy, it is a lot.  The central bank's data, which lags just a bit, shows that Brazil's reserves are up $2b in the first few days of February.   No wonder State Street’s positioning data shows that an exceptionally large number of investors are betting on the Brazilian real.   Brazil’s government is understandably concerned that this inflow will push the real up too much, undermining Brazil’s competitiveness.  Sure, Brazil sells a lot of soy and a lot of iron ore.   But Brazil also makes goods that compete with Chinese goods – and, for that matter, Argentine goods.   And while high inflation is pushing up the real value of the Argentine peso (despite nominal exchange rate stability), the same cannot really be said of China.    The real has been appreciating v. the yuan. But with market pressure for the real to move up, that means that the central bank is constantly buying dollars to keep the real from rising more.  In the process, it removes a lot of volatility from the market.    And then I suspect of a bit of reflexivity (to use a Soros term) kicks in.  Lower volatility makes carry trades more attractive.  Existing carry traders can gear up more without getting into trouble with their risk manager.  Others get pulled in.   That only adds to the pressure on the real.  And that only forces the central bank to intervene even more.  I did some work on Turkey a while back.   This is exactly what happened with the Turkish lira in 2005 and early 2006.  There was an extended period in 2005 and early 2006 when there was less volatility in the Turkish lira/dollar  than in the euro/ dollar.   That was the period when Turkish reserves were rising strongly.  That, of course, changed in May 2006 ….Brazil looks to be in a similar boat.  So long as the money is flowing in and the central bank is resisting appreciation, there won’t be much volatility.  And without much volatility, there is a big incentive to bring money in … The Brazilian carry trade was popular a year ago (Felix Salmon has the details).  it seems to be even more popular now.  No wonder there is now talk of doing a reverse currency swaps action to try to stem some of the pressure [Edit: the previous sentence should read "stepping up its use of reverse currency swaps," as Brazil has intervened in the future market for some time -- thanks to OC in the comments.  It seems like the Bloomberg story was a reference to an ongoing debate in Brazil over whether to do reverse currency swap auction on Tuesday to roll over a maturing swap.].  Brazil’s central bank sold a fair amount of insurance against the depreciation of the real back when that was a risk (in 1998, in 2002), helping to support the real in the spot market. It now seems to be considering doing more or less the opposite … But capital inflows of 10% of GDP are hard for most emerging economies to handle.   And $10b a month works out to a pace well above 10% of GDP for an economy of  Brazil’s size.   Outflows of 10% of GDP  caused the Argentine crisis of 2001 and the Turkish crisis of 2001.   Inflows of that side are a bit easier to manage, but only a bit. The US has a current account deficit of around 7% of GDP, so it needs that kind of inflows (though it would rather not pay Brazilian interest rates to get the money).   But for now, Brazil has a small current account surplus – so it doesn’t need the money.Remember, while investors are borrowing in low-yielding yen to buy high-yielding real, the Brazilians – whether the central bank or the finance ministry – are selling high yielding real debt to buy low-yielding dollars.   If every yen that comes into Brazil is bought by the central bank and used to buy dollars, well, the net result is a yen funded purchase of US treasuries.   That is the net global flow.   The 2 and 20 crowd gets the interest rate on the real and the yen/ real risk.   The Brazilian central bank pays the interest rate in real and gets the interest rate on dollars and the dollar/ real risk. And whenever someone feels forced to take a losing hand, they just might consider changing the rules of the game.   I don’t quite see how Brazil can sustain this level of intervention.The PBoC has positive carry and massive exchange rate risk.   The BCB has negative carry and still quite a bit of exchange rate risk.

Argentina apparently bought $2.1b in the foreign exchange market over the past three weeks.  Brazil – if you are keeping tabs – bought around 3.65b.   The southern cone seems to have joined Bretton Woods 2 … I spent most of 2001 working on Argentina in one way or another, and I never thought I would see the day when Argentina added $2b to its reserves in a month, let alone is on track to add well over $2b.   Just to put this kind of inflow in perspective, in 2001, Argentina lost $20b of reserves (net of IMF lending) through the course of the year.  That works out to an average monthly reserve loss of well under $2b.Some of Argentina’s reserve growth comes from its trade surplus – this is the time of the wheat harvest in the southern hemisphere, and wheat is kind of high right now.  The country that Paul O’Neil famously said couldn’t export ran a $12.5b trade surplus in 2006   But some presumably comes from capital inflows.  Investors may be worried that Ecuador is about to "pull an Argentina," but they don’t have similar worries about Argentina.   At least not now. Incidentally, it is a bit unfair to attribute Argentina’s default to Kirchner.  He wasn’t the President back in 2001.  He is, by contrast, the one responsible for Argentina’s decision to stay in default for an extended period of time and to demand a deep haircut from Argentina’s creditors.  He put the government of Argentina on a course where it had little need to borrow from global markets to finance ongoing fiscal deficits.One of the things that has most surprised me over the past few years is just how willing countries that don’t exactly see eye to eye with the United States have been to finance the US by building up their dollar reserves.   That applies to countries liek Argentina that have a somewhat different view of economic policy than the US and countries like Venezuela that have a very different view of economic policy than the US.  Venezuela apparently still has 80% of its reserves in dollars, even they aren’t held onshore in the US for political reasons.  That applies to countries like China and Russia, which seem a bit more keen on "bureaucratic" capitalism and state control than US, aren’t so keen on little things like democracy and presumably have a slightly different conception than the US of the world’s future geopolitical order.  And it applies to the various sheikdoms in the Middle East, which presumably have a very different vision of the “new Middle East” than the Bush Administration.

If I am doing my math right, Chinese citizens added RMB 4.83 trillion (around US$ 620b at 7.8 RMB to the dollar) to their RMB-denominated bank accounts over the course of 2006.   It seems like more and more Chinese are putting their savings in the bank (rather than holding onto cash) at a time when the PBoC is injecting a lot of "liquidity" into the local economy.  During that same time Chinese citizens reduced their holdings of domestic dollar deposits by RMB 0.033 trillion (around US$4b) even though dollar interest rates exceed RMB interest rates.   Not exactly strong evidence that Chinese private savers are desperate for dollars … China is trying to restrain domestic Chinese investment in its frothy domestic stock market even as it loosens restrictions on capital outflows and tightens restrictions on capital inflows.  Domestic Chinese savers just don’t seem that keen on keeping the dollar share of their portfolio constant.   Come on guys, trendy modern economic theory says that a falling dollar is a reason to increase your dollar holdings – and the out-performance of the Chinese stock markets is a reason to increase your holdings of US stocks.  Get with the program!China’s banks haven’t been able to match their surge in deposits with a surge in lending.  If my math is right, Chinese bank loans increased by RMB 3.18 trillion (around US$ $405-410b) in 2006.   But don’t blame the banks.  They were more than willing to lend out their surging deposit base.  The central bank just wouldn’t let them. And if any one can provide a detailed accounting of what China’s banks did with the RMB 1.65 trillion (around US $210b) that they didn’t lend out, I am all ears …  Some of it is on deposit with the central bank as a result of rising reserve requirements, and some has been used to increase the banks holdings of PBoC sterilization bills.  I also wouldn’t be surprised if some RMB has been swapped with the central bank for dollars … but that is just a hunch.It probably isn't a coincidence though that the gap between the banks deposits and te banks lending roughly matches both China's fx reserve growth and its current account surplus.  The savings of the good burghers of Shanghai that are not being lent out in China are being lent to the US, with a bit of help from the central bank.China, incidentally, isn’t atypical.    Brazilian private savers haven’t been willing to shift enough money out of Brazil to offset foreign demand for Brazilian real-denominated assets (and Brazil’s own current account surplus).    That is why Brazil’s reserves are rising rapidly.  They were up $32b in 2006.And Russian savers also seem increasingly willing to keep their savings in Russia.   Russia just released its (preliminary) 2006 balance of payments data.    Its reserves (flow basis) are up by $107.5b, more than its estimated $95.6b current account surplus.  But that isn’t all.   The government repaid $29b in debt, and the central bank repaid another $7b.   Combine the fall in Russia’s debts with the rise in the central bank’s assets, and Russia’s government generated a net $143.5b outflow. That implies large net private inflows into Russia.And they aren’t that hard to find in the balance of payments.   Net inflows to Russian banks totaled $25b in 2006, up from $6b in 2005.  Net FDI and portfolio flows totaled $27b in 2006, up from $0.5b in 2005.    No doubt some Russians are continuing to move their savings abroad (though increasingly they seem to be holding euros and pounds rather than dollars), but those outflows have been more than offset by private capital inflows. Ruble deposits in Russian banks are way, way up. Look at M2 growth.Indeed one of the big (underreported) stories of the past few years is how savers in emerging markets are increasingly willing to hold their savings in the local banking system in local currencies despite low nominal interest rates (China) or low nominal and negative real interest rates (Russia).   It has been better to get low returns in the local bank than to hold (depreciating) dollars.Foreign investors -- private investors that is -- have also been quite keen to put funds into emerging market financial assets.   That is the basic problem I have with all theories that attribute the uphill flow of capital to financial underdevelopment.  Right now, emerging markest don't seem to be having any trouble generating financial assets that their citizens want to hold, or that foreign investors find attractive.   The big outflows from the emerging market are all coming from ... drumroll please ... the official sector. 

