China can avoid becoming Japan

One counterpoint I often hear about the renminbi’s role in rebalancing China’s economy is “but hey, look at Japan: It’s had a flexible exchange rate for years and, yet, its growth is still reliant on external demand”.

True. So let’s see what’s going on in Japan, whether there are any differences with China and whether the case for renminbi appreciation still stands from an economic rebalancing perspective.

One reason behind Japan’s lackluster consumption growth has been a stagnant growth in real wages: Real wages have barely moved for more than a decade, even while labor productivity growth has actually been strong. As a result, the labor share of income in Japan has declined steadily—some 5-6% of GDP since the mid 1990s.

The reasons for this were explored in a recent IMF working paper and the verdict was as follows:

First, increased trade openness and competition from foreign, cheaper labor has put downward pressures on real wages in tradable sectors (notably manufacturing). This is not a phenomenon specific to Japan: Other advanced economies have also experienced similar pressures on real wages, especially as companies’ ability to relocate to take advantage of cheaper labor has improved.

Apart from globalization, Japan’s economic structure and labor market regulations seem to have exacerbated the fall in labor’s share of income. Specifically, productivity in the services sector has been low, leaving little room for real wage growth there. Which means that, if I’m a manufacturing worker disgruntled with my stagnant real wage, I don’t really have anywhere better to go: Shifting to the services sector will not raise my purchasing power prospects.

From a policy perspective, and to the extent that rebalancing growth towards domestic demand is an objective, the implications are clear: Steps to increase productivity in the services sector would help lift real wages there, putting pressure on the manufacturing sector to do the same and reward their employees more in line with their productivity.

Turning on to China: First of all, household consumption growth in China is not at all stagnant—on the contrary. However, GDP growth has been much faster, bringing the share of household consumption to GDP down to a stunningly low 35%--a 10 percentage point reduction since the mid 1990s. Much of the reason is to be found in real wage growth: While robust, real wage growth has been slower than that of GDP, leading to a steady decline in labor’s share of income to an estimated 50%.

So while the paces of underlying growth in wages and consumption differ widely between Japan and China, part of the reason behind the lackluster performance of private consumption in both countries has to do with the fact that labor has been awarded a declining share of national income.

But there are important differences: First, in the case of Japan, labor’s share of income is still 60%--above the advanced-economy median of around 57%. So the fast decline in recent years has partly reflected a convergence towards advanced economy levels. In contrast, China’s labor share of income, at 50%, is far lower, and “abnormally” so at that, considering that developing economies tend to be more dependent on labor intensive industries (I’ll come back to that).

More importantly, a key reason behind Japan’s (and other advanced economies’) declining labor share of income is a distinctly external shock: That of globalization, foreign competition and equalization of factor incomes through freer trade and relocation of production abroad (including by Japanese companies in developing Asia).

In contrast, China *is* that shock: It is the place where many companies relocate to take advantage of cheap labor costs (as well as a potentially huge consumer base). This means that the decision not to raise the purchasing power of labor (whether it’s by raising nominal wages or through an appreciation of the renminbi) is an autonomous one—not one that is enforced by the global competitive landscape.

Of course, things are not as simple as that. First, not all industries in China have the same degree of profitability. Arguably, there is little room to raise wages in some low-value-added industries, especially since some companies are deemed to survive only because of the undervalued exchange rate (per the government’s recent stress tests on the sensitivity of some companies to renminbi appreciation).

Secondly, even in larger companies with fat profits (including many state-owned enterprises), profitability has been partly sustained by a slew of (what should be) temporary boons: Subsidized energy prices, land subsidies, low interest rates (partly due to controls on capital outflows) and, of course, the favorable exchange rate. Steps to remove these advantages would limit the scope for strong wages increases going forward, as profitability declines.

The underlying issue though is the developmental objective that these distortionary policies are set to achieve: That of an overarching focus on building capital- and resource-intensive industries. This has limited the growth in the number of employed people or, more relevantly for China, in the number of people who can shift out of farming employment in the context of the country’s ongoing urbanization.

This is where the comparison with Japan becomes very informative: If China wants to avoid Japan’s reliance on external demand, it will need to undertake policies that encourage an efficient and dynamic service sector to flourish.

What’s the role of the exchange rate here? As noted above, the exchange rate is just one of the distortionary policies aimed at promoting the development of the tradable sector; but it’s an important one for realigning production and investment incentives.

Renminbi appreciation would reduce the profitability of capital-intensive, export-oriented companies, limiting the recycling of corporate savings back to industrial capacity building (which is what companies have been doing). It would shift production incentives away from low-value-added, exchange-rate sensitive sectors and towards higher-value-added industries as well as the services sectors. It would raise the purchasing power of consumers by lowering the price of imported goods, freeing up income for services consumption. And it would diminish the current influx of liquidity due to the accumulation of FX reserves, raising the cost of capital and, thus, lenders' “benchmark” for efficiency and profitability in both the industrial and services sectors.

Clearly, a change in China’s exchange rate policy is not a panacea for rebalancing growth. A multitude of other policies need to be taken in tandem. But its contribution to realigning production incentives, together with the unsustainability of what UBS economist Jon Anderson has called China’s “expropriation” of savings from the rest of the world, make it a critical and an urgent step.

Ludicrous claims about the renminbi

With the Treasury’s verdict on global currency manipulators coming up on April 15th, the debate on the Chinese renminbi has not just been increasingly heated; it’s also turned ludicrous.

The ludicrous took center stage last week after a key figure in the Chinese leadership suggested that the renminbi is not undervalued.

Shortly after, two of the most loyal Ambassadors of Ludicrous—top economists at a couple of brand-name investment banks—argued that “the renminbi is not particularly undervalued…. China is importing a lot”; or that the US should mind its own business and save more.

Needless to say, these claims are, well, ludicrous.

Starting with the US savings argument… Since the third quarter of 2006, the US trade deficit has declined by almost 3% of US GDP—i.e. US national savings have risen by as much. And yet, the bilateral trade deficit with China has NOT. MOVED. (in US GDP terms). All the adjustment in the US external imbalance has been borne by other countries, notably oil/commodity exporters, Japan and the eurozone. China’s own contribution has been practically zero so far.

On top of that, most people refer to the global imbalances as a US vs. China problem. Not true. The eurozone, which has been running a trade surplus, has seen its trade deficit with China rise almost uninterruptedly for years now. Indeed, the increase in the bilateral deficit with China accounts for 70% of the deterioration in the eurozone’s trade balance since end-2001 (when China joined the WTO) and for one third of the deterioration since mid-2005 (when China began to appreciate its currency).

Both these examples show that the “need for higher savings” argument is bogus. No, I’m not saying that the US does not need to save more. The point here is that despite the recent rise in US savings, China has yet to bear the brunt of this adjustment, instead displacing other exporting countries, many of which are as poor or poorer. Yes, China is “importing more”. But clearly not *enough*. And a prompt and meaningful real exchange rate appreciation is a critical policy tool to make “enough” happen.

Then you have those who say that a renminbi appreciation won’t be of much help in reducing the bilateral deficit with the US. To support this, they point to the currency’s 21% appreciation vs. the US dollar since July 2005, which, seemingly, had no impact on the US deficit with China (the deficit kept increasing in dollar terms until the crisis escalated at the end of 2008).

This argument is equally bogus for at least two reasons: First, it ignores the role of domestic demand growth as a driver of imports. But more importantly, even a 20% change in the exchange rate means very little when the price and wage levels start from an extremely low base.

Chinese wages remain a tiny fraction of wages in the advanced world when measured in US dollar terms. They are also much lower than many of China’s developing-country competitors in global markets for, say, textiles or manufactures (e.g. see Peru, Turkey, Mexico, Romania). Meaning that even a further 20% or 30% appreciation may not be enough to bring wages to par with competitors.

Incidentally, for a country with a stated objective to reorient growth towards domestic demand, raising real wages would be an obvious starting point.

But it goes beyond that. Recent press reports cite that stress tests by China to assess the resilience of its exporters to renminbi appreciation found that some firms would be very sensitive and probably go out of business. In other words, many Chinese exporters only exist because of, effectively, a subsidized exchange rate level. Apart from being unfair in the context of a global competitive landscape, it’s also detrimental for China’s own efforts to move up the value-added chain, by fomenting complacency among its firms.

