Council on Foreign Relations

Dr. DeLong is engaged is a rather spirited debate over at TPMCafe – one that mirrors the debate inside the Democratic party.  It is a debate over trade, but it also is a debate over US grand strategy toward China’s rise.  

DeLong argues that the United States has a compelling national interest in helping China get rich:

There is nothing more dangerous for America's future national security and nothing more destructive to America's future prosperity than for Chinese schoolchildren to be taught in 2047 and 2071 and 2075 that America tried to keep the Chinese as poor as possible for as long as possible. 

DeLong’s position – that the US needs to position itself as a friend of  China’s economic development — is an appealing one.  But it is also one that I suspect glosses over some big issues.  

Both the US and Europe, which has stood by as China actively drove the RMB down v the euro, have done their part to support China’s development over the past few years.   US imports from China have increased from $100 b in 2001 to $280b in 2006 (overall US imports from Asia are also rising as a share of US GDP; China isn’t just taking market share from others in Asia).  Eurozone imports from China have gone from 62b euros in 2002 to something like 130b euros, maybe a bit more, in 2006.    In dollar terms, the increase in European imports from China is far more impressive.   Think of a rise from around $50b to over $160b.  Both the US and Europe have supplied a lot of demand for Chinese goods over the past few years.

The risk of a protectionist backlash is no doubt rising.  But so far, the US hasn’t taken any policy actions that have really crimped the expansion of China’s exports – which is what I think worries DeLong.   Nor for that matter has the US government done much – if anything — to help in the US whose living standards have been adversely affected by China’s export success.   DeLong and Jeff Faux would both agree that tax cuts for the have-mores whose assets are worth even-more thanks to large financial inflows from China doesn’t count. 

The government of China, by contrast, seems determined to keep China poorer than it needs for to be.  After all, the government of China, not the government of the US, actively intervenes in the market every day to hold China’s living standards down – or, if not China’s living standard, certainly the external purchasing power of all those paid in RMB.   

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I was gearing up to write about how volatility in the fx market had disappeared – something that Simon Derrick ably highlighted on Monday.   Even though the yen is very, very weak against the currencies of the advanced economies by almost any measure, the market expected volatility to be lower than it had ever been in the past.  Derrick last Friday:

This has seen EUR/USD 3 month implied vol. collapse to a record low of 5.5% (compared to a record prior to last July of 7.93%). Meanwhile the equivalent price in USD/JPY has spent most of this year trading close to levels not seen since October 1996 (and then only briefly). Similarly, the cable implied vol. price is trading close to levels not seen in half a decade.

What is remarkable about the activity in these three instruments, however, is that they are currently pricing in levels of calm in these currency pairs over the next three months that have rarely, if ever, actually been seen in the past. USD/JPY has only fleetingly seen such low levels of volatility in the spot price on two occasions in fifteen years (the start of February 1993 and late October 1996) while in cable the current implied level of volatility for the spot price over the next three months has only been seen once in past decade and a half (mid-October 1996).

Most remarkable of all though is the current 5.5% 3-month at-the-money-forward implied volatility in EUR/USD given that the lowest level recorded for the historical volatility of EUR/USD (or its components prior to 1999) from 1992 onwards was 6.54% (in October 1996). In other words the EUR/USD currency options market is currently forecasting that the next three months will be the quietest on record for this currency pair by some considerable margin. (Emphasis added)

Well, things changed a bit today.  On an absolute level, volatility no doubt remains fairly low.   However, it is a bit higher than it was – and both the yen and swiss franc rallied after a small correction in the Chinese equity market triggered a general bout of risk aversion.

One interesting point: the dollar didn’t benefit from today’s flight to quality.   Fair enough.   The currencies of countries with big current account deficits facing a shortfall in private inflows aren’t classically considered the gold-standard by those looking for a safety.  