I was not all that impressed by the “day after” coverage of  Thailand’s capital controls in the financial press.     Everyone initially looked for parallels to 1997 – and signs that the most recent bout of turmoil in Thailand could lead to a cascade of trouble in other emerging economies.  Most stories quite rightly noted that the risk of contagion much smaller this time around.  However, the overall tone of the coverage still often struck me as off.   The focus  was on the impact of  a new round of Asian contagion could have on American and European investment in emerging economies.   But parallels to 1997 were played up a bit too much without noting the enormous changes that have taken place since 1997.  The coverage today – particularly the Wall Street Journal’s reporting on the thinking of the Thais and the New York Times’ reporting on the pressures facing all Asian economies -- has been much better. But I still want to put forward my list of the key differences are between 1997 and today -- and note a couple of parallels that in my view haven't gotten enough attention.1/  Emerging Asia doesn’t need capital from the US, Europe or Japan.   That is a bit of an over-generalization, as there are some economies in emerging Asia that are running current account deficits.   But in aggregate, emerging Asian economies save more than they invest – and are net lenders to the rest of the world.    Thailand itself ran a current account deficit in 2005, but is on track for a significant surplus in 2006.  In aggregate, all the private capital that flows into emerging Asia is effectively lent back to the industrial world, whether by private investors, or, more often by central banks.   That is a key change from 1997. 2/  Private investors betting on a rise in the baht or won or renminbi are effectively betting against the central banks of these countries every bit as much as those who bet against the baht or won or rupiah did in 1997.    In 1997, central banks were intervening to keep their currencies from falling.    Speculators would say borrow baht, and then sell the baht to the Bank of Thailand for dollars – a bet that pays if the baht falls.     In 2006, Asian central banks are intervening to keep their currencies from rising.    Foreign investors have dollars and want baht.   And there is more demand for baht than demand for dollars in the private market.   That normally would lead the value of the baht to rise.   But right now the central bank often steps in, selling the baht foreign investors want and buying the dollars foreign investors don’t want.    That means that the central bank loses – and foreign investors gain – if Asian currencies rise in value over time.  The central bank also has to remove the baht it sold to foreigners from circulation (sterilization) to avoid too-rapid money growth, but that is a separate issue.  3/ As a consequence of (2), almost all Asian economies are looking to discourage foreign capital inflows in various ways while encouraging their own nationals to invest abroad.    Private investment abroad helps reduce the central banks need to step in to balance the market – there is more private demand for dollars.   Steps that discourage foreign inflows also help reduce the need for central bank intervention to balance the market.    Thailand is an extreme case.   But the same basic trend is clear in other countries.   Think Korea, Lone star and KEB.  Think of Korea’s efforts to make it harder for Korean banks to borrow funds from abroad -- though that is a policy designed to make it harder for the local banks to bet against the central bank.    Think of China’s evolving attitude towards foreign investment – and reluctance to change the existing de facto rule that basically makes it impossible for foreigners to come in and buy existing Chinese businesses.  Greenfield investment is still welcome, but probably a bit less welcome than before.  Think of China’s desire to liberalize controls on capital outflows – while tightening controls on inflows. The basic trend is pretty clear.  Most Asian economies do not particularly want more money to come in.   Asia already has more savings than it can invest at home -- it doesn't need the rest of the world's savings.   That is a change from 1996 and 1997.  Then many emerging Asian countries not only needed to borrow from abroad, but actively encouraged short-term foreign borrowing.  Thailand did so through the notorious Bangkok Interbank facility. The changed context means that investors are fleeing for very different reasons now.  In 1997, they were fleeing from a potential devaluation -- along with large pontential losses on foreign currency loans that local borrowers without export revenues (think office parks) couldn't repay.   On tuesday, investors fled policy measures designed to keep them from coming in the first place. There is a point here that is worth highlighting. The interests of players in the local markets are not necessarily the same as the interest of the central bank.    Thai stock brokers like a rising stock market as much as US stock brokers.  They hold baht and hold equities, and foreign inflows bid the value of both up.  The central bank, by contrast, is often left holding the dollars foreigners bring in.  It either buys the dollars or lets its currency be bid up.  And since the Thai central bank was intervening, it ended up being long dollars -- and short baht.  Which isn't fun if the baht is rising.Here I would say FT did a bit better job highlighting the key issue than others did on Tuesday.   The FT leader noted:  But given an exchange rate that has appreciated by almost twice as much against the dollar as its neighbours this year, in spite of rapid accumulation of foreign exchange reserves, the central bank obviously felt it had to do something. The FT argued that the market reaction to Thailand's controls will keep other central banks  from following Thailand’s path.    I would add that it hasn’t changed the fact that many other central banks still feel the need to do something. There is a fourth important point -- one that is in someways similar to 1997 and in other ways very different. 4/  Pegged exchange rates constrain policy choices.  In 1997, Asian countries with current account deficits were pegged to a dollar -- which at the time was rising v. the yen.   That didn't help.   Today Asian currencies with current account surpluses are pegged to a falling dollar.  Which also isn't helping.But there is a big change.  Back in 1997 and 1998, China's resistance to RMB depreciated helped the rest of Asia.  Right now, China’s resistance to faster RMB appreciation constraints the policy choices of all other Asian economies.  China’s government – through its central bank – offers buyers of Chinese goods a bigger consumption subsidy than the Thai government offers buyers of Thai goods.   Here, I would say press coverage has been very good.   Many economists – Roubini and Roach for example -- tend to be critical of American criticism of China’s peg on the grounds that American criticism of other countries lets the US off too lightly for its own economic sins.    The pot shouldn’t call the kettle black.     I increasingly think that this is a bit too Amerocentric a view of the impact of China’s peg.   China’s peg isn’t just a subsidy for a bunch of over-consuming Americans who wouldn’t save any way.   African textile producers, Brazilian leather goods manufacturers, Mexican auto parts makers, Thai auto producers, Eastern European machinery firms and  Malaysian electronics companies are impacted by the subsidy of the consumption of Chinese-assembled goods as much the machinery producers in the US Midwest and textile and furniture makers in the US south.    And the size of the subsidy China is offering Europe, Korea and Thailand for the consumption of Chinese goods is increasing more rapidly than the subsidy China is offering Americans for the consumption of Chinese goods.    The RMB is rising v. the dollar.   But it is falling v. a host of other currencies.   That matters.  I found it interesting that the research direct of China’s central bank criticized the Thais for not emulating China’s own macroeconomic policies.    Thailand’s mistake was letting the baht rise in the first place. Tang Xu, head of the research department at the People's Bank of China, suggested that the steep losses on the Bangkok stock market were due to a willingness by Thai authorities to let the baht rise too fast. (Lex has a nice chart illustrating the relative rise of different Asian currencies).  The Thais didn’t criticize the Chinese.  Rather today Thailand’s central bank governor joined China in criticizing the US.  The problem, according to the Thailand, is that the US isn’t doing more to help support the dollar – and thus is creating problems for a host of other countries.    Particularly countries that either peg to the dollar or countries that compete with countries that peg to the dollar! The NYT: The steep decline of the dollar is punishing Asia’s smaller economies and should be addressed by global financial regulators, the governor of the Thai central bank, Tarisa Watanagase, said Wednesday. As the Thai stock market rebounded from a record one-day drop of 15 percent, closing up 11 percent Wednesday, Ms. Tarisa defended the government’s abortive attempt to block short-term foreign investment, portraying Thailand as a victim of the huge imbalances in trade and savings that send trillions of dollars sloshing in and out of developing economies. “This is not a problem unique to Thailand,” Ms. Tarisa said in an interview. “I’m sure that if this sort of problem is not cured in a cooperative manner, we could see similar measures elsewhere.” That suggests a fifth point, one that has some parallels with 1997 though the context has totally changed. 5/ Asia and the US increasingly disagree on macroeconomic policyThe US government would like to see Asia decouple their currencies from the dollar -- gradually to be sure, but a bit faster than say China is moving now.I am sympathetic: Asian countries that have tied themselves too tightly to the dollar for too long, financing widening imbalances rather than putting more pressure on the US to adjust. Many in Asia would like the US to do a lot more to make their preferred currency regime – one still based on a tie to the dollar – a bit easier for their central banks to maintain.  They don't think their link to the dollar is a problem; they think US policies that don't support the dollar are the problem.   I wouldn’t count on any changes in US policy.   The US has never geared its macroeconomic policies toward maintaining the dollar's external value.I also wouldn’t count on Asia’s willingness to finance the US no matter what policies the US adopts – particularly if they are asked to intermediate not just local savings, but the savings of folks around the world who would rather finance Asian than the US even though Asia doesn’t need the money and the US does.One thing is I think relatively clear.  Unhappiness with the policy choices required to sustain the current system is growing.   Especially among Asian central bankers themselves.   They just don't agree on any way out.