Finally, it’s amazing to suggest the renminbi is not overvalued when China has continued to accumulate FX reserves at a rate of $50 million an hour throughout the crisis! And don’t tell me it’s insurance!

After correcting for (an estimate of) valuation effects, almost half of that accumulation in 2009 was accounted for by the trade surplus—no need for insurance there. Another 20% can be accounted for by foreign direct investment flows—the most stable form of foreign investment with little need for precautionary reserves. Even if all the remaining flows were “hot money”, insurance does not involve covering 300% of those flows with reserves, esp. when you already have another $2 trillion in your coffers!

China’s exchange rate policy is a major distortionary force in global trade and also a key impediment for the smooth functioning of global capital markets and the conduct of monetary policy everywhere (including in China itself). As we speak, there are emerging market countries whose stage in the business cycle demands a tighter monetary policy. And yet, they don’t move because of fears of an exchange rate appreciation that would ruin their competitive edge in major markets.

China, along with every major economy interested in participating in, and profiting from, an increasingly globalized world, has a duty to take policies that foster stability in trade and capital markets. In China’s case, exchange rate policy is the number one issue. It's irresponsible for anyone calling him/herself an economist to claim the contrary.

All roads lead to the renminbi

I am amazed with the number of “experts” I’ve heard arguing that the West’s fixation with the renminbi is misplaced: China is doing the West a much bigger favor, the argument goes, by embarking on structural measures to rebalance its growth model and, in the process, increase imports.

I’m not going to finger point here but the fact that some of them work for brand-name investment banks makes me wonder whether it’s vested interests speaking in lieu of economic acumen… which would be ironic for anyone competing to become the Chinese government’s most trusted advisor... That’s because telling China that its renminbi policy is secondary is like telling your best friend that the wedding dress she is about to get looks terrific when it really looks dreadful!

Another way to put this is that a (two-way) flexible renminbi is a critical piece of the “puzzle” called “Addressing China’s structural problems”. The argument works on a number of different levels:

First, the obvious: A flexible renminbi would help reduce Chian's reliance on net exports by shifting capital away from export and/or import-substituting sectors and towards domestic-oriented industries. It would also encourage firms operating in export industries to becoming more competitive.

Second, a flexible renminbi gives policymakers some room to maneuver in their efforts to control investment growth. It's no news that investment in China has grown by 8 percentage points of GDP (to 45%) in the space of 8 years. This has prompted many an analyst(including in China) to warn against potential excesses in capacity leading to price declines, lower profits, loan defaults, financial sector instability and a collapse in investor confidence.

What’s the role of the renminbi here? The answer is “control of monetary policy”. Basically, one reason why investment has been growing rapidly is very low lending rates, which, in turn, have been low due to government ceilings on deposit rates.

Liberalizing interest rates is critical for improving allocative efficiency and contain investment growth (you can only go so far with the “Thou shalt not lend” approach!) But interest rate liberalization will be harder to manage while the renminbi is fixed: Even with capital controls in place, raising rates would drive speculative capital into China, forcing further rate hikes to withdraw excess liquidity.

Of course, flexible exchange rates are no panacea either. Even countries with floating currencies are invariably flooded with speculative capital, which can complicate the conduct of monetary policy. Yet, one lesson from the 2008 panic was that those emerging markets with policies in place to increase their economies’ resilience to exchange rate swings came out of the crisis in pretty good shape (contrast, say, Brazil with the Baltics or with Hungary).

In this sense, a stable renminbi can even be counterproductive: As Chinese companies get comfortably accustomed to a stable exchange rate, the incentive to develop and trade financial instruments to manage exchange rate risk is minimal. This postpones the date when they are ready to face not just a stronger, but also a more volatile home currency.

Third, a stronger renminbi would help “transfer” wealth away from corporates and towards households, facilitating the rebalancing of growth towards domestic consumption. When people refer to China’s large pool of savings, they often cite a misleading fact: That private consumption to GDP is at (a shocking) 35%. The number is misleading in that it is partly a symptom of a low labor share of income rather than abnormally high household savings.

The low labor share of income, together with low prices for fuel and utilities and an artificially competitive exchange rate, have allowed corporate profits to soar. This has brought corporate savings (including state-owned enterprises (SOEs)) to more than 20% of GDP.

Clearly, raising utility and fuel prices and/or structural reforms to provide education and healthcare and thus reduce households' precautionary savings would be desirable and in the right direction. But at the core of the matter is the low level of household income. A stronger renminbi would raise households’ real incomes, even if at the expense of (export-oriented) companies. No, I’m not talking “socialism” here.. The point is about boosting private consumption; and creative incentives for better corporate governance by making companies less reliant on cheap inputs and a cheap exchange rate to maintain a competitive edge.

Finally, we do also have the global imbalances. Here, some note that the renminbi may have too little a role to play in narrowing the global imbalances. One argument rests on a counter-example: Accordingly, the US trade deficit remained large between July ‘05 - July ‘08, even as the renminbi appreciated some 20% during that period. A second argument questions the very presumption that the renminbi is undervalued.

I find the first argument misleading. First, we don’t have the counterfactual—as in, what the US trade deficit would have been, had the CNY not appreciated. Second, relative price levels do matter. Depending on how low the starting point is, a 20% appreciation may not be enough to restore competitive equilibrium. Third, people forget that China runs a trade surplus not just with the US but also with the eurozone and (yes!) with Japan—ie. regions with overall current accounts in balance or surplus! In other words, the plummeting US savings ratio is only part of the story behind the US external imbalance with China.

When it comes to how much undervalued the renminbi is, here we are entering abstract expressionist territory. That’s why my preferred approach to assessing an “equilibrium” exchange rate rests on the concept of external sustainability (instead of reduced form equations with ad hoc explanatory variables, or estimations based on current account “norms” and the like). The question boils down to the following: Having amassed a sizable amount of claims on US residents, and with trade surpluses continuing to add to those claims, how does China plan to get paid back?

Counting on the rest of the world to absorb an increasing amount of US exports (via the dollar’s depreciation vs. the euro, the yen etc) won’t work anymore, when countries compete for the “most undesirable currency of the season” award. Resting on the astuteness of US investors to generate a positive income balance despite an overall net foreign liability position of the US as a whole also has its limits—including from China’s perspective: The People’s Republic of China will not exactly be serving its people, if it continues to channel an excessive amount of national savings into low-yielding US Treasuries when there are higher returns to be made either at home or elsewhere.

Importantly, we should not forget that the US income balance has been positive partly “thanks” to the dollar’s weakness. In the same vein, America’s net foreign asset position remained fairly stable (pre-2008) despite large US current account deficits, thanks to capital gains on US foreign assets resulting from the dollar’s depreciation. So, barring a surge in the US net exports to China, China will have to allow exchange rate adjustment if it wants to get “paid back” (in part with capital losses).

All in all, there is no way around the fact that China needs to allow two-way flexibility of the renminbi urgently and for its own sake. Downplaying the importance of this step is naïve, if not disingenuous, for anyone with the word “economist” in their job description… If anything, China’s own fixation with the renminbi does enough to prove them wrong!

On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!

What Triffin dilemma?!

Time and again you read these days many a commentator arguing that the recent global imbalances have been the inevitable corollary of the dollar’s role as a reserve currency.

It’s the Triffin dilemma, they say, after economist Robert Triffin, who, back in the 1960s, maintained that the country issuing the global reserve currency must be willing to run trade deficits, in order to supply the world with enough of its currency to meet the global demand for reserves. The “dilemma” arises from the fact that, the more dollars, say, are supplied to the world through US trade deficits, the more the value of the dollar is undermined, threatening its role as a reserve currency.

So, as it happens, I disagree both with Triffin (notwithstanding his Yale credentials)… as well as with the premise that it’s that very dilemma that has led to the global imbalances we still see today. Here is why…

First, probably a lesser point but, as a matter of principle, the supplier of the reserve currency (let’s call it United States) doesn’t have to run trade deficits. Countries wishing to accumulate FX reserves can do so by accumulating foreign liabilities. China’s central bank, for example, can buy the dollars entering China through foreign direct investment, and invest these in US Treasuries. Alternatively, countries can borrow dollars long-term from the official sector or even the private sector, and keep them invested in Treasuries in case there is a crisis.