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Richard McGregor of the Financial Times: 

“The fastest growing export sectors in 2006 were aircraft parts, shipbuilding, integrated circuits, cars and car parts, electrical machinery and telecommunications equipment.”

Hmmm.  I guess China no longer just imports parts (like "integrated circuits") from abroad for final assembly.  It increasingly is making parts for export – and increasingly is moving beyond the final assembly of electronics.   That shouldn’t be a shock.  Its 2006 trade surplus ($180b) is only a bit smaller than its total exports in 2001 – the pace of change over the past few years has been breathtaking.

McGregor quotes Jun Ma of Deutsche Bank:

“China’s export sector is experiencing a rapid structural upgrading in areas including technology, product mix and marketing,” said Deutsche Bank economist Jun Ma. “Most visibly, many textile, machinery and auto parts companies have dramatically expanded their product categories, enhancing their pricing power and profit margins.” 

China increasingly has the export and industrial production profile of a middle income country – but it still has the wages of a low-income country.   And with an export base of now nearly a trillion dollars seemingly expanding at 25-30% on a y/y basis, it casts a very long shadow over the world economy.   One reason Brazil is intervening so heavily to limit the real's appreciation right now is that it worries about Chinese competition.  There are parts of Brazil that produce goods, not commodities.

The case for RMB appreciation isn’t that it will it will immediately get rid of China’s trade surplus.   It won’t.   The case for RMB appreciation is that it is necessary to keep China’s trade surplus from continuing to expand. 

It also is necessary to create the conditions that will eventually allow China’s government to avoid adding an ever-rising sum –  a sum that is likely to be around $400b in 2007 — to its foreign assets.  

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I think anyone who visits Dubai right now is bound to be dumbstruck by the sheer scale of the construction.  It, quite honestly, puts anything I saw in China in early 2005 to shame.   To the naked eye Dubai looks to be building more office space than exists in lower Manhattan — and Wall Street, despite a bit of competition from the City and Hong Kong, still attracts far more IPOs than Dubai’s new international financial center.  Stephen Roach found the actual data — and it turns out that Dubai is putting up the equivalent of down downtown Minneapolis in 2007, and downtown San Franscisco in 2008.

Based on industry sources, 26.8 million square feet of office space is expected to come on line in Dubai in 2007, alone — more than six times the peak rate of completions in Pudong in 1999 and nearly equal to the total stock of 30 million square feet of office space in downtown Minneapolis.  Based on current projections, another 42 million square feet should come on line in Dubai in 2008 — the equivalent of adding the office space of a downtown San Francisco.  There is one obvious and critically important difference between these two urban development projects: Pudong has an indigenous support base of 1.3 billion Chinese citizens.  Dubai’s current population is 1.3 million.  Throw in the entire native population of the UAE and the support base is still only around 4 million domestic citizens.  That's right, a region with less than 0.5% the population of China is out-building the biggest construction boom in modern Chinese history.

The amount of residential construction is equally staggering.  If you build it, the theory goes, they will come.  The amazing thing: even with so much prospective new supply, rents and property prices are — last I checked — still going up.

I consequently fully agree with Stephen Roach's key point: the stereotype of the economically stagnant Gulf is now very, very dated.   Almost as dated as the argument that China doesn’t really have a trade surplus.  The Gulf is not just flush with money – it is now filled with the bustle of loads of new activity.

I don’t buy all the hype coming out of the Gulf though: the arguments about diversification seem a bit overdone.   The Gulf has diversified from pumping oil to pumping oil, refining more of the oil locally and using more of the region's gas to support a petrochemical business.  All that makes a lot of sense, but it is still derivative of the core hydrocarbon business.   And I am not sure that spending oil dollars on construction is real diversification.   If the oil money dries up, so does the construction.