The title of his December 15th column was “Asian central banks may spook investors in 2007.” He mentioned China, India and South Korea.    Thailand seems to have beat them all to the punch. Mukherjee noted that both the RBI (India’s central bank) and the Bank of Korea raised reserve requirements earlier this month – India on local currency deposits, Korea on both won demand deposits and foreign currency borrowing.   Higher reserve requirements on foreign currency borrowing are a kind of covert capital control – the Bank of Korea wanted to make it harder for Korean banks to borrow yen or dollars, yen or dollars that the banks then converted to won. Mukherjee didn’t relate this story to the broader global pattern of capital flows and currency moves – a story discussed exceptionally well by Menzie Chinn and Kash Mansori their Wall Street Journal econoblog.   But I will. I don’t think it is an accident that India, Korea and Thailand have all taken actions to lock up domestic liquidity in the banking system (through higher reserve requirements) and in some cases to try to limit capital flowing into their economies in the month of December.There was a significant shift in global capital flows in November.  Look either at the euro/ dollar -- or the increase in the reserves of Asian central banks. Money that previously flowed to the US – or perhaps Europe – started to flow into Indian markets (especially the equity market), Korean markets and Thai markets. All faced upward pressure on their currencies.  The won and the baht had already appreciated more than other countries in the region – so their exporters in particular worried about further intervention. And all started to intervene in the foreign currency market in a big way.   And intervention isn't --despite what some say -- costless.   So called sterilization can be difficult. But the influx of foreign capital also raised another issue – one that Yu Yongding has raised in the case of China but that applies more generally.     Right now, Asian central banks have to buy dollars for two reasons.   One is that many countries exporters are bringing in more dollars than are needed to pay for their countries imports, so the countries are running current account surpluses.   The central bank buys foreign exchange off the exporters to keep the currency from appreciating.    The central bank may end up taking a loss on its dollars, but the country’s exporters gain. The other reason central banks are buying dollars is that foreign investors – whether companies, banks, pension funds or hedge funds – are moving funds into Asia.    Those inflows also puts pressure on the currency to appreciate.   But when the central bank intervenes, it ends up buying dollars off the hands of foreign investors.   And should the central bank end up taking a loss on those dollars, foreign investors gain. Actually there is a third potential reason why central banks are buying dollars – the local banking system may also be borrowing dollars and bringing the funds into the country.  Korean banks reported borrowed $40b abroad in the first 10 months of the year.  Some in dollars, but some in yen – borrowing yen to buy higher-yielding won is another form of the carry trade.  The local banks are effectively betting against the central bank – they gain if say the won rises and value of their local currency assets increases relative to their foreign currencies liabilities.   The central bank, by contrast, loses. While many Asian countries seem quite keen to subsidize their exporters (or, per Roubini, US consumers), they aren’t so keen to offer the same subsidy to foreign investors (or their own banks).   That is why China maintains stiff restrictions on most portfolio flows.   And it is the underlying reason why Thailand ended up imposing controls – controls that it partially lifted after the Thai stock market crashed. Bad – or at best poorly thought through -- policies don’t come out of the ether.   Thailand faced a series of real dilemmas.    Let’s look at Thailand’s options. Thailand could have allowed the recent surge in capital inflows to push the baht up higher.   But, well, that would have hurt Thai exports.   The baht has already moved by more than the renminbi this year.   China’s de facto export subsidies don’t just help the US consumer (and the US treasury, by lowering its borrowing costs); they also hurt all countries whose producers compete with Chinese producers.    Lex: Thailand’s preference for capital controls over more orthodox monetary tools such as lower interest rates suggests an element of panic. This is understandable, since it reflects the policy dilemma faced not just by Thailand, but by all countries trying to compete with China. That applies to Mexico manufactures and South African textiles as much as Asian electronics and cars.    The pressure the RMB peg places on other emerging economies is something I wish defenders of the China’s peg paid a bit more attention to – it doesn’t just impact the US and China. The Thai central bank could have cut interest rates to make holding baht less attractive – and thus try to discourage foreign capital inflows/ encourage domestic capital outflows.   That is one of the responses China adapted to strong capital inflows.   But easy money risks fueling a domestic boom – something Mukherjee emphasizes.   And sometimes booms lead to bust.   Thailand's central bank could have intervened more.  But buying dollars for baht  increases Thailand’s money supply.   The increase in the money supply could have been offset by an increase in the issuance of sterilization bills.   However, heavy sterilization could drive up domestic interest rates.  That risks attracting more capital inflows.  And higher domestic interest rates obviously cost the central bank money – it ends up paying out more on its liabilities (sterilization bills) than it earns on its assets (US Treasuries).  The Bank of Thailand could have intervened more – and then limited its own sterilization costs by raising reserve requirements.   Reserve requirements basically shift the cost of sterilization onto the banking system.  They have to lend a large share of their deposits to the central bank at low rates. Or it could break the link between domestic and international markets with controls.   China does that.   Thailand tried.   But once your financial system is integrated with global markets, suddenly interrupting those links can be costly.   Lot of investors put a high premium on liquidity – they don’t want their money tied down and locked into a country. Thai businessman don’t like the strong baht.   But they also don’t like a tanking stock market. The key point: many Asian countries – Japan – excepted are struggling with many of the same issues facing Thailand.     That includes China.   This year it limited the pace of its reserve growth by forcing the banks to hold the money they raised in their IPOs offshore – and perhaps by conducting various swap operations with the banks as well.   It also encouraged domestic institutional investors to buy more dollars.   But now the banks are taking losses on those dollars.   And they aren’t too pleased. I suspect Chinese state institutions are less inclined to help the PBoC out in 2007 than in 2006.   It looks likely that someone in China will need to accumulate $350b or more in foreign assets in 2007 to keep the current system going.  Many analysts – including Stephen Green of Standard Chartered – now estimate that China’s current account surplus will come close to $300b in 2007.  And China is attracting both net inflows of FDI and some portfolio investment as well.   Chinese stocks are booming.  And it seems pretty clear to me that the PBoC isn’t happy adding $250b to its reserves a year – let alone the $350b it may need to buy in 2007.    I take the unhappiness of Chinese banks holdings dollars – and the growing complaints from the PBoC about the difficulties with sterilization (see Denise Yam for the details) -- as another sign that Bretton Woods 2 is showing a few more signs of stress now than earlier in the year, or in 2005. The key question for the stability of the current system of central bank financing of the US isn’t just whether central banks will give out before private markets – something Menzie Chinn noted in the Econoblog.   It is also whether central banks will continue to be willing to increase their financing of the US when private demand for US assets falters. It faltered in November.   We are seeing – in my view – some of the consequences of the required increase in central bank intervention now in December.