Understandably, the latter (ie borrowing) option is anathema to most countries, due to the implicit or explicit conditions attached to these loans. Similarly, countries may need to hold more precautionary reserves than the foreign currency entering their market in the form of more stable, long-term liabilities such as FDI. So what’s the alternative?

It’s what some emerging markets have been doing in recent years: Namely, accumulating reserves partly through running trade surpluses. But is that sufficient to undermine the value of the US dollar? Not necessarily.

The presumption that it “should” rests on the concept of external debt sustainability—i.e. the fact that a country cannot accumulate liabilities for ever. Countries that do, usually end up with their currencies depreciated, which helps correct the external imbalances through valuation effects on their external balance sheet. But here are a few caveats for the case at hand:

First, if it’s precautionary reserves that we’re talking about, emerging markets reaching the desired/”optimal” level of reserves would stop accumulating further dollars (beyond an annual “maintenance” amount proportional to the capital and trade flows into the country).

Second, even if the stock of (precautionary) reserves is large, this doesn’t mean that there are “too many” dollars floating around. Countries demand reserves for insurance purposes—i.e. the stock of dollar reserves is not used to splurge in European luxury goods or Brazilian bikinis, which could lead to the dollar’s depreciation. Instead, dollar reserves are saved (e.g. invested in Treasuries) and are ready to be employed if there is a sudden stop in capital inflows.

Even (even) if the dollar depreciated somewhat, that wouldn’t matter anyway—again, if it’s precautionary reserves we’re talking about; and if the bulk of a country’s external obligations (e.g. imports or debt payments) are also denominated in dollars. In other words, even if the dollar were to depreciate, this should not undermine its role as a reserve currency.

So done with the Triffin dilemma?

Not yet... we still we need to answer the question… has the dollar's status as reserve currency encouraged the circulation of “too many” dollars around the world? And if yes, was that inevitable, as per Dr Triffin?

To see if there are “too many” dollars on would need to check whether (a) the foreign private sector is flushed with more dollars than it wants or needs; (b) the foreign official sector (i.e. governments) hold excess reserves (ie reserves that would eventually be spent on goods and services). So what has been the situation in recent years?

Abstracting here from the post-crisis period, and the Fed’s massive dollar-supply operation, (a) does not seem to have been the case in recent years. Looking at the US international investment position, the net amount of dollars in private foreign hands (i.e. the US net liabilities to the foreign private sector) had actually been declining in US GDP terms since 2002 (and more so in global GDP terms, which is more relevant).

What have ballooned instead are America’s net liabilities to the foreign official sector. And provided that some of these reserves are “excess”, yes, there are “too many” dollars floating around.

But surely that’s not the result of a Triffin dilemma and the dollar’s role as reserve currency. That’s the outcome of another (well-known) dilemma altogether: The growth-model dilemma of some emerging markets (and their fixation with exports).

I shouldn't let the US completely off the hook here... Countries do not accumulate any types of foreign assets as reserves. Instead, they prefer assets that are safe, with deep and liquid markets. And the US for decades has offered the perfect product for FX reserves, namely US Treasuries (unlike the eurozone, where debt markets are liquid but fragmented due to the different creditworthiness of each eurozone member).

In this sense, the return of the US fiscal deficits post-2002 (and associated rise in the supply of Treasuries) facilitated reserve accumulation. And so did the (not-so-implicit) guarantee on the GSEs, which offered a tremendous pool of spready products with the kind of government backing that FX reserve managers love. But still, that should not divert attention from the fact that these assets were accumulated as a result of policy intent.

So where do we go from here? Well, first of all, China’s ongoing accumulation of Treasuries is only delaying the inevitable down the line. Second, its slow asset shifting from dollar to non-dollar assets (e.g. using its dollars to acquire companies in the resource sector in Africa, etc) is not really a sustainable solution: At some point, you begin to irritate the recipients of these flows, as their currencies appreciate vs. the dollar (and the renminbi for that matter), hurting exports and encouraging voices of protectionism.

Ultimately, part of the solution rests on what has become the consensus call by Western policymakers and academics alike: A conscious decision by China to replace its fake Prada bags for the real deal!

Giving up the dollar addiction

There is a whiff of irony in hearing Asian government officials nagging about the potential debasement of the dollar, and then seeing them going to buy the very currency they love to hate.

Yet, that’s exactly what's been happening: Since the beginning of the year, Asian central banks have resumed their foreign exchange (FX) reserve purchases, accumulating more than $75 billion on aggregate. Peanuts by the standards of recent years, though not if one puts the number in the context of collapsing global trade and finance. Evidently, some addictions are hard to give up!

Admittedly, in some cases (e.g. Korea) the buying has been simply recuperating reserves lost in the midst of last winter’s global financial meltdown and the sudden stampede of foreign capital.

But still: At more that $5 trillion, emerging Asia’s reserves remain $870 billion higher than their end-2007 levels ($460 billion excluding India and China), making a clown out of anyone who dares suggest they are not “adequate”.

So where does one stop? Some have suggested that, as emerging markets continue to attract foreign capital flows, build up larger foreign liabilities and liberalize further their capital account, reserve adequacy considerations would justify more reserve accumulation going forward.

Frankly, I see this as a very narrow-minded argument: Reserve adequacy does not have to be achieved through reserve accumulation. But let me first discuss the framework…

The costs and the benefits: One way to assess reserve adequacy was laid out most recently in a 2008 IMF working paper titled “Are Emerging Asia’s Reserves Really Too High?” At the crux of the argument lies a cost-benefit analysis of the “optimal” level of reserves. It goes like this:

As in most things in life, when you hold FX reserves there are benefits and costs. The benefits stem from the central bank’s ability to employ those reserves in order to cushion the economy from a major disruption due to a sudden investor stampede—i.e. when foreign (and even domestic) investors decide to take their money out of the country.

The benefits of holding reserves are then larger when the probability that a country experiences a “sudden stop” of capital flows is high; and when the sudden stop can generate a very large loss of output, employment and so on, if left uncontrolled.

But reserves also involve an opportunity cost. For example, to avoid a rise in inflation, the central bank may need to absorb (or “sterilize”) the money it creates from its purchases of reserves. It will do so by selling securities domestically, on which it will have to pay interest. So when this interest is higher than that earned on the FX reserves there is a net cost.

Based on this framework, the “optimal” level of reserves is the level at which the marginal benefit from holding an extra dollar of reserves equals the cost of that extra dollar. And, per the authors’ estimations, as of late 2007, reserves in most Asian countries were more or less optimal, except for China, Taiwan and Malaysia where they were (already) unquestionably excessive.

Abstracting from any reservations one may have about some of the authors’ assumptions (and I do), there is a broader question here: How should a policymaker use this framework in order to assess (and achieve) reserve adequacy?

Reserve accumulation is not the only path to reserve adequacy: Think again of the cost-benefit framework for reserve adequacy. An obvious application of this framework is to answer the following question:

How much reserves do I need to accumulate as an “insurance” against sudden stops, given the probability of a sudden stop and given my economy’s vulnerabilities to it?

But policymakers can use the framework to tackle a different challenge: Change the “givens”!

Policy can aim, for example, at speeding up reforms that make the economy more resilient to violent moves in capital flows, in order to reduce the resulting output loss (and, hence, the need for FX reserves).

The list of reforms is long but at the top are certainly measures to increase the depth, liquidity and sophistication of local capital markets, and develop viable hedging tools (including for interest rate and foreign exchange risk) to facilitate a better management of balance-sheet risks by banks, companies and households.

Another “given” that could be changed by policy is the probability of a sudden stop. You see, while the recent stampede from emerging markets was very much driven by the shenanigans of banks in the developed world, in the past “stops” have often been driven by bad policies in the emerging economies themselves.

The opportunity cost of reserves may be higher than you think: On top of policies to change the “givens”, there is also a case for revisiting the concept of the opportunity cost of holding reserves. The IMF paper presents three different approaches to measuring this cost (of which the fiscal cost of sterilization I mentioned above is one). But there is a fourth one: The difference between the rate of return on US Treasury bills and the return from investing the money at home.

