Global Imbalances and the War of Attrition

Back in 2005, Ben Bernanke, then (“just”) Governor at the Federal Reserve Board, coined the term “global savings glut” to describe the “significant increase in the global supply of saving” that, as he argued, helped explain the increase in the US current account deficit and the low level of global real interest rates.

In short, a deliberate rise in emerging market (EM) savings from c. 2000 onward flooded the world with cheap money, helping finance an ever-widening US trade deficit and contributing to the perverse lending incentives that eventually led to the 2008 financial collapse.

Five years later, Ben has a chance to restore the global savings-investment landscape; i.e. help force a “correction”, in the form of an exchange rate adjustment and/or a decline in EM net savings. The key here is to recognize that a repeat of the EM savings glut story is less feasible because of important differences between then and now. And the Fed has the capacity to make it, if not impossible, at least extremely costly.

The first difference is that, back then, crisis-ridden EMs in Asia, Latin America and Eastern Europe saw a need to raise their savings in order to pay down foreign debts acquired during their crises. Today, with the EM deleveraging more or less done (or not as urgent), this channel for absorbing any accumulation of dollar (or euro) reserves is no longer there.

Secondly, in the aftermath of the 1990s EM crises, many EMs saw a need to increase their resilience to foreign “hot money” with a commensurate increase in their foreign exchange reserves. This may have been possible then, but it’s considerably less so now, partly "thanks" to Ben's QE.

The reason is that this “asset swapping” from the US to the EMs and back can come at a cost: An EM central bank effectively borrows at the local short-term interest rate (the cost of sterilizing the inflows) to purchase medium/long-term US Treasuries.

For countries with historically high interest rates (e.g. Brazil, South Africa or Turkey), sterilization costs have always been high, so the "insurance" benefits of any additional FX reserve accumulation have had to be juxtaposed against such costs. However, for low-interest rate countries (incl. China, Malaysia, Singapore, Taiwan or even Korea) the “cost” of sterilization during the boom years was actually not a cost but a profit! Yields on, say, 5-year US Treasuries rose from around 3.2% at end-2003 to about 5% in 2007, which was above these countries’ short-term interest rates (i.e. they enjoyed a positive “carry”).

Today, the “carry” has turned negative even for coutnries like Malaysia and China, due to the extremely low nominal US rates across the US yield curve. This makes EM FX accumulation financially costly and politically unpalatable.

On top of that there is a third important difference: Back in the “2000s”, many EMs were operating at below-full capacity, either because of the crises of the late 1990s or because of a structural excess in the supply of unskilled labor (e.g. China). In that context, they saw it fit to promote export-led growth through an “undervalued” exchange rate, while domestic demand remained weak, and in the process maintain relatively loose monetary conditions at home.

Today, domestic demand in some major EMs is rising fast, putting pressure on inflation. Under normal circumstances, this would point to either an increase in imports to meet excess demand (--> a gradual closing of the imbalances) or a rise in interest rates to curtail demand—although the latter would come at the “expense” of a more costly sterilization of any FX interventions due to a more negative carry.

An alternative route of course is to respond by trying to cutrail foreign inflows through the imposition of taxes (or other controls) on foreign capital. But these can only be at best a temporary solution, not least because the EMs themselves do not want to stop all capital from entering. This creates an assortment of loopholes for willing, yield-seeking investors to find their way in. And in case one needed further evidence of the long-term ineffectiveness of capital controls, I'd say, "ask China!"

In that case, the Fed arguably holds the key for the reshaping of the global savings-investment landscape: If it could credibly commit to keep nominal US yields at ultra-low levels for a sufficiently long time, it could force EM action by turning current policies financially costly (through an increasingly negative carry) and politically difficult to sustain.

Of course, that's a big if. First because, unless low rates reflect (very weak) US economic fundamentals, the Fed will have to devote an increasing amount of resources to hold rates down. And the more Treasuries it buys, the larger the negative-carry costs on its own balance sheet, when the time comes to raise its own policy rate beyond 2.5-3%.

Second, in light of the widespread (and misinformed, I might add) outcry against QE in the US, it is questionable whether the Fed can credibly commit to mobilizing sufficient resources to keep yields low for long enough—that is, for longer than many major EMs can sustain their own distortionary policies.

Against this backdrop, global monetary policy-making has not been reduced to a global currency war, as Brazil's Finance Minister recently suggested. It is rather a war of attrition.

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!

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!