Most gulf oil flows East. And most of the talk at the DIFC/ Euromoney conference was about what HSBC has labeled East/ East financial flows.     Gulf money wants to flow east as well No doubt such flows exist.  But they still strike me as small relative to (far less exciting) flows into the US and Europe.  Here is why.Heather Timmons of the New York Times reports that investment bankers are looking at a $20-30b flow from the Gulf to Asia next year.   “The banks estimate that Middle East buyers will snap up some $20 billion to $30 billion in Asian assets in the next year, with a focus on real estate and industrial companies.” That is real money, no doubt.  But I would bet that the Gulf’s current account surplus will be about $150b next year, assuming oil stabilizes around $60 and Gulf state imports and spending continue to rise.   That leaves $120-130b to invest in the rest of the world.  Some will go to the parts of the Middle East that don’t have oil (Egypt, Jordan even Turkey).  But most will go to the US and Europe – where there are big, deep, liquid markets that can absorb big flows. What of 2006?  No doubt some Gulf money flowed into Asia.   KIA took a large share of ICBC’s IPO, as did QIA (Qatar’s investment arm).  ADIA seems to have bid as well .. and so on.   One of the big Gulf funds also (I think) participated in the consortium’s that made pre-IPO investment in the Chinese banks as well.  Government investment funds like buying shares in state banks.     Those investments have done very, very well indeed.  Ask Goldman.   Investments in Indian stocks have also done well.   Hence the interest.  Lots of folks are chasing last year’s good investment. But if flows in 2006 are gonna rise substantially to $20-30b, that suggests to me that flows this year were in the maybe $10b range.    Gulf flows into the Chinese bank IPOs seem to have been in the $1-2b range.  China wouldn’t let the Gulf investment funds buy more!    Total foreign inflows into Indian stocks from all over the world are only in the $5b range this year.   I doubt the Gulf provided more than $1b of that. The Gulf’s current account surplus is going to be in the $200b range.  The Gulf is attracting some capital inflows as well (project finance mainly).    Let’s set those aside though.  Even if $10b flowed from the Gulf to Asia in 2006 and another $10b flowed from the Gulf to Egypt, Lebanon, Turkey and the like, balance of payments math suggests that $180b flowed from the Gulf to the US and Europe … Those big flows, however, are rather politically incorrect flows.  Better to talk up the much smaller (I suspect) flows to Asia …  But there is one point here that is important.  More oil state spending implies more imports from Europe and Asia – and somewhat less demand for financial assets.   A shift toward Asia also implies somewhat less Gulf demand for US and European financial assets.    So Gulf demand for US debt/ equities and dollar denominated bank accounts will likely fall significantly .. The saving grace?   Asia doesn’t need the Gulf’s money.   As a region Asia runs a big current account surplus.  One region with a lot of surplus savings cannot finance another region with a lot of surplus savings.   At least not in aggregate.    What do Chinese banks do with the funds they have raised in the Gulf?     Buy US treasuries!  Or maybe agencies or even CPDOs … The global current account only adds up if the regions of the world with more savings than they need finance the regions of the world with less savings that they need. More Gulf flows to Asia, barring other adjustments, just imply more Asian financing of the US … 

That seems to be the IMF’s message to Latin America.    The latest regional outlook lauded programs like Brazil’s Bolsa Familia:“These and other social assistance programs show considerable progress as a tool for poverty reduction as they successful target spending on the needy.” Interestingly, the IMF found that Chile spends more on these kinds of programs (1.5% of GDP for “Chile Solidaro”) than Brazil (which spends about 1% of its GDP).     And that spending on these kinds of programs generally pales relative to the 6.5% of GDP implicit fuel subsidy in Ecuador, where domestic fuel prices are frozen at 2003 levels.No wonder Ecuador seems to be about the only oil exporter than doesn't have a significant current account surplus with oil close to $60. While SUVs may be a big part of the middle-class lifestyle in the US, I suspect cheap gas benefits the upper-income brackets in Ecuador rather more than Ecuador’s middle class. Another interesting tidbit in the IMF report:  The productivity of Mexico’s VAT is only ½ that of Chile’s.   Even Argentina does better.   Who would have thunk.   Indeed, I thought the IMF’s regional outlook did a nice job with a range of cross-national comparisons – and did a good job of putting the “Changing oil and natural gas fiscal regime in the Andean countries” in a broad global context, one where all commodity-rich countries are looking “to secure a greater share of the windfall profits” from high commodity prices. UPDATE: the implicit subsidy required to keep petrol at 12 cents a gallon in Venezuela must be large.  Venezuela still has -- I think -- a current account surplus, but I think it is also running a fiscal deficit.  That takes a bit of effort with oil at $60 ...

CATO’s Dorn attacks a coordinated policy response to global imbalances on the grounds that it presumes that governments have a better sense of the “right” exchange rate than the markets: A negotiated approach to resolving trade imbalances presumes that “experts” know the relevant market-clearing exchange rates and that governments can agree to enforce them – neither of which has proved to be true. Any exchange rate that was fundamentally misaligned would eventually be attacked and governments would be ill-equipped to prevent it. Moreover, the longer that adjustment was delayed, the higher the cost would be in terms of resource misallocation. But doesn’t the current system hinge on “experts” rather than markets setting key exchange rates?   In this case, the key experts are China’s State Council (which seems to make Chinese exchange rate policy), the central banks of the GCC countries and the heads of all the other emerging market economies intervening in the fx market at an unprecedented rate.  And hasn’t a key lesson of the past few years been that governments are a bit more able to ward off attacks if they are defending an undervalued exchange rate than if they are defending an overvalued exchange rate?   Particularly if they have somewhat effective capital controls in place ...   And, viewed, from Dorn’s perspective, doesn’t delaying the end of the current system  only increase the misallocation of resources created by central banks massive intervention in markets and the resulting deviation of key exchange rates from market levels?It seems to me that a big part case for policy coordination is precisely that current emerging market exchange rates are so far from market clearing exchange rates – look at the current scale of reserve accumulation in the emerging world – that any changes needs to be both gradual and coordinated.   Ending the United States bond markets dependence on its central bank fix by going cold turkey wouldn’t be fun.    Another part of the argument for coordination is that absent a bit of coordination, everyone will continue intervening at the current – or perhaps an even bigger rate.  Coordination is needed to convince folks to change.  And a final part of the argument for coordination is that adjustment would be a lot easier if everyone was confident that steps to reign in US demand growth were matched by steps to spur demand growth outside the US.    See Larry Summers.