The common argument that the current boom in the Gulf is different than past boomds because it isn't just based on a surge in government spending also strikes me as somewhat over-stated.    Tis no doubt true that less is being spent on classic welfare spending this time around.   But big government sponsored (and in some cases government financed) real estate projects are manna from heaven  for construction contractor.  A cynic might call the current construction boom welfare for the Gulf's business elite, which tends to be found in, guess what, the construction business. The line between spending (building a palace) and investment (building a hotel that doubles as a palace … ) can be a thin.    

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Binky Chadha and my friend Jens Nystedt of Deutsche Bank think so.

In a world where the (net) global flow of capital is increasingly dominated by official flows (Chadha and Nystedt note "emerging market central banks
are the largest participants in FX markets"), the yen's unpopularity as a reserve asset has certainly contributed to the yen's weakness.   Emerging markets in particular are adding to the reserves (and oil funds) at an enormous pace, yet rarely hold many yen in their portfolio.

That means, among other things, that FDI inflows from Japan get turned into demand for euros and dollars by actors like the PBoC.  Remember, China uses, in aggregate, net FDI inflows, to finance reserve accumulation, as its domestic savings is more than enough to finance its (high) level of domestic investment.

A lot of money has flowed into the euro and pound recently.  I estimate that euro and pound reserves increased by close to $300b in 2005, and close to $200b in 2006.  Those flows are one reason for pound and euro strength.   Central banks looking for alternatives to the dollar have flooded into Europe — and shied away from Japan.

Chadha and Nystedt argue that this should change.   The right time to buy euro was in 2001, when the euro was weak.   Not in late 2004, when the euro was strong — or, for that matter, in 2007.   By the same token, there has rarely been a better time to buy yen.   

Sure, yen interest rates are low, but, over time, there is probably a greater chance that the yen will appreciate v. the euro than that it will fall even further.  If your un-dollar choice is euro or yen, you currently can get a lot of yen for your buck, so to speak.

Chadha and Nystedt have suggested that central banks should buy yen in the past — a call that was perhaps a bit premature.  I sympathize: my warnings about the US current account deficit were too. 

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The Bank of Japan's recent rate hike doesn't seem to have dented the world's appetite for carry trades.  If anything, the BoJ's signal that it won't changes rates too quickly seems to have added to the financial world's already strong desire to borrow yen to buy other currencies.  

That brings up a question that we discussed extensively two weeks ago — just how big is the yen carry trade? 

Detecting carry trades can be a bit like detecting planets orbiting a distant star.   Because many carry trades are done off-balance sheet – and even the data for on-balance sheet carry trades has its limits (long lags) – sometimes the presence of large trades needs to be inferred from the wobbles that appear in various financial markets.  Just as the presence of a planet is often detected by the way its gravitational pull leads to wobbles in the light from their star  … 

Right now, I see lots of indirect evidence of the popularity of carry trades.   Large Glacier bond issues and large — perhaps record large – foreign positions in the Icelandic Krona.  A strong kiwi.   Strong reserve growth (implying rapid capital inflows) in high carry emerging economies like Brazil, India and Turkey.  The FT's concerns about slow Brazilian growth don't seem to be shared by the markets: Brazil could add close to $10b to its reserves in February alone trying to fight carry trade inflows.  A weak yen and Swiss franc.   

The case that there are big yen-financed carry trades out there doesn’t hinge entirely on the large speculative short position that shows up in the data from the futures exchange.

Measuring the size of the global carry trade is fraught with difficulties, not the least methodological.   Are central banks that hold pound reserves but not yen reserves engaged in a carry trade?  Are Japanese retail investors who buy – without borrowing any money – New Zealand bonds engaged in a carry trade?   What of Japanese pension funds who buy US agency bonds for the yield pickup?  

Or are we really just interested in the size of the leveraged carry trade, that is the amount of yen that have been borrowed by various financial market actors – be they New York or London hedge funds or Japanese day traders – to buy higher yielding currencies?

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Presumably the BRIs (Brazil, Russia, India) sound like a French cheese, while the BRICs are pronounced like a construction material.  No matter.   The BRIs are increasingly giving China a run for its money when it comes to accumulating foreign assets. 