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 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

Dissecting the Oil-Dollar Affair

Don’t we all have a penchant for drawing inferences from patterns! Put that together with a fascination with gossip, and you get all sorts of (wild) stories—great for entertainment’s sake but potentially dangerous if they lead to, say, a suicide attempt or… the wrong investment idea!

Take for example the rumor that Tom Cruise has a crush on… Will Smith . Apparently he has been following him “everywhere” recently... and, let’s face it, Smith is such a charming guy! A pretty harmless gossip, you might think, though not if it were to drive Cruise’s official other-half, Katie Holmes, to a suicide attempt after spending sleepless nights reassessing her skills as a wife.

So here is the latest in gossipville.. Dollar and Oil are having an affair! Yeap, the two have been flirting for years now, but they say this time it looks serious. They have been spotted together way too many times… and their (cor)relation seems much, much stronger than before! Each time the dollar weakens, oil strengthens—and vice versa.

What’s going on?

I decided to do a bit of a detective’s work to find out for myself. No, I’m not jealous, this is not personal! It’s about setting the record straight.

Who is after who? Generally, you would expect the dollar to respond negatively to an increase in the price of oil. All else equal, higher oil prices make America’s imports more expensive. So the trade balance worsens, aggregate demand falls, interest rates are cut to kickstart the economy, returns on dollar assets fall, dollar loses its relative appeal and, long story short, it depreciates. That’s how a higher oil price might bring about a weaker dollar.

Another version looks at the other side of the coin: The oil exporters. Since the barrels of oil they export are priced in US dollars, every time the dollar depreciates the price of their exports goes down, all else equal: The dollars they receive for their barrels of oil will buy fewer Gucci bags, since the latter are priced in euros. So, what can they do?

Well, they can either cut their oil supply, in which case prices will go up, re-establishing their buying power; or they can just raise the price of a barrel of oil outright. If the dollar falls, say, 20% against the euro, they could set the price of a barrel by about as much in dollars, to make sure they can buy as many Gucci bags as before. So that’s how a weaker dollar might bring about a higher oil price.

Both stories are sound in principle (subject to caveats), yet what disturbs me is the following: Both are as much true now as they have been for the past few decades! So why is everyone talking about a stronger dollar-oil correlation NOW? Has anything changed?

So they say. So let’s examine the recriminating evidence.

Gucci or Krispy Kreme? One argument has to do with the fact that America’s exports are not as sought after as before among oil exporters: Back in the early 1980s, for example, the US accounted for around 15 percent of the total imports of oil exporters. Whereas now this has dropped to barely 9 percent. What’s this got to do with the dollar-oil affair?

The idea is the following: As the oil price increases, oil exporters become richer since they receive more money for their barrels. Yet, they don’t seem to be using their new wealth to buy more Heinz ketchup and Krispy Kreme’s. Instead, they’re going after more and more Chinese textiles, Korean semi-conductors and some of those Gucci bags—among other things.

The result would seem to be that, as the price of oil goes up, America’s trade balance deteriorates faster than before: US (oil) imports are more and more expensive while US exports remain stagnant (I repeat, all else equal).

Indeed, this deterioration is much worse that in most other advanced economies: America’s deficit with oil exporters rose by almost $60 billion between 2003 and 2007. This compares with just $8 billion for the Eurozone. And that’s why the dollar should be falling (e.g. versus the euro) these days faster than previous years.

Perhaps… but not necessarily. As we have already seen, oil exporters are becoming a lot richer—as in "530 billion dollars richer" in export revenues in 2007 compared to 2003. Sure enough, they’ve been spending more on imports. But even after you take these into account, you’re still left with an increase in their trade surplus of around $140 billion in 2007 compared to four years before. Right, that’s (a whopping) $140 billion of pocket money! What do they do with it?

Citigroup or Ferrari? Here is the catch. You see, America doesn’t just export movies, ketchup and donuts. It also “exports” investment assets: Like government debt securities (quite a lot of those); shares or bonds of American companies (like Citigroup); debt of government-sponsored enterprises (such as Fannie and Freddie); real estate (like condos in Miami); what have you.

And you might be surprised to hear that oil exporters still fancy America’s financial assets quite a bit, despite their growing intentions to diversify…and despite the shameless collapse of stocks like Citigroup, Lehmans & co. Indeed, according to the latest quarterly report by the Bank of International Settlements (BIS), also summarized here by RGE, oil exporters increased the dollar assets they hold in BIS-reporting banks by record amounts during the first three months of 2008.

What does this mean? It means that whatever deficit America had with the oil exporters continues to be more than offset by flows from these countries back into the US. Ergo, the argument of higher oil-->higher US trade deficit-->higher dollar-oil correlation lacks sufficient corroborating evidence.

