Council on Foreign Relations

The headline is mine.   Don’t blame Dr. Prasad.  

But that is the conclusion I took away from Eswar Prasad’s most recent paper.     I usually write about how China’s exchange rate policy distorts the global flow of capital, and impedes effective balance of payments adjusmtent.  Eswar Prasad – now at Cornell, but formerly one of the IMF’s leading China hands – focuses instead on how China’s peg has distorted China’s domestic economy. 

Maintaining the peg, in Dr. Prasad’s view, impedes China’s ability to achieve many of the Chinese government’s stated goals – jobs, an efficient financial sector and a more balanced economy.       Moreover, incremental reform no longer works – especially not when the de facto peg effectively constraints a host of other policies.  

“There are inherent limits to the incremental reform strategy that has worked well in the past.   At a certain level of development and complexity of an economy, the connections among different reforms become difficult to ignore. …   Ignoring these linkages – for example, trying to push ahead with banking reforms while holding monetary policy hostage to an exchange rate objective – makes an already difficult reform process harder.” 

The right answer is to do more, not less – and to so now, when strong growth makes reforms easier.  Dropping the peg is key.    Why?   Because a host of other policies in China are now directed at reinforcing the peg, and those policies cannot easily be changed if the paramount goal of Chinese policy is a weak RMB.

“The … inflexible exchange rate, while not the root cause of imbalances in the economy, requires a large set of distortionary policies for its maintenance over long periods.  It is these distortions that – though multiple channels – hurt economic welfare and could, over time, shift the balance of risks in the economy.”

Dr. Prasad continues:  Read more »

Both the Financial Times and the Wall Street Journal have done a great job reporting on the rise of sovereign wealth funds.   Joanna Chung and Tony Tassel’s nuanced analysis of the impact of sovereign wealth funds on assets markets stands out (also check out Joanna Chung's contribution to today's special report), as does Henny Sender’s reporting on QIA and ADIA. 

For the outlines of the emerging policy debate, though, no one has matched the FT.

I liked Larry Summers' note of caution better than John Gapper’s more ethusiastic line.  

The FT leader and Lex’s analysis of sovereign wealth funds also stood out.

Why?  Lex and the FT leader displayed a healthy outrage at China’s insistence on pegging to the dollar — a policy that has required that China adopt a series of other policies that have pushed its savings rate up to spectacularly high levels.   The editorials of the major US papers on China rarely strike a similar tone: they often seem to worry more about the risk that RMB appreciation might push up import prices than about the consequences of relying on China’s government to finance an awful lot of US investment.  

The FT and Lex also recognize that the US cannot realistically expect China to finance the US current account deficit by building up an undiversified portfolio that contains only the lowest-yielding of US assets forever.  Lex:

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David Bloom (director of currency strategy at HSBC), paraphrased by Peter Garnham in Friday’s FT:

“Today the euro represents growth and has become a big equity bet, while the dollar is firmly entrenched as a fixed income currency.

“In order to get yield enhancement the market [BWS note: really just the part of the market that isn’t central banks] moved away from government bonds in the US and since 1999, has taken a $2,100bn bet of US credit” says Mr. Bloom. “Given that the big play on the US has been the credit markets it makes total sense that a credit market problem is a dollar problem”

One of the reasons why the dollar rallied over the past few days – at least in the eyes of some – is that Americans who had heavily invested in foreign, including European, equities over the past year or so decided to take some money off the table.     So, strangely enough, bad news for the US stock market became bad news for the global stock market and good news for the dollar (see BNP), overwhelming, at least temporarily, the dollar’s subprime problem.    

At least that is one story. 

Incidentally, one question I have long had is whether or not Europeans holding exposure to US credits typically hedge their exchange rate risk.  AXA's cash plus fund must have, though that didn't prevent the fund from getting into trouble taking a bit of ill-advised credit risk …

UPDATE: More from the Financial Times, drawing on the thinking of UBS's Mohi-uddin:

Mansoor Mohi-uddin, chief foreign exchange strategist at UBS, said while the sudden sell-offs in asset markets, carry trades and emerging market currencies were helping the yen and the Swiss franc to regain lost ground, investors should be aware that the dollar would benefit from safe haven seeking flows as well.

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The BIS reported data on central banks’ accumulation of dollars in the international banking system today (Table 5c).    Central banks added $24.5b to their dollar holdings – but also repaid $53.5b in loans from the world’s banks.   That works out to a $78b increase in central bank’s net dollar position – which rose from $534.5b to $612.5b.   When a central bank pays back a loan from a commercial bank, the commercial bank is able to lend those funds out – increasing the “liquidity” available to private borrowers.    Not all these dollars flowed to the US either.  But the availability of dollar financing in offshore financing centers certainly makes it easier for a range of financial players to buy US securities.  

The same BIS data shows a $50.7b increase in central banks net euro position in q1 ($47b in flow terms) and a $10.7b fall in central banks net pound position (-10.3b in flow terms).   