That isn’t easy.  I continue to think that China will need to add about $400b (gulp) to its foreign assets in 2007 to offset a $300b plus current account surplus (gulp) and ongoing FDI inflows.  That works out to $30b plus a month.  If China’s capital controls aren’t effective and hot money finds a way to profit from the RMB's expected rise, total foreign asset growth could be bigger.   

But consider what happened in the first full week of February.  India’s reserves increased by $5b.  Russia’s by a bit less than $5b ($4.9b).  Brazil’s reserves were up by $2b.  The euro inched up v the dollar in the first week of February, but not by much.  Most of the growth in the BRIs reserves was real, not the product of valuation changes.  $12b a week implies something like $48b for the month.  That is a China-like pace.

What about last week?  Brazil’s reserves were up by almost $3b in the first four days of last week.  We will have to wait til Carnival ends to find out how much more they added on Friday. (Update: Brazil's reserves reached $97.2b, an increase of around $3.35b) And we don’t have data on the others. 

Right now, private investors the world round are quite keen to borrow yen to buy Indian rupee and Brazilian real.    No wonder.  Those countries have current account surpluses (Brazil) or smaller deficits (India) than the US and they offer higher interest rates as well.   Get rid of the emerging economy stigma, and, well, they offer a more compelling source of yen returns than the US …

For that matter, even the Russia ruble may well offer better yen returns than the dollar.  Goldman expects the ruble to continue to appreciate this year.

None of these countries needs the money, or at least, none of the BRIs needs as much money as the private markets want to supply.   India runs a current acount deficit, but the others don't.

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Serhan Cevik has published a series of interesting notes on the Gulf.  Last week, he gave away the Gulf’s dirty little secret: an awful lot of the Gulf’s foreign assets are still in dollars.  This week, he highlights how the GCC’s dollar peg – combined with an understandable desire to put the GCC’s oil money to work at home – is leading to rapid inflation.  Cevik:

…Exchange rate regimes pegged to the US dollar have also turned into a channel for importing inflation  …. Consumer price indices show a clear upward trend in inflation in all oil-producing countries, but we believe that measurement errors in outdated official figures understate the degree of acceleration in inflation. For example, in the United Arab Emirates, independent surveys point to an inflation rate of 15-25%, as opposed to 10% according to the official index. Given the extent of liquidity abundance and the mix of extremely accommodative macroeconomic policies, the behaviour of non-tradable prices is the obvious culprit. But we should not overlook the role of imported inflation. Pegged to the dollar, the currencies of oil producers in the Middle East have tracked the dollar’s sustained depreciation since 2002, even as their export earnings have soared to record levels. And since the majority of imports come from Europe and Asia, the dollar’s weakness has become a major source of inflation by pushing up the price of imported goods and services.

Indeed.  Oil states dollar pegs combined with surging oil state revenues have led to monetary instability.  The necessarily real adjustment has come from inflation – and with the dollar falling, generating a real appreciation has required a lot of inflation, and led to negative real rates that risk leading to over-investment.

Saudi Arabia is the exception.  Inflation ticked up in 2006 (recorded inflation) but it still remains remarkably low, all things considered.    However, the odds are that Saudi inflation is higher than the reported number, as is the case in the UAE.  More importantly, low inflation rates may not last once the Saudis get around to really spending their current oil wealth.  The Saudis currently seem to have a bit of Dubai envy: $650b in planned “infrastructure investment” certainly has caught the eyes of London’s vigilant I-bankers.  The Saudis have — up til now — saved far more of the oil windfall than most.  That looks set to change.

Cevik also highlights something that I think should get more attention.  Real interest rates in most GCC countries – for that matter, most oil countries that peg their currencies – are negative.   Very negative.  Dubai has inflation of say 20% and US dollar interest rates.   No wonder there is an investment boom.   