The IMF received its share of criticism over the past two weeks. The IMF governance structure is dated.  Europe is over-represented on the IMF board (and isn’t inclined to allow much change).  Asia is under-represented.    Countries guard their position on the board jealously.   The difficulty getting agreement on a modest ad hoc quota increase (Brazil and India objected because they were not among the winners) doesn’t necessarily bode well for the next set of more ambitious changes.The IMF remains strangely (given its original mandate) unwilling to criticize countries with inappropriate exchange rate pegs (its silence on Saudi Arabia’s peg is a case in point; the IMF only delivers criticism in its regional outlook); hopefully the G-7’s call for the IMF to update its guidelines for exchange rate surveillance will spur a bit of change.The IMF’s advice on how to reduce the surpluses of the world’s big surplus countries and the deficit of the big deficit countries is generally unheeded.    The US hasn’t shown any real commitment to balancing its budget over the economic cycle.  China has let its real exchange rate depreciate this year, even as its trade surplus exploded -- not that you would know about China’s growing surplus if you just read the IMF’s public reports.   For that matter, the markets -- at least after June -- don’t seem to share the IMF’s concern about imbalances.  Market players are bidding up the currencies of countries with large current account deficits (New Zealand, Iceland, the US – v. at least against the yen), and pushing the currencies of countries with surpluses down (Japan).The IMF isn’t – despite what some argue – outgunned by the private markets.  At least not in the emerging world.  The $25b the IMF provided to Turkey is far more than the international sovereign bond market ever supplied Turkey (once you net out the bonds held by turkey’s own banks, which are effectively a foreign-currency denominated domestic loan).   But it is outgunned by the huge stockpiles of reserves held by many emerging markets.  $200b and change in loanable funds isn’t what it used to be. The IMF’s model for generating the income needed to pay its staff is in a bit of trouble.  The IMF used to pay its staff out of interest in got from lending to the big emerging economies ….   That in some ways is a shame.   The IMF staff still do more comprehensive analysis than just about anyone- I challenge my friends in the markets to match the IMF’s analysis of petrodollars or its assessment of Lebanon’s balance sheet risks.  Ironically, though, the IMF’s current absence of income is evidence of some real successes.    The IMF isn’t in the business of providing long-term financing.  It is in the business of providing short-term financing to supplement the reserves of cash-strapped emerging economies.   That is an important role – there is a reason why emerging economies concluded that they need to hold more reserves … And lo and behold, if you look at the IMF’s balance sheet over the past ten years, it basically has performed its mission.   If you want to look at the supporting evidence (including some fancy charts), read on.  Over the past ten years, the IMF has lent counter-cyclically, supplying emerging markets with reserves when private market financing dried up. And – as one would expect – those emerging economies have paid the IMF back as private flows resumed and as higher commodity prices provided many emerging economies with a windfall.    That means IMF lending increased during periods of turbulence – Mexico in 95, Asia, Russia and Brazil in 97-98 and Argentina, Turkey, Uruguay and Brazil again in 2001-02.     Those surges of lending show up clearly in a chart of the IMF’s non-concessional loans outstanding.Incidentally, if US bilateral lending was added to IMF lending in 1995, the peak would be a lot sharper – the US lent its funds out fast, and got repaid far faster than the IMF. The following chart presents the same data in a slightly different way.  It shows the one year change in total IMF loans outstanding.  It is in dollars billion – not SDR – so it tends to slightly understate IMF lending when the dollar is strong and slightly overstate IMF lending when the dollar is weak.  But that source of error is small (and few folks think in terms of SDR).>In Bailouts and Bail-ins, Nouriel and I argued that the IMF’s lending subtly changed between 97-98 and 01-02, as the countries that the IMF lent to in 01-02 were more indebted than the countries the IMF lend to in 01 and 02.    This experiment lending to more indebted countries – countries that needed a sustained period of adjustment to bring their debt ratios down – looks to have worked out better than Nouriel and I expected.   Argentina is obviosly the case that didn't work.  IMF financing was -- mistakenly in my view -- used to put off a necessary depreciation in the peso and a necessary debt restructuring.  But even Argentina ended up in a position where it could repay the Fund.   And Brazil, Turkey and Uruguay all avoided default. Global conditions took a turn in emerging markets favor.  The dollar’s decline helped those emerging economies with lots of dollar debt (particularly if they exported a lot to Europe).  Turkey is a case in point.   Commodity prices rallied, big time.  Low rates in the “center” fueled a new wave of capital flows to the periphery.   Global growth was exceptionally strong. I think though the evidence does still suggest that lending to more indebted countries is more risky.  Even with very favorable conditions, the countries that took out big IMF loans in 01-02 have repaid the IMF a bit more slowly than the countries that received large amounts of IMF money in 97-98 (Russia actually didn’t get that much new money in 98, which no doubt helped … ).    Consider the following graph, which plots the IMF lending surge in 01-02 against the 97-98 surge for comparison’s purpose.   >The big loans stayed outstanding for longer in 01/02.  That may reflect the slower buildup of the crisis.  Brazil took out a loan in 2001 to guard against contagion from Argentina, got into real trouble in 2002 and ended up borrowing a lot of money in 2003 to rebuild it reserves.  Brazil consequently explains most of the surge in IMF lending in the q8-q12 period of the most recent wave of crises.   But I suspect it also reflects the fact that the IMF is lending to more indebted countries. Consider a graph showing both IMF and US loans outstanding to Mexico and to Turkey when both are plotted side to side.  Turkey had a lot more debt.  And it has taken a lot longer to repay.>However, even Turkey now looks to be in a position where it will be able to repay the IMF when the time comes.  That is how it should be.  The IMF shouldn’t have large loans outstanding when times are good.  Its job is to be ready to lend when times aren’t so good. Alas, that isn’t the only role the IMF should perform either.   Indeed, looking ahead -- given all the changes in the world economy --  providing crisis financing to cash-strapped emerging economies may be the IMF's least important future role.

Table 1.2 of Chapter 1 of the WEO makes one thing abundantly clear.  When the IMF talks about the need for investors to “increase the share of their portfolios in US assets for many years” (p.16) in order to avoid nasty slum, they aren’t really talking about private investors. OK, private investors need to be willing to continue to hold onto their existing exposure to the US.  And that may be a challenge. But the new financing the US needs to sustain large current account deficits – at least right now – is now coming overwhelmingly from the governments of the world’s poorer countries.   Private investors the world over are quite willing to finance the emerging world.   Only the intervention of the governments of the emerging world turns these private flows into the emerging world into massive net capital outflows out of the emerging world. Let’s go to the data tables.   And yes, I am the kind of guy who looks forward to reading the data tables in the WEO …  The IMF estimates the emerging world will add $666b to its reserves in 2006.  And there will be another $239b of “official outflows” from the emerging world.  Some of that will come from paying back the emerging world’s debts to the IMF, to the World Bank and to the Paris Club.   But most of it will come from oil investment funds and the like.    The net outflow from the emerging world’s governments will be around $905b. $905b is real money.  It is about the size of the US current account deficit.  How did the emerging world generate enough money to finance the US deficit.   Two ways.  With a current account surplus of $666b.   And with net private inflows of $211b.  Those private flows are important, since they demonstrate that private capital still flows downhill … from the rich to the poor.   The uphill flow of capital comes entirely from the policy choices made by governments. Compare that to 2001.  The reserve build-up then was only $122.  Add in $3b in net official outflows, for a total outflow from the governments of the emerging world of $125b. That was financed by a current account surplus of $87b and net private inflows of $65b – a total of around $150b.  The totals don’t quite match because of errors in the global balance of payments data.     2001 wasn’t entirely atypical either – 2000 and 2002 don't look all that different.   The governments of the emerging world were building up their external assets then too, but the annual increase was in the $150b to $200b range.  Not in the $900b range.   The defining feature of the world economy since then has been the huge surge in official outflows from the emerging world.   And the huge surge in the current account surplus of the emerging world – a surplus that the world’s financial markets transformed into a surge in investment in residential real estate in the world’s advanced economies.  Much as I enjoy the WEO data – there really is nothing comparable – I couldn’t help but notice that the IMF forecast for China’s current account surplus ($185b) is too low.   Its forecast for the eurozone’s deficit also looks a bit low.     One reason why China’s overall export growth hasn’t slowed even as the growth in US imports from China have slowed (and the pace of deterioration in the overall US trade deficit slowed) is that European imports from China picked up and the European (either Eurozone or EU-25) current account deficit grew.   