The opportunity cost seen this way will likely exceed the one measured by all three approaches in the paper. After all, high expected returns in emerging markets are the very reason foreigners enter those markets in the first place. But a higher opportunity cost means that the “optimal” reserves should be lower: A government would be better off investing part of its net export proceeds at home, instead of amassing reserves.

Finally, one would have thought that the current crisis has opened the eyes of reserve managers to another factor affecting the cost of holding reserves: The fact that reserve accumulation by many countries collectively can lead to adverse global outcomes, even when from an individual country’s perspective it might look like an optimal decision ex ante.

In other words, while it may make sense for, say, Taiwan individually to continue accumulating reserves, when everyone does it we get large global imbalances, artificially low global yields and tremendous risks to global financial stability. Risks that are not “priced in” the cost-benefit optimization framework above.

Sadly, the noises coming out of Asia betray a continued “addiction” to reserve accumulation. Even while concerns about the dollar’s future are becoming louder and louder, the solution proposed is… a new currency to park FX reserves!

In the end all the talk about the dollar’s debasement or a new global monetary system is just blabber and a distraction from the real policy challenge facing emerging markets: How to achieve reserve adequacy without relying on more reserve accumulation!

Treasury myths

So that’s what it takes these days, huh? A few “bps” along the yield curve, scattered wobbles in the equity markets and a falling dollar for people to start prating about inflation scares, monetary debasement and what to do about it!

Big deal, I say. Headlines aside, the market moves we’ve seen in recent weeks are not only minute by inflation-scare standards but, actually, have little to do with inflation at all. Instead, they should be seen as part of the markets’ steady march towards normality.

Let me throw in some evidence:

The “sell-off” is global: First, the recent rise in long-term yields is not just an American phenomenon but a global one. Ten-year yields have gone up in countries like Germany, France or Canada, which haven’t yet embarked on quantitative easing (i.e. the purchase by the central bank of government bonds or other assets to reduce long-term yields and boost aggregate demand). Even Japan, which is already in deflation territory, has seen its long-term yields rise!

Sure, the rise in US yields has been larger than in those countries: Ten-year US yields have gone up 1.50% this year, i.e. more than twice the increase in European or Canadian yields.

But that’s from the absurdly low levels reached late last year, as the financial crisis deepened and investors rushed into the liquidity and “safety” of US Treasuries. So, effectively, US yields are now playing catch-up with foreign ones, as investors feel better about the health of the financial system and are beginning to look for higher returns elsewhere. The steady decline in corporate spreads, even as Treasury yields trod upwards, only confirms that view.

Misleading TIPS: Then you have the TIPS—the Treasury Inflation-Protected Securities. These are government bonds indexed for inflation. Analysts have historically looked at the difference between the yields of standard (or “nominal”) Treasuries and those of TIPS of the same maturity to derive an estimate of investors’ inflation expectations.

Since the beginning of the year, the difference between five-year nominal and real yields has “spiked” up by roughly 1.5%, prompting sounds of alert in some segments of the investor community.

But the analysis is misleading: The comparison of TIPS with nominal Treasuries is not an “apples to apples” one. There are two opposing forces affecting the yields of TIPS that make the comparison an art more than a science.

The first force is related to the uncertainty about the inflation outlook. When you invest in nominal Treasuries, the yield you require will be equal to the real interest rate plus your expected future inflation rate; but it will also include additional compensation for your (or the market’s) uncertainty about the inflation outlook. TIPS eliminate that uncertainty and therefore their yields will in theory be free of that inflation premium (i.e. lower).

The second force works the opposite way and is related to the relative liquidity of nominal Treasuries and TIPS. TIPS are less liquid that standard Treasuries and investors will therefore require additional compensation for holding on to them—a liquidity premium.

The bottom line here is that deriving the “true” inflation expectations from a comparison between TIPS and nominal yields requires disentangling these two effects—it’s not a simple act of subtraction.

If this disentanglement has been an art in the past, today it has moved well inside the borders of abstraction. The reason is that, as the crisis escalated last year, the relative liquidity advantage of nominal Treasuries became such a dominant factor that the yield investors demanded from TIPS moved above the yield of nominal Treasuries! In plain terms, not only were you getting inflation protection; you were also getting paid for it!

The decline in TIPS yields this year should therefore be seen in the context of normalization of liquidity conditions and risk appetite, rather than a “surge” in inflation expectations. Indeed, survey-based measures of inflation expectations such as the University of Michigan’s 5-year-ahead inflation expectations or the Conference Board’s 12-month-ahead number do not point to any measurable increase in expected inflation.

The dollar’s woes: The dollar’s broad-based sell-off is part of the same story: A story of normalization in liquidity conditions, appetite for risk and higher yields, and renewed investor focus on economic fundamentals. It has nothing to do with fears of monetary debasement.

The dollar surged at the height of the financial crisis for reasons largely unrelated to the health (or not) of the US economy relative to its peers: One reason was the flight to the safest and most liquid securities around, which are (still) the US Treasuries. Another was the tremendous funding pressures faced by banks.

Basically, as Lehmans collapsed, banks across the globe found themselves short of cash and, in particular, short of dollars—which had been the currency of choice for funding all the “exotic” stuff that originated in the US, like mortgage-backed securities, collateralized debt obligations and so on. Demand for dollars surged therefore, and so did the dollar’s exchange rate.

But funding pressures have been coming down. You can see that for example in the Fed’s balance sheet: Term auction credit to US banks has declined by $80 billion this year, while the Fed’s swap facilities set up to provide dollars to foreign central banks (which, in turn, lent them to their own banks so that they can meet their dollar needs) have shrunk by $370 billion.

Market indicators also point to the same direction: I’m about to get a bit nerdy here but you can look for example at the difference between the short-term interest-rate differentials between, say, the dollar and the euro as implied by exchange-rate forwards; and as implied by the LIBOR (interbank lending) market.

These should be almost equal in normal times due to arbitrage. But at the height of the crisis, as the LIBOR market shut down, investors turned to the FX markets for their dollar funding needs, creating a large spread between these two differentials that pointed to a huge premium for owning dollars. The spread has now come back to normal levels.

Given the widely known weaknesses of the American economy, and opportunities for higher returns elsewhere, it was only a matter of time before the dollar began to sell off. The gradual normalization in financial markets, together with perceptions that some foreign markets might be more resilient to the global slowdown than the US itself, prompted investors to seek to put their money at work elsewhere.

Indeed, as mutual funds data suggest, US investors have been net buyers of foreign equities for 11 consecutive weeks now. Clearly, this may not be a one-way street, and may reverse as the global economic outlook changes. But my point here is that the dollar’s recent sell-off is unrelated to putative concerns about monetary debasement.

I could keep going but I’ll stop here for brevity’s sake… with one additional point, especially for my friend Ben:

Credit conditions have been easing, even while Treasury yields are rising. Indeed, the increase in Treasury yields is partly the result of credit easing. Therefore, the case for the Fed’s Treasury purchase program, whose stated objective was “to improve overall conditions in private credit markets”, is now weaker than ever.

If Ben wants to expand the purchases beyond the original $300 billion, as some analysts have called for, he will have to find another reason. And, frankly, the only reason I can think of is “to avoid at all costs disappointing the markets”!

Dollar faithfuls

Next time I see an article with the words “dollar,” “collapse” and “China” in the same sentence, I’ll dump it straight to the recycling bin… I suggest you do the same.

The latest such gem comes in the form of an op-ed piece by “independent economist” Andy Xie in the Financial Times.

Xie’s thesis is that the Fed’s recent money-printing binge risks undermining global confidence in the US dollar as a store of value and (as a result) as a reserve currency. In turn, if loss of confidence prompts China to accelerate the process of deepening its financial and exchange rate markets, “the dollar will collapse”.

Big words, somber conclusions, yet unfortunately for Xie, his arguments are too thin to support them.

Let’s first get the money-printing argument out of the way. Coming from an “economist”, it reveals a puzzling lack of understanding of the reasons that made the expansion in base money since last September a necessity—namely the unanticipated surge in the demand for the safest and most liquid form of dollar assets—like, money(!)—by the private sector in the US and abroad, as the financial crisis escalated.