In ball park terms, net dollar deposits ($78b) grew almost twice as fast as net euro and pound deposits ($40b).  That doesn’t suggest much of a shift away from the dollar.  I wouldn’t put too much faith in this data though.  It covers a small subset of total central bank claims, and I suspect that central banks ran down the pound deposits to buy other pound assets, not to buy dollars or euros.

The BIS data can be combined with the US data to get an estimate of the total increase in central banks dollar holdings.  The US BEA reported $147.8b in net official inflows to the US in q1.  Most of that came from the purchase of US securities, but there was also a $29.4b increase in (“onshore”) bank deposits.  To get an estimate of reported dollar reserve growth that avoid double counting, I need to subtract the increase in onshore deposits from the US total and then add in the overall increase in dollar deposits reported by the BIS.   That produces a $196.4b increase in central banks “known” net dollar holdings. 

The q1 2007 US current account deficit was $192.6b.  

Even if not all central bank offshore dollar deposits flowed directly to the US, it doesn’t take a genius to figure out who is currently financing most of the US deficit.

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OK, SAC-Temasek seems a bit more likely.   But SAC (A big hedge fund) does seem to be marketing itself to a range of Asian state investors.

“SAC has been marketing possible stakes in its management company to foreign investors including Asian state funds such as Temasek of Singapore.”

That is why the FT’s headline (the sale to private investors bit) seemed off.    State funds aren’t quite private investors, at least not in the classic sense.  

A lot of big official investors are buying in to their money managers – or, in China’s case, perhaps buying into their future money managers.  Think:

• CIC-Blackstone
• ADIA-Apollo
• CDB-Barclays

The FT again: 

Many of the stakes are being bought by cash-rich investors in Asia and the Middle East.

Too bad all the GCC countries and China seem to be devoting more energy to finding new ways to manage their money rather than finding new ways to manage their exchange rates … 

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I thought the reason why China couldn't revalue its currency was its desperate need for jobs — you know, all those migrants from rural China who needed to be absorbed into the modern economy.    Apparently not.

Bloomberg reports that "China will curb exports of cheap labor-intensive products to force manufacturers into making higher-quality goods."

Restricting labor-intensive exports rather than say letting the currency appreciate makes very little sense to me. China isn't having any trouble moving upmarket into more capital-intensive exports on its own — look at the migration of electronics components production to China and the development of China's auto sector.  

The contradictions in China's development model keep growing. 

Communists — even , or perhaps especially, the descendants of immortals — are becoming global capitalists.    And the government of a labor-rich economy where wages are falling as a share of GDP is taking a step that on its face seems likely to reduce demand for labor.

One of the ironies of China's current boom, as this new paper by Eswar Prasad notes, is that it simply hasn't created all that many jobs.   The low-interest rates associated with holding the RMB down — and the absence of any need for now-profitable SOEs to distribute their earnings as dividends — has instead encouraged the substitution of capital for labor.   

And this time it let the dinar rise by a bit more than in the past.   1.7% is a lot more than the dinar moved the last two times (0.4% and 0.7%).  Monica Malik of EFG-Hermes:

“They're revaluing because of the weakness of the dollar against other major currencies. The revaluation last time was just too small.''

The cumulative move is still small, but at least the trend is in the right direction.  I increasingly wonder which GCC country will break next.    There is no good fundamental case for further GCC currency depreciation when oil is above $70.   Goldman wrote this morning:

We believe that the UAE and to a lesser extent Qatar are likely to follow Kuwait's example and allow for greater exchange rate flexibility, in time. Both economies are suffering from serious inflation problems, reinforced by imperfect sterilisation of inflows and rising food prices. The ultimate remedy to the inflation problem in both countries will have to be a fiscal one. But the oil bonanza continues and there is no sign of meaningful fiscal adjustment on the horizon. Under the circumstance, currency appreciation could help at least check imported inflation coming through trade weighted USD weakness and provide some relief.

The combination of US interest rates and high inflation rates means that real interest rates are now very very negative in several Gulf countries, especially Qatar and the UAE.

A part of me wonders if the Gulf's investment funds — which increasingly seem to want Asian and European equities rather than US dollar bonds — are contributing to the dollar's slide, and thus to some of the difficulties confronting GCC central banks (and expats).  Check out Henny Sender's brilliant profile of Qatar's Investment Authority — which clearly fancies buying companies, not just shares in companies.   And at least for now, it isn't trying to buy a US company.

There is something about SAFE — maybe the fact that its full name, the State Administration of Foreign Exchange, seems to come straight from the Ministry of (Bureaucratic) Magic –  that seems to inspire Harry Potter analogies.  

Macro Man calls China’s reserve managers Voldemort – in part because investment bank research never (or almost never) refers to China by name.    Diplomatic analysts prefer to write about “Asian accounts.” 

Andy Mukherjee got into the act yesterday as well.  He – drawing on Paul Meggyesi’s work for JP Morgan – argues that China’s reserve managers must have an invisibility cloak.   