A small widening of the European deficit allowed the broad surplus of the emerging world to keep growing even as the pace of deterioration in the US deficit slowed a bit.  But the overall story of the past five years is overwhelmingly simple: the current account surplus of the emerging world soared even as private capital poured into emerging markets.  And the offsetting deficit is found almost entirely in the US. (Graph here) Felix asks if “Could foreign official assets in the US start falling any time soon?” My answer is that it is bloody unlikely.      Central banks have been providing the US with between $400-500b of financing (in my estimation) of financing for the past several years.   Going from $500b to zero would produce a very hard landing.    Going from $500b to $200b would be enough, I think, to produce the dreaded hard landing. The IMF estimates $750b in reserve growth in the emerging world in 2007.   That seems about right to me.    And it seems rather unlikely that all $750b would go into euros.  That said, Europe does play an important role as a financial intermediary.  In 2005, both the eurozone and the UK attracted bigger gross inflows of capital than the US.  See the statistical appendix of the IMF’s global financial stability report.  Those inflows were just offset by big outflows.  More on that later.    My baseline scenario is that the only way global imbalances unwind in an orderly way is if the same folks who financed the expansion of the US deficit end up financing the slow and orderly contraction of the deficit.     That’s the rub.  Financing the expansion of the US deficit generated all sorts of fun for the emerging world.    Hell, it might even have produced a cover jinx.    I suspect financing the contraction of the US trade deficit (and the rise in US interest payments to the world’s central banks and oil investment funds) won’t be half as much fun.   Rather than subsidizing the growth of their export sectors, some countries may end up having to provide even bigger subsidies to the US than they do now just to keep their export sector from shrinking …

“The IMF has been asleep at the wheel in an era when private capital flows have been growing at an unprecedented pace”  So says Tim Adams, the Treasury Under Secretary (in the New York Times). I think it would be more accurate to say that: “The IMF has been asleep at the wheel in an era when official capital flows have been growing at an unprecedented pace” It is true that private capital flows to emerging markets have recovered, more or less, to their pre-crisis levels.   If they are now growing fast, it is only because they fell so far.  In absolute terms, they must be a smaller share of the world economy than in the mid-1990s.  And what are those capital flows now used for?   In aggregate, to build up the emerging world’s reserves.   Private capital flows to the emerging world come back to the industrial world as official capital flows.    I used to work for the Treasury, so I know that the notion that we live in a world dominated by private capital flows is part of the Treasury’s boilerplate.   But it is time to retire that boilerplate!  The defining feature of today’s world economy is how big a role official actors – central banks and oil investment funds – play in the global flow of capital. Don’t believe me?    Look the WEO data.   The IMF may be a bit sleepy, but it usually gets its numbers right. Try Table 35 of the WEO's statistical appendix.   Emerging and developing countries added $525b to their reserves in 2005.   That is the change in their reported stock of reserves.   Adjust for changes in the dollar/ euro and the real "flow" increase was well over $600b.   You also might want to add the $90b in “other official outflows” that appear in Table 33 from the Middle East to that total.   That presumably picks up on the activities of the Gulf’s oil investment funds.    Compare that sum – it is about $700b – with the $250b net private flows to the emerging world the IMF reports in Table 1.2 in the WEO.   Incidentally, the IMF reports $580b in reserve growth here (I am not quite sure what explains the difference, as I don't think the IMF adjusts for valuation – it may be the IMF folks are including all the Saudi’s central banks foreign assets in table 1.2).  The sum of official outflows and reserve outflows in table 1.2  is around $720b.    $700b in official outflows.  $250b in private inflows.  What is bigger?  Think a bit.  Where are the big savings surpluses of the world now found?   China, Japan and the oil exporters.   Only in Japan are private flows the vector that carries those domestic saving surpluses into global markets.   China’s central bank invests the dollars generated by China’s current account (savings) surplus – along with the dollars coming in from private capital flows.    The Russian central bank manages most of Russia’s savings surplus.  T The Saudi surplus is managed by the Saudi Monetary Agency and a host of other quasi-official bodies.  No one knows for sure where the Emirates savings surplus is found, but the Abu Dhabi investment authority seems like a might good guess. Russia’s reserves were up $15b in July.  The Saudi Monetary Agency’s foreign assets rose by $7b.    Annualize $22b a month.  It is real money.  And there are lots of other countries that produce oil too. Or just read Martin Feldstein’s Jackson Hole comments.  He gets it.  That said, I am being a bit unfair on my Treasury friends.   Their boilerplate is dated.  But their policy is not.  China – and a host of other countries – do need to be given a larger stake in the IMF.  Otherwise they will opt out of the “system” even more than they have already. Dan Drezner asked all the right questions earlier today.  I won’t repeat them.   The Treasury is gambling that increasing China’s stake in the institutions of international economic governance will prompt China to act like more of a responsible stakeholder – and be a bit less inclined to rely on exports and under-valued currency to drive its own growth.   It is a gamble though. I’ll answer Dan’s last question directly.  Dan wrote: If I had told you five years ago that Weisman would write the following sentence: But because the I.M.F. has not recently had a major crisis, some economists joke that with little to do, board members have the luxury of squabbling among themselves for power over an organization with an ill-defined mission” would you have believed me?  The answer is no.    I should know.  I spent a year and a half writing a book about IMF crisis lending.  I thought it was an important issue.   It just happened to be published when the IMF stopped lending.  Bad timing. Yet the next time trouble strikes, if nothing changes, it could well be that the IMF does NOT resume lending.   China might decide not to outsource crisis lending to the IMF, so to speak.    One of more consequential decisions the US made in the 1990s was not to bailout lending itself, and instead rely on the IMF.    Make no mistake though, the US had the financial capacity to do big bailout itself.    The Bush Administration has shown that the Treasury can borrow big time to finance a war (and a remarkably unsuccessful reconstruction).  It certainly could borrow big time to finance crisis lending.   But after Mexico, the US decided to invest in building up the IMF’s lending capacity rather than creating the institutional mechanisms needed to do bilateral crisis lending.   China will likely be faced with the same choice at some point.   That is one other reason why the debate over IMF governance matters.

Bernanke says no:The traditional distinction between the core and the periphery is becoming increasingly less relevant, as the mature industrial economies and the emerging-market economies become more integrated and interdependent. Notably, the nineteenth-century pattern, in which the core exported manufactures to the periphery in exchange for commodities, no longer holds, as an increasing share of world manufacturing capacity is now found in emerging markets. An even more striking aspect of the breakdown of the core-periphery paradigm is the direction of capital flows: In the nineteenth century, the country at the center of the world's economy, Great Britain, ran current account surpluses and exported financial capital to the periphery. Today, the world's largest economy, that of the United States, runs a current-account deficit, financed to a substantial extent by capital exports from emerging-market nations. Bernanke is right to highlight the fact that emerging markets are exporting capital to the US, financing the US current account deficit.  Euroland and the UK both have deficits, and Japan's surplus hasn't increased significantly -- so the recent rise in the deficit has largely been financed by an increase in the surplus of emerging markets.But does that make the distinction between the core and the periphery less relevant? Not in my book.   Those flows aren't coming from private citizens and private financial institutions in the periphery.  They are coming from governments.  China is a case in point, but the oil exporters matter too --  Russian reserves grew by about a billion a day in the first ten days of August.  The Saudis are sitting on a huge inflow of dollars.  Even Brazil is once again adding to its reserves at a rapid rate.    That means there is a big difference between the core and the periphery.   In the periphery, private capital inflows are used to finance the build-up of reserves.  In the core, official capital inflows are used to finance current account deficits. That is true for all of the "core" -- not just the US The pound's rising share of global reserves implies that central banks are financing a big share of the UK's deficit.   Stephen Jen is right on this point. For that matter, by my calculations (alas, hidden behind the RGE firewall), central bank inflows into the eurozone are more than enough to finance the eurozone's 40 to 50b euro ($50-60b) current account deficit over the past 12 months. The world's central banks probably added over $200b to their euro portfolios in 2005. And I write non-stop about the role central bank inflows play financing the US current account deficit. That seems to make the core-periphery distinction all the more relevant.   Government policy choices in the periphery are leading them to finance the core. On this, I fully agree with Dooley, Garber and Folkerts-Landau!