I do admit that the Fed’s decision to buy Treasuries does not easily fall under the “necessity” argument. It’s also one that I myself have protested many a time on both theoretical and empirical grounds. But, it’s also one that China should be happy about, as it serves to support the very securities that it holds in its reserves. Indeed, one of the (many) reasons I think the Fed’s Treasury purchases is a waste is the “leakages” that would arise IF the likes of China take it as an opportunity to sell their own holdings.

I don’t want to downplay “exit”-related risks—risks that the Fed is very much aware of and alert to. But the focus on base money expansion as a harbinger of the dollar’s future collapse is a very narrow one, because it is predicated on the assumption that adjustment in the real economy will not be forthcoming.

But this is a wild assumption. The future shape and structure of the US (and the global) economy is admittedly tough to predict but, in the meantime, adjustment has already been forthcoming. The US current account deficit has shrunk by 3% of GDP since its peak at end-2005; and the savings rate jumped back up to 4.2%, its level in the late 1990s, as spending declined. And while the explosion of the fiscal deficit looks scary, a closer look at the numbers suggests the impact on the national balance sheet (public+private) may actually be smaller than you think.

Specifically, CBO projections show that a good chunk of the surge in the deficit (some 5% of GDP) is driven by the TARP and Fannie/Freddie-related subsidies—which basically amounts to the public sector taking over private-sector liabilities. Unless the private sector begins to re-leverage soon, the net impact on the national balance sheet will be small.

In addition, on the revenue side, a big part of the projected decline is in the taxes on realized capital gains. In better years, these gains were partly directed to finance discretionary household spending—spending that won’t be repeated any time soon, unless we get a J-shaped upturn in the stock and housing markets. Translation: Higher household saving offsetting the fiscal dissaving.

The bottom line here is that adjustment is already happening--it’s just not the kind of adjustment that China likes to see, given the over-reliance of its recent growth model on US consumers.

Which brings me to a more important point: Xie’s focus on the potential flaws in the US policy response to the crisis diverts the attention from the blunders of China’s own policy framework, notably the glacial speed of its capital markets reforms.

If the ethnic Chinese have a problem, it’s in their own back yard: Their problem is that both their savings rate, and the assets to which those savings are allocated to, are determined, by and large, by their government.

This makes Xie’s suggestion that America should conduct asset sales to fix its balance sheet all the more laughable. I mean, dude, hello? US assets have been available for sale to foreigners for decades, be it an equity stake in Microsoft or a villa in the Hamptons. Only that interested buyers must be able to get their money out of their own country first. The ethnic Chinese can’t (with some exceptions), thanks to their own government’s policies. Meanwhile, their government invests in US Treasuries.

This brings me on to my next point… What will happen when China does move to liberalize its capital markets, floats its exchange rate and opens up its capital account (steps I would be delighted to witness in my lifetime)?

It’s far from clear that the dollar would collapse. Notwithstanding the stunning accumulation of foreign exchange reserves by the Chinese government, China on aggregate remains substantially “home-biased” compared to an advanced-economy average. Increased sophistication of its investors and its capital markets could therefore well imply a higher share of foreign asset holdings. The US dollar would be a lead beneficiary of this home-bias-reduction process, provided of course that the US retains a dominant share of world capital markets in the foreseeable future.

Finally, could the dollar collapse, say due to a spectacular screw-up by the Fed/Treasury/Congress combo? Possibly, but it, in my view, it will have to be a truly spectacular screw-up, given the absence of enough viable alternatives that can serve as havens of liquidity and safety. Moreover, one should consider the sharp adjustments that would be forced upon the rest of the world (e.g. the rapid correction of the Asian trade surpluses), which, in turn, would put pressures on the currencies of those countries to depreciate.

Not everything is rosy in the US dollar realm.. And flaws in the US policy response have been aplenty, especially as politics has inevitably gotten in the way. But rather than coming up with ominous warnings against potential US policy mess-ups, China should focus on acknowledging its own role into the genesis of this crisis and then do something about it. The world would welcome that, even as it still keeps its good share of US dollars!

China's latest thought experiment...

It is easy to take China’s recent call for the establishment of a new global reserve currency as a joke.

I mean, with all due respect Governor (Zhou), there is a difference between “reserve reserves”—i.e. the funds central banks should keep for contingencies; and excess reserves, which is the stuff they end up with because of their governments’ active policy decisions.

Clearly, China’s concerns are about the latter: It has massive (excess) dollar holdings, as a result of an active government decision, and it now fears that their purchasing power might be eroded due to inflation-prone policies by the U.S. government.

That’s unfortunate, but actually not a legitimate motivation for a discussion on a new (reserve) reserve currency. A more fitting motivation would be a case where existing alternatives fail to play the role well; and/or where a new currency would help fill any gaps in the current international monetary framework. But neither is the case and here is why…

1) Existing alternatives are really not that bad. First, a reserve currency has to be fully convertible, highly liquid, relatively stable and should be backed by deep and sophisticated financial markets. This is to ensure that reserves bear minimum liquidity, credit and market risk so that they can be made available whenever they are needed most.

In addition, reserve currency/ies tend to be widely used in international trade and financial transactions. This is because a central bank would be expected to broadly align the currency composition of reserves with that of a country's external obligations, such as imports of goods and services, gross foreign debt obligations coming due, or demand from residents wishing to obtain foreign currency, etc. The currencies that dominate these types of transactions would therefore be expected to dominate in central banks' reserve pools.

At this moment in time, two currencies fit the bill pretty well: the US dollar and the euro. Apart from being liquid, stable and backed by sophisticated financial markets, the two currencies dominated global transactions by far—with the US dollar accounting for 86% of total reported foreign exchange transactions in 2007 and the euro second at 37% (see BIS data),

2) Return, while desirable, is only a subordinate objective of (reserve) reserves. As I already suggested, the primary focus of reserve management is to minimize liquidity, credit and market risks. (This is not the case for excess reserves by the way). And what this means in turn is that a currency's qualification for reserve currency does not hinge upon its yield but on all that other stuff.

Some have argued that the dollar’s recent volatility may undermine its usefulness as reserve currency by unduly exposing central banks to such volatility. But this is a gross exaggeration.

First of all, even during the height of the crisis, the dollar’s volatility was comparable to that of the sterling and the euro and lower than that of other advanced economy peers. Second, to the extent that a country’s external obligations remain largely denominated in US dollars, the dollar’s volatility does no undermine the ability to cover $-denominated obligations.

3) A new currency a la “Special Drawing Right” (SDR) would face serious challenges to its credibility and governance structure. In its strictest interpretation, China’s proposal would have the IMF as the international “supervisor” of countries’ macroeconomic policies and manager of global liquidity—a global central bank in effect. But barring an unrealistic surrendering of economic-policy sovereignty, that China itself would resist, the Fund would lack the enforcement authority to bestow the new currency with the due credibility.

One only has to remember the Fund’s multilateral consultation (MC) with the US, the eurozone, Japan, China and Saudi Arabia on global imbalances. As crucial as the topic was (we are now living through the consequences), the only outcome was an IMF staff report and participants noting “that the MC had been a useful initiative, which had contributed to an improved understanding of the issues and of each other's positions”. Put differently, “participants noted that the MC had been a useful initiative, then took the staff report and flushed it down the toilet”.

A less strict interpretation of China’s proposal would have members surrender part of their reserves to the Fund in exchange for SDRs, effectively making the Fund a global vault. The benefit here would be simply one of diversification—the Fund would have no enforcement authority in the management of global liquidity beyond its current one.

But how would that help China in its current problem? If everyone expects the dollar to tank, reserve managers would only be willing to change their dollars for SDRs, not their euros. This would drive the dollar weaker in the same way it would if China went and sold dollars for euros outright in the FX market.

Importantly, it’s unclear whether the diversification benefit would be enough to make reserve managers willing to hold SDRs instead of dollars (or euros), unless the SDR takes a prominent role as unit of account or medium of exchange in global trade and financial transactions.

4) The use of an SDR in international trade and finance would be painfully slow. Geographical, historic and cultural ties create inertia in the currency/ies chosen as units of account in international trade and finance.

The euro is a case in point: It has yet to take off as the currency of choice for financial transactions at the global level. This limits its usefulness as a reserve currency for countries where private agents (or even governments) continue to prefer trading or raising finance in dollars—e.g. in Asia or Latin America.