Something doesn't quite add up in the U.S. Treasury's International Capital System statistics, or TIC data.

Why, for instance, did U.K. investors begin buying U.S. securities just as the People's Bank of China started increasing its pace of reserve accumulation in 2004?

“Is this more than a coincidence? I believe it is,'' Meggyesi says. For the past three years, the reserve buildup in Russia, China and rest of Asia has overshot the recorded official purchases of U.S. securities.

And the growing difference between the two has moved in lockstep with the reported purchases by U.K. investors, “providing very strong evidence that much of this reserve accumulation is being channeled via the U.K., and is in the process being incorrectly recorded in the TIC data as a private rather than official inflow,'' Meggyesi says.

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The alliance between the Chinese state – lest we forget, still a (nominally) communist state — and the high priests of global financial capitalism is close to complete.   

Goldman, Royal Bank of Scotland and Bank of America all have invested in China’s big state banks, effectively partnering up with China’s government.   And China’s government is now an equity investor in Blackstone and – with a bit of Blackstone help – looks to be taking a stake in an (expanded) Barclays as well.  Technically, the investment in Blackstone came from the new investment company while the cash for Barclay's is coming from China Development Bank, but, well both ultimately have the same owner.   I presume some part of China's government will soon buy an equity stake in a major hedge fund or investment bank as well.   Why not go for the trifecta .. 

Commercial banks used to be robbed, according to the famous quip, because that was where the money was.  Now the money is in the hands of China's government.   And China seems willing to deploy it far more aggressively than in the past.  The formation of the state investment company seems to signaled a decision to go straight from bonds to strategic stakes, without bothering to fiddle with small, liquid holdings in a range of companies.   Any one looking for financing to do a really big deal will, I would guess, soon make a pilgrimage to Beijing.

Dr. Dooley, Dr. Garber and Dr. Folkerts-Landau have long argued that China needs to hold liquid foreign exchange reserves — think US Treasuries — as collateral against foreign investment in China.  But China's state no longer seems all that interested in swapping Chines equity for low-yielding debt denominated in a depreciating currency.  Western banks investment in China’s large  state banks should be offset by equally large Chinese investment in large western financial institutions.  Rather than swapping equity for debt, China's government wants to swap equity for equity. 

The ironies abound.  

The British state’s retreat from the “commanding” heights of the British economy seems increasingly to be offset by ascent of other states, whether the Chinese state or a set of active Gulf states.   The point here is more general:  Asian and Middle Eastern governments – through their investment funds — increasingly are playing a role in Western economies that voters do not necessarily think their own governments should play.

China's investment in Barclays is coming from a lender theoretically devoted to "development"  — both domestic infrastructure lending and subsidized lending to Africa.  I guess there is more poverty in the City than I thought.   Either that or China Development Bank is now more commercial than China's state commercial banks.

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Oil is once again quite strong.    Last summers’ rally was driven in part by a rise the geopolitical risk premium.   This summers’ rally seems a product of both strong global growth and relatively restrained supply growth.    The latest IEA report certainly seemed to suggest that high oil prices are here to stay absent a lot more investment in either oil or renewables.

The dollar is once again quite weak.  It is now very weak against almost all the G-10 currencies.  Every day it seems that Bloomberg has a new headline indicating that some currency – the pound, the euro, the Australian dollar, the New Zealand dollar  – has hit a multiyear high against the dollar.   The yen is the obvious exception: According to Mitsubishi UFJ securities, the yen is now weaker in real terms than in was before the Plaza accord.

The dollar isn’t weak against most emerging economies – and it isn’t hard to figure out why.   I smile when I read that the dollar floats.   It is true that the US doesn’t intervene in the market.   But that doesn’t mean the dollar floats – not when other central banks intervene like mad.   Right now, the dollar floats v about half the world.    That matters.  A growing fraction of US trade is with those countries that do not let their currencies move (by much) against the dollar –

It certainly seems though that neither high oil prices nor the weak dollar are attracting as much attention the second time around.  Back in 2004, the magazine cover indicator was screaming red – as all sorts of publications did big stories on dollar weakness.   Not now.   And it certainly seems like the risks stemming from high oil prices were a much bigger topic of discussion back in 2004 – and in the summer of 2006 – than they are now.   Now there seems to be more talk about sub-prime, private equity and the Dow … 

Tim Duy is right.   The longer the US economy sort of absorbs various shocks – I say sort of because housing clearly has reduced the pace of US growth recently even if it hasn’t slowed the stock market – the less attention certain shocks get.    Financial markets have come to expect that central banks will finance the US when private markets don’t want to – so they expect (correctly, at least so far) that dollar weakness won’t push up US rates, at least not by much.   And if the US absorbed the last oil shock, why won't it be able to absorb the current shock? 

Still, there are some differences between the current strong oil/ weak dollar combination and the strong (tho not nearly as strong as now) oil/ weak dollar combination of late 2004 — or for that matter, the strong oil/ strong dollar combination of much of 2005.

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