Russia is less extreme, but real interest rates are negative there too.  No surprise, it too has its mega-projects (Gazprom tower, Gazprom city … ).  And, like Dubai, its own property boom.  Moscow property prices are way up. 

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Garnham and Tett’s large article last week on the risks of the carry trade – or perhaps the absence of risk, as they hint the big carry traders are now insured v. a surge in yen/ dollar volatility (aside: but who is selling the insurance?) – raises a topic that has interested me for a while.   The growing extra-territorial uses of certain currencies.     This is sometimes called the "internationalization of a currency."

How to start? 

Back in the old days, Japanese households saved in yen, and their yen were used to finance yen-denominated domestic mortgages and yen-denominated loans to Japanese business.   Maybe some yen were lent out to Japanese firms looking to finance investment abroad or to emerging markets governments looking for financing (Samurai bonds), but the sums were pretty small.  

Japanese savers didn’t generally hold their financial assets in currencies other than the yen.  New Zealand banks didn't finance themselves by borrowing from Japanmese households.  And households in say Latvia didn’t generally borrow in yen to finance the purchase of a home.   That seems to be changing, and fast.

Now, you might say, back in the old days a lot of Latin Americans (and others) preferred to save in dollars than in their local currency, and either had dollar bank accounts in Miami (or Panama or Uruguay) or dollar-denominated deposits in Argentina or Peru.   And lots of governments borrowed in dollars as well – whether by issuing an international bond in dollars or by issuing dollar denominated domestic debt.   Ricardo Hausmann famously called this “original sin” (he thought some countries were born unable to borrow in their own currency) others prefer liability dollarization. 

Or put, differently, the dollar has been an international currency for a long-time.

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Goldman seems to have confirmed something that I — and, for that matter, Stephen Green of Standard Chartered and Louis Kuijs of the World Bank – have suspected for a while: China's "true" reserve growth is higher than the reported number ($247b).

Goldman via Reuters and Pakistan's Daily Times:

To shield the banks from currency risk at a time of a rising yuan, the People’s Bank of China (PBOC) may have arranged a total of $40-50 billion in currency swaps with Bank of China, China Construction Bank Corp and Industrial and Commercial Bank of China at an implied yuan appreciation rate of 2-3 percent a year, the bank said. Goldman’s research is the latest attempt by PBOC-watchers to explain an apparent paradox: given China’s current account surplus last year of about $230-250 billion and foreign direct investment inflows of $63 billion, why did the PBOC’s official reserves rise in 2006 by only $247 billion? 

The gap between China's reported reserves and the sum of its current account surplus and net FDI inflows is even bigger if you strip out estimated valuation gains from the reported $247b increase.  China holds some euros, and those euros rose in value in 2006.  If China has about 70% of its assets in dollars and say 20% in euros, 5% in pounds and 5% in yen, valuation-adjusted reserve growth was more like $220-225b.  Even with $40-50b in swaps, the 2006 increase in valuation adjusted reserves ($220-225b), off-balance sheet reserve growth ($40-50b) and transfers to a large reinsurer ($4b) add up to between $265-280b.  That still seems to be a bit less than the sum of the current account surplus ($230-250b) and net FDI inflows ($60-65b).   There may be a few more dollars out there in someone's hands …

The use of swaps also explains why the banks have been willing to buy dollar bonds when private Chinese citizens's haven't shown comparable interest in foreign assets: they aren't bearing the currency risk.   Goldman again:

Liang and Yi said it was hard to argue that banks chose to buy FX bonds on commercial grounds because they have limited FX operations and, since August 2006 when the yuan’s pace of climb started to quicken, the trade has been losing money. Furthermore, the banks’ decision to add aggressively to their FX assets contrasts with a steady drop in Chinese households’ holdings of FX assets. Just this week, Bank of China said it had closed one of the first funds through which retail investors could buy overseas bonds because of heavy redemptions.

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