5) And what would an SDR-denominated reserve asset be like? Conceivably, there would be a set of interest-bearing securities with different maturities backed by the underlying asset pool surrendered by the/(some?) IMF members. But these underlying assets are likely to have different risk characteristics, legal provisions, etc, making the asset pool a nightmare to “securitize”. There could also be “free-rider” problems—e.g. as some countries would be tempted to free-ride on the sounder policies the others.

Ultimately, barring the fully-fledged adoption of the SDR as the global currency, issued and managed by a credible global central bank, an SDR fund would not be an improvement to the status quo.

Still, this doesn’t mean that reserve diversification is not desirable—on the contrary. To this end, rather than calling for a distant utopia, China would serve the world best by deepening further its financial markets, increasing the robustness and sophistication of its financial sector, making its currency fully convertible for capital account purposes and, thus, offer a real alternative to the dollar and the euro as a global reserve currency.

I look forward to that!

When the dust settles...

…the sky opens… the light comes down… Lehman is history… and Fannie and Freddie are happily snuggled in the Federal government’s coffer… what happens to the dollar?

One of the most mystifying developments in recent weeks has been the dollar’s audacity in the face of tremendous and persistent upheavals in America’s financial markets. Upheavals that, somehow, don’t seem to rhyme well with the customary verse that “dollar = safe haven.” Yet, the dollar has been relentless, rising by double-digits against most major currencies—partly the result of a widespread stampede out of risky assets, be it commodities or emerging market stocks.

There are two ways one could proceed here. One is to spend endless sleepless nights, twisting and turning, trying to fathom investors’ psychology at times of generalized panic. Another is to keep cool and try to figure out instead what investors might do with their stack of repatriated dollars once the dust settles and the US Treasury opens the tap to support Fannie, Freddie and their debt/mortgage holders.

Not that the latter is an easier problem to tackle. If history is any guide, larger fiscal deficits have had a mixed impact on exchange rates: For example, the dollar strengthened during the early 1980s, when America’s fiscal deficit increased. Ditto for Japan, in the early 1990s. But other industrialized countries had the opposite experience, seeing their currencies depreciate as deficits widened: France in the early 1980s, Canada in the mid-80s or Finland and Sweden in the early 1990s. But then, is there anything we can say about the future of the dollar?

The good old story: Standard economic textbooks give us the story as first told by economists Robert Mundell and Marcus Fleming. Accordingly, when Hank at the US Treasury raises the budget deficit (say by giving out tax rebates or a fat bailout for Freddie), Americans will likely spend more—be it Heinz ketchup or a new home. Aggregate demand will go up, putting pressure on prices, and forcing Ben at the Federal Reserve to raise interest rates to keep inflation at bay.

Suddenly, American bonds look more attractive, so foreign money floods in to take advantage of the higher yield. Mind you, not only foreigners; Americans too, from pensioners in Topeka, KS, to teachers in St Paul’s, MN might decide that those exotic Japanese bonds they own are not longer as appealing as their American equivalents. And as the money flows in, the dollar goes up. So a larger fiscal deficit should be good for the dollar, right?

Ce n’est pas la vie: Life is not as simple as that… First of all, the story assumes that Ben will play it tough, rather than letting monetary policy loose to accommodate a rise in prices. But if he doesn’t, the higher inflation should be bad for the dollar, eventually. Importantly, the framework set by Messrs Mundell & Fleming makes a number of brave assumptions (for simplicity’s sake).

First, expectations are supposed to be static—meaning that the value of the dollar today will not be affected by how you, the Topekans or the Chinese expect future government policies to evolve. That’s kind of hard to buy—if you thought Hank or Ben might “blow” it at some point down the road, by letting public debt swell or inflation spike, you might want to sell your dollars today and send your money back to Japan… Read “larger deficit bad for the dollar.”

Secondly, the Mundell-Fleming model does not take into account any changes in investors’ perceptions of how risky are American assets compared to assets elsewhere in the world. What could prompt such changes? Uncertainty over future government policies, among other things. For example, if our foreign lenders suddenly feared that a larger deficit (and thus debt) might prompt the government to inflate its way out (i.e. allow higher inflation so that the value of its debt falls in real terms), they might decide to get out today. Read: “larger deficit bad for the dollar.”

How will it play in Beijing? But think of another scenario: What if investors bought US assets like Fannie and Freddie debt and MBSs precisely because they expected the US government to bail these companies out, if they failed? What a terrible disappointment it would be, if Hank let them down! I mean, who cares about the larger deficit (at least for the moment)? “Either you keep your (implicit) promise, Hank, or we get out!” Read: “larger deficit, good for the dollar!”

Arguably, Hank’s bailout of Fannie and Freddie was partly aimed at maintaining the appeal of US assets. For good reason, you might think. With foreigners holding 2.6 trillion of America’s debt, and a hefty chunk of Fannies and Freddies, it’s kind of hard to tell the Chinese “we don’t need you!” (Although… I can’t help thinking of the old motto that “if I owe you 100 dollars, it's my problem. If I owe you 2.6 trillion, it's yours!”) So Hank delivers, bond markets rally, mortgage rates drop… and the dollar?

Ultimately, persistently large budget deficits raise America’s foreign debt. So either the dollar has to fall to boost American exports and help us grow out of our debt (read: “deficit bad for the dollar”); or interest rates will have to rise to keep luring foreigners into buying US debt (read: “bad for mortgage borrowers,” defeating the purpose of the bailout in the first place!).

True, some foreign creditors (like the Chinese government) seem to be “infatuated” with US debt assets for their own growth-policy reasons, even if expected returns are negative. But even those guys are sending subtle signals they are considering alternative options.

Importantly, if I am a private, profit-maximizing investor, there is little to stop me from cashing in my gains from last week’s bond rally and get out of dollar assets—until I see interest rates rising again to levels that compensate me for the risk of higher government debt issuance in the future. Read: “larger deficit bad for the dollar!”

So there you go. A bailout providing short-term respite but building up pressures for both long-term interest rates and the dollar. Hard to see how Hank could stop these... well, unless of course he took out a real, M20B1 Super Bazooka!

Glossary: Mundell-Fleming model, deficit vs. debt, bailout, super bazooka.

The dollar’s decathlon

You don’t have to go to Beijing to get a taste of “Olympic” action these days. Whether you like dives, sprints, hurdles or jumps, all you have to do is turn on your computer screen and follow the …dollar! With one difference: Unlike the Olympics, where America appears to be ceding its gold-medal supremacy, the dollar has been the unambiguous champion in currency markets this summer.

After diving spectacularly in March, as the housing and financial crisis translated into an investor stampede out of dollar-denominated assets, the dollar turned into a “hurdler,” with its attempts to come back hindered by a series of bumps. By August, however, it was time for the jumps! And what a jump we got: A three-standard-deviation jump, on August 8th, followed by a steady run back up to levels seen in January… as if Bear Stearns, Fannie & Freddie and the US housing crisis are now a distant memory.

Many a currency expert “sprinted” last week to pronounce the end of the dollar’s decline with such literary headlines as “Is the Greenback?” or “Godot has arrived!” I can’t help noting of course that IF they are right, they were a couple of weeks late!

But are they right? Has the time come for a steady and broad-based strengthening of the dollar after six years of weakness? Should we be really looking forward to pepping up our wardrobes with cheaper Italian suits as early as this Fall?

The beauty contest: Most will admit that the speed and scale of the dollar’s recent jump has been a surprise. Sure, we got unambiguous evidence that the rest of the world is slowing too, all the way from Europe to Japan, via Australia.

But hey, in the beauty pageant of world economies, America is not exactly the beauty queen! True, she has personality, but she also has a collapsing housing market, declining employment and a frail banking sector which remains in the ER, after $250 billion of write-downs and still more to come.

Importantly, while investors now sound more pessimistic about growth outside the US, their expectations about the direction of monetary policy abroad has not changed that much (with a few exceptions)—and certainly not enough to account for the dramatic moves in the dollar over the past couple of weeks.

Expected interest-rate differentials between America and other countries (one important driver of the currency’s “turning point”) remain clearly in favor of most G-10 currencies except for the Japanese yen. This means that you’ll be losing money if you keep on betting in favor of the dollar, unless the dollar continues to appreciate at a fast pace.