Last week I was beginning to think the IMF might be back in business.   A couple of press reports hinted that Lebanon’s central bank was facing real pressure.    Folks fleeing the country wanted dollars.  Dollars cash.   Not dollar, or Lebanese pound, bank accounts.   And Lebanon’s tenuous financial stability hinged on growing deposits – not shrinking deposits.  Lebanese banks take in dollar deposits by offering a slightly higher interest rate than you can elsewhere (and take in pound deposits by offering a higher interest rate than they offer on their dollar deposits).   And then they lend those dollars to the government for a profit, financing the country’s fiscal and current account deficit in the process. Right now, though, Lebanon’s reserves are shrinking.    That usually means a call to the IMF.   Unless you can call the Saudis instead.  Saudi Arabia’s central bank now has about as much hard currency as the IMF (SAMA now has around $190b in foreign assets).   And it tends to lend it out to its friends in the region on somewhat more generous terms.    Lebanon got $1b in cash (along with a commitment of $500 million for future rebuilding).   I suspect it will need a bit more.  To prevent an old fashioned bank run as well as to rebuild (eventually).   Lebanon was effectively bankrupt even before the current conflict.  Its debt to GDP ratios are obscene – the government’s $40b of total debt doesn’t seem like much, but it is around 150% of Lebanon’s GDP (See the IMF’s Staff Report).  Lebanon has long been the country that should have had a crisis but didn’t.  Largely because bank depositors never ran, in part because Lebanon has a history of paying its debts.  But it is all a bit circular.  Lebanon only could pay its debts so long as depositors didn’t run.  A bit of Saudi help at crucial points in time also helped a lot. Back in 2002, when Lebanon was in a bit of trouble, Lebanon got a French/ Saudi bailout.  The so-called Paris II deal provided Lebanon with $4b in financing, in return for Lebanese pledges to reduce its fiscal deficit.  The IMF’s terms would have been a bit more onerous.   At the time – it was just after Argentina – the IMF was rather concerned about injecting tons of money into countries with way too much debt.  It was supposed to bail out the illiquid, not the insolvent.  Lebanon got its banks to pledge to help out by deferring a few payments, but it wasn’t much. Today, though, I bet if Lebanon wants a bit of IMF cash in a few weeks the IMF won’t insist on a debt restructuring.  Lebanon doesn’t want to be forced to teach its bond holders a lesson.  Not when the biggest holders of its bonds are its own banks – and its own citizens.  And I doubt the US wants a Lebanese financial crisis on top of everything else. Incidentally, while the Saudis may be able to finance Lebanon, they will be hard pressed to match the IMF's analysis of the sources of Lebanon's financial vulnerability.  The selected issues paper – particularly the first two sections by Juan Sole, Julian di Giovanni, Edward Gardner and Tushar Poddar --  is really excellent.  I may be biased, though.  The first section builds the 2004 work of Christian Keller and Christoph Rosenberg (my friends and co-authors).  Fans of balance sheet analysis will appreciate the description of how Lebanon’s central bank helps the banks manage fluctuations in demand for dollars and pounds.   

An anonymous partner at a mid-sized London hedge fund expressed something I was trying to say a couple of weeks ago fair better than I could have.   From the Financial Times: "A lot of managers have gone from being long-short funds [funds that make bullish and bearish bets on stocks] to being long-long funds with leverage, which removes the whole point of hedge funds offering protection in the event of a downturn," said a partner at a mid-size hedge fund in London.  I expressed my argument somewhat less elegantly – saying that that some hedge funds were not really hedged.   And many of my readers pointed out  -- quite correctly – that no one that is fully hedged makes money.   But what I was getting at was that it was quite costly to hedge say a long position in an emerging market equity market with an offsetting short position in the same equity market.    Funds that hedged in the same market didn't do as well as funds that did not hedge.    Until May, a rising tide was lifting all boats.  And punishing shorts.  So there was a temptation to become a long/ long fund. Or to find proxy hedges that didn’t cost you an arm and a leg.  The one that I am most familiar with comes not from emerging market equity markets, but from the market for the local currency debt of emerging economies.  It went like this:  Buy the local currency debt of an emerging economy with a high coupon. Don’t hedge the currency risk.  That cost you.  Instead buy insurance against the risk that the country would default on its foreign currency denominated debt.   That meant holding a credit default swap – i.e. buying credit insurance.   This trade isn’t a secret.  Joanna Chung, quoting Mohammed Grimeh in the FT:  Mohammed Grimeh, global head of emerging market trading at Lehman Brothers, said: “Over the last few months, as credit spreads tightened, hedge funds have been moving to illiquid local instruments that offer a higher risk and reward but they are also buying CDS protection against overall country risk.” The IMF also discussed it in its most recent financial market update (see footnote 4 on page 9). It isn’t hard to see the logic of the trade.  Turkey was paying a 12% coupon – maybe a bit more – on its local currency debt at the beginning of the year.  Insurance against a default on Turkey’s dollar bonds cost maybe 200 basis points.    You were hedged … sort of.    And the whole trade had a nice carry.    A real nice carry.   After all, you were holding a rather overvalued currency and needed some compensation for the risk.  It was a long/ short trade, not a long/ long with leverage trade.  But the long was on local currency debt and the short was on external foreign currency debt. The hedge even has worked in Turkey.   Sort of.   A contract insuring against the risk of default on Turkey’s foreign currency debt is worth a lot more now than it was in January.   Unfortunately, both the Turkish lira and Turkish lira bonds are worth a lot less now than they were then too.  Still, it has struck me that there was something a bit strange with the trade.  It worked in a backward looking sense.   In the past, indebted countries often had lots of local currency and foreign currency debt.  So when a country’s currency has declined and the value of its local currency bonds fell, the value of the country’s foreign currency bonds also fell.  Credit spreads rose.  So the value of a contract providing insurance against default rose.  It actually worked in another sense.  In times of huge distress, the local currency debt of some countries is arguably less risky than the foreign currency debt.  Countries like Argentina defaulted on their foreign currency debt but honored their local currency debt.    So in a really bad scenario, it arguably made sense to be long the local currency stuff and short the foreign currency bonds.  Never mind that Russia did the opposite of Argentina, defaulting on its local currency bonds and honoring its Russian era Eurobonds. Incidentally, the other trade that works in backward looking stress tests is “long the external bonds of Argentine corporates, short the external bonds government of Argentina.”  Both firms and the government defaulted.  But you did better in the restructuring holding the bonds of the Telcos than the government …   So why do I say that there was something strange about the hedge?  Simple: The hedge implicitly assumes that correlations that held in the past would hold in the future, even though conditions change.     And in this case, two conditions were changing: First the scale of foreigner’s local currency exposure was growing, big time.  That changes the country’s incentives.  And second the amount of sovereign foreign currency debt was falling, big time.   Still is.  Chris Mewbourne of Pimco thinks repayments will top new issuance this year.  So the stock of external debt is falling absolutely, not just relative to sovereign reserves.  That is why insurance against the risk of default is cheap.    At the limit, a country might not even have any external debt left to default on.   Or just a trivial amount.  But a bank could still sell insurance against external default.  Why not?  The risk is low.  And nothing prevents the folks from selling more insurance than there are bonds.  Delphi showed us that.  Selling insurance (off the balance sheet) is another way to get an easy yield pickup. And folks holding local currency debt could still buy insurance against default on non-existent foreign currency debt as a hedge.  The backward-looking correlations work.  And why worry too much about the possibility that the conditions that gave rise to those correlations have changed? Sorry about an obscure post.   I am sure that my tendency to delve into this kind of thing (and ferret out obscure reserve data) is one reason why this blog isn’t always an easy read.  But the operation of the sovereign debt market is one of my long-standing interests. As are market dynamics under stress.  I suspect that a lot of folks scrambled to find hedges for previously unhedged positions over the past two months -- and to shore up their proxy hedges.    But I am reading market tea leaves, not speaking from direct knowledge. And I do still wonder about the robustness of some of the hedging strategies used by players in the credit markets of advanced economies in truly adverse conditions …