Keeping up with Gucci: What about the purchasing power argument? Let's see... If oil exporters had as big a bargaining power as to raise oil prices every time the dollar fell and their (non-dollar denominated) imports became more expensive, why didn’t they do it before? Like, when a barrel of oil fetched just 20 bucks?

More generally, you would have seen oil prices moving up every time oil exporters faced an adverse price shock on their imports, so as to maintain their purchasing power. In other words, you would have seen fairly constant terms of trade (ratio of export to import prices) in these countries. But you don’t see that; oil exporters’ terms of trade have been fluctuating a lot, and very much in line with… oil prices.

The “photos”: Best bit last.. Actually, there is not even a “correlation” to gossip about. Take a look at some numbers: The dollar appreciated during both April and May (versus the euro), yet oil prices continue to rise unabated. This is the opposite direction to the one all those gossipmongers are talking about (which is weak dollar-->strong oil). Sure, perhaps if you look at weekly data, or maybe daily or hourly data, you might start seeing "correlations" that last for… a few days. But, I'd rather call that a "fling," if not "data mining" (the economists' equivalent of "gossip fishing").

Where does this leave us? Yes, dollar and oil have a “thing” going on, for years now. Yes, that “thing” tends to be in the direction of strong-oil-weak-dollar (and vice versa). Yes, had the dollar not weakened (because of the abysmal state of the US economy), oil prices might have been somewhat lower (1/).

But no, there is no compelling reason to believe the correlation has recently increased. Their "status" is at best a fling, and certainly nothing I would bet my money on.

Glossary: correlation, terms of trade, all else equal, data mining, fling.

1/ I feel I should reference here studies by the IMF (in its April WEO report, Chapter 1, Box 1.4) and the Dallas Fed, which have tried to estimate the impact of the dollar’s depreciation on oil prices... Even though I actually find their methodologies lacking in a number of ways that probably deserve a whole other article.

Bulls and Bears

The origin of market “bulls” and “bears” is apparently quite obscure (even Wikipedia says so!), but as far as I’m concerned, both are pretty aggressive animals. So if I’m invited to a dinner to exchange views on the hot question of “Quo vadis dollar?” I expect to see a few objects flying across the table at the very least.

So what a disappointment, when a recent event with the above theme turned out a non-event. The idea was admittedly very appealing: Bring together a bunch of counterparts in competitor Wall Street firms, imbue them with alcohol and let them exchange views on the state of the world.

Now you have to admit, this has the potential of a Tuesday-night-“must,” and not just because of the food... With credit markets in shambles, stock markets reeling and brand-name banks seeking rescue from unlikely partners in the middle and far east, it’s kind of fun getting to know those who actually move the markets and what they think—especially when drunk!

The problem is implementation. You have a bunch of Wall Streeters, predominantly male of course, still in their work suits (and ties), looking drained, wine glass on the right hand, left hand in the pocket, discussing in low voice. Two camps eventually emerge, the “Bulls” and the “Bears,” yet from a distance, these guys look as if they are exchanging tips on flower arrangements or their next tea party!

“The dollar has to go up from here,” contends a Bull. “It’s pretty undervalued on purchasing power parity grounds. Just go to Switzerland and try to pay for a bag of chips!”

“May I point that purchasing power parity considerations can only give good guidance for the dollar’s direction in the long-run, but not necessarily for the next six months,” counters a Bear.

“No doubt the dollar will benefit from all the boost America’s economy will get from Bush’s tax rebates and Ben Bernanke’s aggressive cuts in interest rates,” intersects another Bull. While the likes of Europe, England and Japan will go downhill “thanks” to their lame central bankers, who simply lack Ben’s balls.”

“Growth?” questions a Bear. It will take about six months to see the impact of the tax rebates. Not to mention that many investors—us included—are still waiting for all the subprime-related crap to come to the surface before we are confident that bank credit can resume and growth can pick up again.”

(“Crap”? Did I hear the word “crap”? Surely this warrants at least a few greek olives being thrown at the offender!)

But no.
“The dollar will inevitably get a boost by the tremendous appeal of American assets,” continues a Bull, entirely deaf to the provocation. “The Dow is oversold and foreign investors are bound to see the value and bring back their cash again.”

“May I ask what appeal there is in a 3 percent (or less) interest rate? When Euroland and England still offer me quite a bit more? And when European stocks look cheaper form a < P/E valuation perspective than American ones?”

(By the way, that was the same Bear who used “may I” in order to intersect earlier. I’m sure he’s a Brit.. and he must still live in disbelief about the pound’s calamitous collapse recently!)