The oil-dollar affair revisited: Then we had the collapse of oil prices (and commodities more broadly) in recent weeks, which seems to have triggered the unwinding of long-oil-short-dollar positions by the herd of believers in an Oil-Dollar affair. As I argued back in June (here), the (available) evidence is too weak to corroborate the gossip, let alone support a trade idea.

Moreover, when it comes to proclaiming momentous events like the dollar’s turning point or Godot’s arrival, a drop in oil prices is not going to be your trigger: While it would clearly benefit the dollar vis-à-vis the currencies of net oil exporters, it is not a compelling catalyst for a broad-based dollar strengthening, notably vis-à-vis the currencies of “fellow” net oil importers such as the eurozone or Japan.

Still, one can’t deny that a large number of long-oil-short-dollar positions were on regardless, and that their unwinding may have contributed to the currency drama of the past couple of weeks. Similarly, with Europe stumbling and Japan tumbling, investors rushed to declare America their beauty queen, confident that a slew of men—from Hank to Ben to the entire US Congress—will catch her if she falls.

So here is the question: If it’s true that fundamentals did not move decisively enough to justify the size and speed of the dollar’s move, why wasn’t anyone willing to take the other side of the bet? Could they change their mind as the “dust” settles?

Following the (order) flow: Part of the answer may lie in the so-called “microstructure” of exchange rate markets. The idea goes as follows: Economic researchers have invariably found a disconnect between the short-run dynamics of exchange rates and macroeconomic fundamentals. In other words, even the best exchange-rate models that rely purely on macroeconomic variables (such as interest rates, inflation, trade imbalances, etc) can only explain (and forecast) a very small portion of the short-term variation in exchange rates.

It should be no surprise then that we got a pretty dramatic jump in the dollar recently without a “matching” drama on the macroeconomic news front. But even if there is little surprise, this is not very useful for judging what actually happened and, critically, how long any “disconnect” can persist. This where the “microstructure” guys step in.

Accordingly, information that may be relevant for the pricing of currencies is dispersed across many economic agents, be it individuals, firms or banks. What determines the persistence of any “disconnect” between macro-fundamentals and the price of a currency is the speed with which this dispersed information becomes common knowledge and is embedded in the market price.

“Order flows” are an important channel via which agents’ private, dispersed information is aggregated and incorporated in the price. These are the orders for foreign exchange that you, me, your bank or a furniture-exporter place with our foreign-exchange dealers, based on our respective information about our foreign-currency needs and our expectations about the economy. Dealers (who are the ones who set the price) observe their customers’ order flows, as well as news on the macro-economy, and try to make inferences about the direction of the exchange rate. Dealers also deal among themselves and, through the flows they place in the inter-dealers’ market, their individual information becomes market knowledge and is eventually reflected in the price.

The problem is that the information content of order flows is often hard to interpret—for example, flows may be generated by a customer’s idiosyncratic foreign-exchange needs rather than due to a “fundamental” piece of information. This can slow the information-aggregation process and lead to exchange-rate quotes that are disconnected from fundamentals. The disconnect could persist for months, if firms end up incorporating these “wrong” exchange rates in their real decisions on trade, investment, etc.

Stop-losses and cascades: Idiosyncratic orders could also lead to “price cascading” of the type we saw on August 8th, when the dollar staged its “Olympic” jump. For example, some researchers have suggested that in a scenario where, say, a downward move in the exchange rate triggers "stop-loss" orders, the move can have a cascading impact on the exchange rate, whereby the price jumps fast and discontinuously from one quote to the next. This is because, under asymmetric information, dealers don’t know whether the orders are due to (idiosyncratic) stop-loss policies or private information on the economy. Thus, they may end up quoting prices that are unrelated to the true state of the economy, triggering more stop-loss orders, etc etc.

So what’s next? If markets are quick to digest the fundamentals, we could see a correction of the dollar from its highs over the coming days, particularly if “cascading” or other short-term “momentum” trading have contributed to exaggerating the jump. Alternatively, if the “digestion” process is slowed by continued uncertainty, the dollar’s newfound “strength” could persist for weeks(/months). Of course, we could also see a drastic economic deterioration in Europe and elsewhere, unaccompanied by supportive policies à la US, which may well justify the dollar’s move after the fact.

Paulson & co. have clearly come out to “ban” the dollar from diving. But as we’ve seen, there are other sports the dollar can claim leadership in, from jumps to sprints to hurdles. And don’t forget... the trampoline is also an Olympic sport!



Glossary: macro-fundamentals, micro-structure, dealers, agents, order flow, stop-loss orders, price-cascading, Waiting for Godot

The euro@10: One currency, fifteen soccer teams

I found myself at a beach in Portugal over the weekend, eating sardines and watching the Eurocup final. For those who don’t know what I’m talking about, that’s the European soccer championship—a tournament that, every four years, ignites passions the world over, with the exception of America and, possibly, Tuvalu.

“Underdog” Spain staged an impressive victory over three-times-champion Germany though, for me, far more interesting was the set up: A sandy beach, beer and sangrias, and a bunch of Europeans—Germans, Spaniards, Portuguese, Austrians—cheering passionately for their chosen favorite.

As I was watching, a thought sprang to mind: Is it remotely conceivable that anyone in the group would ever give up their national soccer team for a pan-European one? I mean, think of the efficiencies: Portugal’s Ronaldo for forward, Germany’s Ballack for midfield, Spain’s Ramos for defense, Italy’s Buffon as goalkeeper… A dream team with far better chances of beating the likes of Brazil at the World Cup.

Unthinkable? Perhaps. But if that’s so, why, when it came to their national currencies, European countries did precisely that?

Coincidentally, year 2008 also marks the 10th anniversary since the inception of the euro—Europe’s single currency. And with 10 being a nice round number, it was inevitable that some stock-taking was conducted to assess whether the euro was a good idea after all. So what’s the verdict?

The wedlock: Think of a currency union (CU) like a marriage—both with their costs and benefits. In the case of marriage, the cost boils down to the loss of one’s independence. When it comes to the benefits, well… you tell me! But at (the very) least, you get economic synergies from paying a single rent and buying napkins in bulk.

Thankfully in the case of a CU the benefits are easier to pinpoint, at least in theory. The CU means the elimination of exchange rate risk among its members, which, in turn, reduces the costs of cross-border trade and investment, fosters price and output stability and encourages a more productive allocation of resources within the CU area. By implication, the more countries trade with, and invest in, each other (i.e. the more “integrated” they are) the higher the benefits they will likely draw from sharing a common currency.

Sharing the same roof: What about the costs? Similarly to a marriage, they have to do with the loss of a country’s “independence”, only the monetary policy kind: As a result of a CU, countries give up their ability to set interest rates as they see fit for their own economic circumstances, for a reason dubbed as “the impossible trinity” (nothing to do with “triangles” here). The one difference with marriage is that not all economists agree that this is a bad thing.

Those who say it’s bad argue that different economies often face shocks at different times and, therefore, must maintain the ability to adjust rates independently in order to facilitate their transition back towards potential output growth and “full” employment. But some disagree, arguing that monetary policy should not (and cannot) target “real” stuff, like how many goods we produce or how many people are employed—instead, a Central Bank should contain its mandate to “nominal” stuff like price stability.

Debate aside, let’s assume here for the sake of argument that there is a role of monetary policy beyond the realm of the “nominal” and that, hence, giving up monetary policy independence is costly. By implication, the costs of entering into a CU are higher the more asynchronous the economies are—i.e. the more their business cycles move out of sync.

Passion or reason? So when is a single currency a good idea? Think marriage again. However strong the initial passion, success is more likely when the parties involved are sufficiently compatible. I mean, what if she can’t live without a pet while you shudder with horror each time the poochy poo rushes to lick your feet? Or (worse?!) what if you, an ardent fan of Germany, are asked to tolerate her (sooo inconsiderate) loud cheering of Spain’s victory? Put it plainly, success requires that the benefits exceed the costs; and compatibility is, if not a sufficient condition, at least a good start.