Nouriel and I postulated back in early 2005 that there was a meaningful risk that the next “emerging market” crisis might come from the US – and it might come sooner than most expected.   The basic quite simple: Ferguson’s debtlodocus might find that it no longer could place its debt with the world’s central banks, the dollar would fall, market interest rates would rise, US debt servicing costs would go up, the economy would slow and the value of a host of financial assets would tumble.     Why the emphasis on central banks?  Simple: they have been the lender of last resort for the US, financing the US when private markets don’t want to.  See April 2006.  Consequently, a truly bad scenario for the US seemed to require a change in central banks’ policies.   Real emerging markets aren’t so lucky.  When private markets don’t want to finance them, they typically aren’t bailed by someone else’s central bank.   It sure doesn't look like sudden stops in financial flows and sharp markets moves have been banished from the international financial system.   Certainly not this year.  They just didn't strike the US, but other countries with large and rising current account deficits.  Iceland’s currency is way down (its stock market too) even though interest rates on Icelandic krona are up.   The private market’s appetite for krona disappeared.      Inflation is up too, driven by the weak krona. The Turkish lira is way down.  Lira interest rates are way up – as is Turkish inflation.  Turkey's central bank sold dollars this week -- for the first time in quite some time.  It was buying dollars in a big way in the first quarter.  Times change. Currency collapses do not necessarily translate into economic slumps.   That was a key point that the Federal Reserve has made in response to fears about a US hard landing.  A fall in the currency doesn’t always translate into higher interest rates, at least in post-industrial countries.     And in part because lots of the damage from a fall in the currency comes when firms, banks and the government have borrowed in foreign currency, turning a currency crisis into a debt crisis.   The US, thankfully, has financed itself by selling dollar-denominated debt, pushing currency risks onto its creditors.   But so did Iceland.   And even Turkey increasingly financed itself in Turkish lira.   Particularly in 2005, there were big inflows into Turkey’s local debt and equity markets.   Turkey obviously still has a fair amount of dollar debt.   It is an emerging market after all.  But things were changing.  I still think the financial slump in both Iceland and Turkey could easily turn into a sharp economic slump.  In both countries, both policy and market interest rates are up significantly – in part because a weaker currency (and still strong oil) translates into higher prices for imported goods.   And I suspect higher interest will, over time, slow the pace of both economies’ expansion. One big reason why Turkey was growing fast was that because its banks were lending tons of money to Turkey’s households, whether to buy a car or buy a house.    But it only makes sense to lend long-term at 13% (say for a mortgage) if inflation and nominal interest rates are expected to fall over time.  This year, both inflation and nominal rates rose.  Ouch (if you are a bank).   I suspect that the result will be a significant slowdown in credit growth – and in the Turkish economy.  Charles Gottlieb of the European Capital Markets Institute notes that Iceland too was growing in part on the back of a strong expansion of credit (see his figure 1) – though in Iceland’s case, demand for Icelandic Krona was for a while so long strong that Icelandic issuance alone couldn’t meet it.  Consequently, European banks started issuing so called Glacier bonds in krona (a note: I am sure the banks hedged their krona exposure, I just don’t know how).  And Gottlieb nicely shows what a sudden stop looks like.   See his Figure 4.  It shows a huge surge foreign purchases of Icelandic securities issued by Icelandic residents (I think that means it excludes Glacier bonds) up until January of this year.  And then a huge – and I mean huge – fall.  Inflows became outflows.   Foreigners sold; Icelanders bought.  I am not convinced Iceland is the next Thailand – but there are lots of unpleasant outcomes that aren’t quite that severe. Turkey and Iceland are not the only markets who went through a rather nasty sell-off.   Emerging market equities just has their worst run since 1998.  Of course, it comes after a huge run-up.    And as no shortage of credible observers – like Ragu Rajan of the IMF -- have noted, the markets that are selling off the most are the markets that rose the most.  That suggests that the causes of the sell-off are global, a change in the markets willingness to invest in emerging economies, not local – that is what the generally bearish BIS thinks and in this case they have support from some (former?) bulls, like MSDW’s Turkey analyst Serhan Cevik. Despite this indiscriminate sell-off, there is still no agreement among investors as to what the sudden burst of global volatility actually reflects. …. Risk reduction always brings indiscriminate selling of all ‘risky’ assets at the early stages, regardless of underlying economic structures and policy frameworks. The team at Danske bank hasn't been as consistently bullish at Cevik, but they seems to agree that it is hard to pin down any fundamental cause of the recent sell-off. I certainly didn’t see this kind of global sell off of emerging economies coming, though I worried about a few specific markets.  And not just ex post.   But then again I am usually good for a cautionary quote …  And in some sense, the fact that the current global sell-off focused on emerging economies is a bit strange.   I see the logic: what went up too fast has to come down.   But the defining characteristic of the recent boom in private capital flows to emerging economies is that, at least in aggregate, capital was flowing into emerging economies didn’t need the money.   The US was attracting more financing that it needed to run very large deficits, and using some of the money to invest in emerging economies.   And emerging economies were taking financial flows from say Europe and using them to lend to the US.  It was a rather complex equilibrium.  Look at the statistical data in the latest issue of the World Bank’s (very useful) Global Development Finance.  Developing economies collectively ran a current account surplus of $245 billion in 2005.    Private inflows of $490 billion were used to pay back the IMF and to build up reserves -- these countries reserves were up by $395b or so in dollar terms, more than their current account surplus. (One note for true balance of payments geeks: the GDF’s reserve increase isn’t adjusted for valuation changes.  If you make that adjustment, total reserve growth would be bigger, and the errors and other flows term would fall)  Of course, what happens in aggregate can mask big differences in the specifics.   China, Saudi Arabia and Russia all had big current account surpluses.   Brazil a more modest surplus.  India had a small and growing deficit. Turkey – and Hungary -- had big deficits.   Despite these differences the equity markets of Russia, Brazil and Turkey have all tumbled this year.  Foreign funds that poured into these economies earlier this year poured out in May.  When the data comes in, the change will look a bit like Gottlieb’s graph showing flows in and out of Iceland. My hypothesis therefore is twofold:  The recent correction has been driven as much by developments inside the financial markets of the post-industrial economies as by a change in the emerging economies themselves.  Hence the general sell-off. And the impact of the correction will vary dramatically.   Some countries didn’t need inflows.  Russia.   Others did.  Turkey.   But even in turkey, the inflows that were coming in far exceeded what Turkey needed.    In the first quarter, annualized inflows were something like $60b relative to a current account deficit of $30b.  If flows go to $30 or $25 Turkey is fine.  If they go to zero, not so much.  Actually, my hypothesis is threefold. In April, the G-7 communique triggered a fall in the market’s willingness to finance US deficits.    We saw that in the TIC data.  There also was a bit of a surge in capital inflows to Asia that prompted a bout of intervention.   Central banks financed the US when markets didn't want to. In May and early June, folks who borrowed dollars and yen to buy emerging market equities (and debt, to a lesser degree) sold their emerging market equities and repaid their loans.  Call it deleveraging.   The net effect has been to help finance the US.   Less money was flowing out of the US – US purchases of foreign equities averaged about $10b a month for the first four months of the year.   And if Americans may have actually reduced their exposure to emerging economies in May and June.   That too would help to finance the US deficit.   Deficits can be financed by selling (external) assets as well as issuing (external) debt.  My question:  What happens once this process is over? Do higher US rates continue to draw the financing the US needs to run big current account deficits – a deficit that I still think will be over $900b?   In part because China and the oil exporters continue to use their central banks and oil investment funds to finance the US? Or does the US join the list of high-carry (at least relative to Japan and Europe) countries that have experienced trouble in 2006?  And what happens if an incipient US slowdown start to generate expectations that US rates have peaked and won’t provide as much support for the dollar? If I had to guess, I would say Bill Gross (quoted in Business Week) is right.    It's like Peter Pan who shouts, "'Do you believe?' And the crowd shouts back, in unison, 'We believe.'" You can believe in fairy tales and Peter Pan as long as the crowd shouts back, "we believe." That's what the dollar represents, a store of value that people believe in. They can keep on believing, but there comes a point that they don't. Greenspan was here two months ago and talked with us for two hours. The most interesting point was his comment that there will come a time when foreign central banks and foreign investors reach saturation levels with their dollar holdings, and so he sort of drew his hand across his neck as if they've had it. Why can't they keep on swallowing dollars? Logic would suggest that these things start to fray at the fringes. Once the snowball starts it can really get going. ...The dollar is really well supported by its yield. We've got 5% overnight rates and Japan has zero. You get over 2% relative to the euro, so obviously 5% or 5.25% is dollar-supportive, and the more that Bernanke sounds off that he's going even higher, the more that supports the dollar. The real question is what starts it on the way down? At the moment people believe that's O.K. and yes, housing is starting down, but the rest of the economy is looking good, 2% to 3% GDP growth isn't so bad. I would say that if that's the case we've got a pretty good little fairy tale going here. But if it doesn't, if 5% leads to a crack in the housing market and the unwind of various global markets and the U.S. stock market ... If the stock market keeps going down then that's a sign that 5.25% is too onerous a rate. So what the question becomes then is can the U.S. economy be supported at that level? That's when the question of whether there's the possibility of an avalanche begins. If we get rates then down to 4.5% and then all of a sudden the [other central bankers] are moving up, the money flows out. It's not because of the [lack of a] yield advantage; they've had it up to their necks in terms of dollars. The unwind of the dollar can come from saturation or geopolitical issues or simply that the U.S. economy isn't as strong as people think and they stop believing in Tinkerbelle. A big fall in the dollar isn’t bad for the US.  A big fall in financial inflows that led to a rise in US interest rates though is another story.  A 200 bp move is not so big for emerging economies, but it is big for the US.  And because the US financial system is much more leveraged, it would also have much bigger consequences.