As the Bulls regroup, he continues: “And I should mention that the still large US current account deficit can’t help. Foreigners may begin to demand more than 3 percent to lend to you in order to finance your consumption.” (ok, when was the last time this guy looked at Britain's own pretty massive deficit?)

“How about those foreign Central Banks? The Chinese, the Saudis or the Brazilians who care far more about keeping their exports cheap than making money out of their dollars they buy?,” dares a female… Bull (I mean, should I really say “Cow”?).

“If you see the data, foreign purchases of dollars have shot up in recent weeks, this will certainly put a floor on the dollar,” she remarks.

“Certainly, foreign central banks will keep on buying dollars. But historically, they have not been able to reverse a trend—up or down. They can only lean against the wind: Buy when everyone else sells.” A pretty assertive Bear, no?

Enters another Bull: “You’d only need to see recent foreign investor activity in the US”. “It’s surging! Didn’t you read that New York Times article the other day? From the Saudis to the Chinese, even the French are coming in for the goodies. And then you have those Sovereign Wealth Funds who are putting their copious capital into all these brand-name US banks. Let’s face it, America is on sale! That’s a big “dollar-positive.”

OK, I’m drained myself now. You just can’t keep my full attention after 12 hours of work without the promise of a real bull fight.. (ok, as I said, a few flying olives might do). Next time dinner’s at my place. Just make sure you bring your red capes!

Glossary: purchasing power parity, current account deficit, sovereign wealth funds, bulls, bears, bullfights.

Dollar vertigo

Hank Paulson did it again. Earlier this week, the Treasury Secretary repeated his “strong dollar” talk with the earnestness of a confessor and the conviction of a tiger attacking its prey! Check this out: “It comes from my mind, my heart, my experience -- a strong dollar is in the nation's best interest.” Never mind that the dollar kept on falling last week.

It’s not the first time. With the dollar nose-diving from its heights in late 2000, Paulson speaks as if he hasn't been watching... A dollar vertigo? This is Paulson at the Fortune Global Forum in India, last October: “I am strongly committed to a strong dollar.” And this is Paulson again speaking with CNBC’s Maria Bartiromo, in August 2006: “Let me say this, Maria. I believe very strongly that a strong dollar is in our nation's interest. And that currency value should be determined in an open and competitive market, based upon underlying economic fundamentals.”

So let’s talk “fundamentals” then. Because they matter indeed, and they are not necessarily flattering for the prospects of the dollar in the coming months.

There are a number of economic factors (or “fundamentals”) that affect the path of a currency like the dollar in the medium term. (In the short run, economists are pretty lousy in predicting currency movements, and so is everyone else!) As a start here I will mention two, promising more in posts to come.

One is the so-called “external imbalances”—a fashionable term for America’s vast trade deficit. Large external deficits are a symptom of an America living beyond its means for years now, helped by borrowing from foreigners. Eventually there comes the payback period—or “adjustment.” This occurs either by a decline in consumption and investment (aka recession) and/or a hefty depreciation of the dollar to help US exports become more competitive abroad and to stop you from buying all those Nintendo Wii’s.

So where do we stand today? Despite some improvement from the 2006 peaks, the November trade data were a reminder that US export growth may have hit a ceiling despite the plunging dollar, as foreign demand may be slowing. The import bill however is accelerating, inflated by the surging price of oil. Doesn’t bode well for the dollar.

Then we have interest rates. With the Fed increasingly fearful of an impending recession , markets now expect more cuts than before in the federal funds rate. This means lower interest on your dollar savings. Now why would anyone—especially those fickle foreigners who loved us so much only a few months back—keep their money in dollars if they only earn interest of around 3 percent, when they can buy German T-bills and earn 4 percent? Or even more than 6 percent if they go down under for the more “exotic” Australian bills? In sum, differences in interest rates tend to affect the demand for currencies, and this was partly why we saw more dollar dumping late last week.

Paulson would do himself a favor, then, if he talked about the weather next time he’s asked about the dollar. It's an embarrassment to his intelligence and track-record, especially if you notice a not-so-flattering parallel with neighboring Venezuela: In the midst of skyrocketing inflation, President Chavez decided to inspire confidence in the economy by replacing the old currency, the “bolivar” with a new one, which he called… “the strong bolivar!”

His motto was “a strong bolivar, a strong economy, a strong country.” Sounds familiar?

Glossary: fundamentals, external imbalances, adjustment, vertigo, Nintendo Wii , strong dollar, dollar