Same in currencies—however solid the political will, economic compatibility is pretty important. To throw a bit of jargon, the countries contemplating a CU should ideally meet the criteria for an “optimal currency area” (or OCA). For example, are they sufficiently integrated? Are their economies synchronized? Are they flexible enough to be able to adjust to idiosyncratic shocks without the “luxury” of their own interest rates? And, going back to our original question, how does the eurozone fare against these measures?

Let's look at a couple of basic metrics: When it comes to the synchronicity of business cycles, it varies—for example, countries such as Austria, France or the Netherlands tend to have a higher correlation with Germany (the eurozone’s largest economy) than their Mediterranean peers /1. When it comes to trade integration, about half of the eurozone’s total trade is conducted within its membership. Is that “sufficient”? Well, it depends on whether you want to see the glass as half full or half empty. But… does it matter that much?

Love is endogenous: Some argue it might not. Their premise is that, once stuck into the wedlock, “things just happen”… You begin to like the poochy poo, you miss it when you’re gone, and you might even wake up one day to find you support Spain!

Similarly, in a CU things are supposed to happen, "endogenously"—meaning on their own, without the interference of external factors: Trade between the countries increases, financial markets become more integrated, interest rates converge, business cycles begin to move more in sync. As a result, the costs of a CU fall and the benefits rise, bringing the CU members closer and closer to the OCA benchmark.

Indeed, in the case of the eurozone, such a convergence and integration did occur—only that the euro on its own was not exactly the reason. According to a recent report by the European Commission /2, the rise in synchronicity was likely the result of the removal of barriers to trade and capital in the context of the establishment of the European Single Market in 1992 and the subsequent reforms in the run-up of to the euro’s adoption.

Fans of the “endogeneity” theory for OCAs may still read the eurozone’s business cycle convergence as a validation of their premise that “things just happen.” Yet, some other “things” have yet to happen: For example CUs are envisaged to provide incentives for structural reforms to improve their members’ competitiveness. These include, among others, reforms to make wages and prices more responsive to output or productivity shocks, make employment more flexible and more mobile across borders, or encourage research and development to better compete in global markets.

Progress in this area has clearly fallen short. The result being that countries like Italy are seeing their competitiveness on a steady downward spiral, or others such as Greece or Spain building external imbalances of a scale that, one day, might raise questions of sustainability.

Honeymoon is over: With the honeymoon passion over, could eurozone members be entering a phase of wedlock fatigue? And, if the first 10 years were hard enough, how about the next 10, which promise high commodity prices, the eventual unwinding of global imbalances and the admission to the euroclub of numerous more countries that are arguably less “compatible” than the club’s original members? Will countries strive to work things out or could they (as the pessimists like to entertain)… file for a divorce?!

Whatever answer I try to give, at this stage it remains a highly subjective one. All I'll say is that I’d like to believe the divorce option is at least as unthinkable as a pan-European soccer team!


Glossary: optimal currency area, currency union, single market, impossible trinity, real vs. nominal, endogenous vs. exogenous, soccer vs. football

Interesting Reads:
Not so unthinkable? See here: "Betting on the possibility of breaking up the eurozone", in the Financial Times

1 See "Optimal Currency Areas And The European Experience", by the Chair of International Finance

2 See http://ec.europa.eu/economy_finance/publications/publication12682_en.pdf

Pass-through ails

What do a barrel of Belgian ale and a barrel of feta cheese have in common? How about a dental-extraction forceps and a Rolex watch?

Dying to find out???

Ok ok, I’ll give it away. It’s their levels of “pass-through”: That is the degree to which a depreciation of the dollar will translate into higher prices for you, me and your dentist. As it turns out, the prices we pay for beer and feta are less sensitive to changes in the dollar’s exchange rate (they have a low pass-through), while prices of forceps and watches are more so.

So what determines the level of pass-through? And who cares?

First question first. Since 2002, the dollar has declined 42 percent against the euro and 25 percent against a basket comprising the currencies of America’s main trading partners. Now, you would expect consumer prices to rise as a result—not least because imported products (from Belgian ale to dental forceps) should be more expensive.

So let’s see what happened: Looking at the consumer price index (or CPI), the cumulative increase over the same period has been 22 percent. Hmmm, that’s close to the dollar’s depreciation against the trade-weighted currency basket.

But don’t jump into conclusions: Much of US inflation in recent years has been driven by huge increases in the world prices of food and energy. As an example, the import prices of fuel and energy products have risen a staggering 530 percent over this period—way larger than the move in the dollar. This means that if you isolate the impact of the dollar’s depreciation, you’ll find it to have been fairly small. In other words, you’ll find a low pass-through.

Indeed, studies looking at industrialized countries have shown that the exchange rate pass-through to prices is generally small, industry-dependent, and significantly less than one for one (meaning, if the exchange rate falls by, say, 10 percent, prices will rise by considerably less than that). Importantly, pass-though has been lower in the United States than in other countries. How come?

First of all, there are two stages of “pass-through”: The pass-through from the dollar’s depreciation to import prices; and the pass-through from the change in import prices to retail prices. Let’s take a look at each one:

From Belgium with love: Think of a Belgian trappist monk who aspires to elevate his obscure ale, Westvleteren, to a household name in the US. Abstracting from the fact that he might want to change the ale’s name into something more… pronounceable, the monk decides it would be a good idea if his export prices were not completely out of whack with those of his American competitors.

That was fine back in the good old days when the euro was trading one to one to the dollar: He could sell his six-pack for $8.99 in America and make roughly the same as he made in Brussels—9 euros per pack. But what does he do now that one euro is worth 1.55 dollars? Does he raise his prices to $13.95 to preserve his profit margins in euros? Or does he take a profit hit?

Turns out that most exporters choose to take a hit—they prefer to cut their margins and preserve their market share, rather than raise prices in line with the change in the exchange rate and lose out to competition. That’s what we call “pricing to market.” And that’s partly why the exchange rate pass-through to prices is fairly low, particularly in countries such as the United States, where markets are vast and consumers reliably compulsive.

A Babel affair: Another reason for low pass-through has to do with the globalization of production—the fact that to produce, say, a t-shirt these days, you start in a cotton plant in Texas, move to a factory in Shanghai, then jump to Hong Kong for some finishing touches before your “Economists Rock!” t-shirt travels back to your local Walmart store 1.

Why does this matter? It does because not all exchange rates move together at the same time. For example, while the Chinese renminbi has been appreciating (begrudgingly!) against the dollar in recent years, Hong Kong’s dollar has not moved (because it’s pegged to the US dollar). So import price of the t-shirt would rise only party, since only one stage of production is priced in a currency that moved against the dollar.

Port-to-door: How about the pass-through from import prices to the retail stores? Economists have estimated that storage costs, transport costs and wholesale and retail costs tend to account for between 30-50 percent of a product’s final price 2. This means that, to the extent that distribution costs remain fairly stable over time, they act as “pass-through absorbers:” They cushion the final price from changes in the exchange rate.

So pass-through has been low... But could it rise? And going back to my original question… Who cares? Well, the Fed does.

Taking it personally: You see, the Fed takes the level of pass-through a bit… personally. Here is why: Suppose the dollar depreciates because of a factor beyond the Fed's control--say, oil prices shot up and the US trade deficit widened. If the Fed has a solid track record as a guardian against inflation, the Belgian monks will know the Fed won’t allow the dollar’s move to affect general prices and they will not raise the prices of their trappist brew.

But what if the dollar’s depreciation is perceived as the outcome of irresponsible Fed policies?!! Like... lowering interest rates too much to "bail out" the financial sector?! Everyone, from the foreign monks to the local ale producers, will expect broader prices to go up, and they will be more ready to pass on the dollar’s depreciation to the final prices.

In effect, the Fed sees a low level of pass-through as a signal of people’s trust in its capacity and willingness to fight inflation. So if there were evidence that pass-through has recently increased, the Fed might tilt closer towards raising interest rates in the near future. And that’s when I start to care. You should too, by the way, and you might also want to tell your dentist.


Glossary: pass-through, trade-weighted currency basket, pricing to market, dental-extraction forceps, trappist ale

1 For a colorful account of the globalization of production see the “Travels of a t-shirt” by Pietra Rivoli

2 Jose Manuel Campa and Linda Goldberg have done interesting research in this regard. See here if you’re curious