Are we on the path to recovery?

According to the latest data from Bloomberg, as of March 31, 2009 The US Treasury and Fed had committed a total of $12.8 Trillion to the financial rescue efforts. Out of this committed limit, $ 4,169.71 billion was drawn down as of March 31, 2009.

More on the US Treasury Finances

The Auction schedule for the US Treasury debt securities shows the planned auction dates till November 05 2009.
As of April 28, 2009 the International Reserve Position of the United States shows total foreign exchnage reserves of $ 75, 877 million - or around $ 76b, according to this press release from the Department of the Treasury.

According to a Treasury statement to the Associated Press, The US Treasury plans to borrow $361 billion in the current April to June Quarter. Excerpt:

The $361 billion estimate for borrowing this quarter compared with borrowing needs of just $13 billion in the year-ago period. Normally the government's borrowing needs shrink sharply in the April-June quarter because of all the tax revenue being collected.

But, please remember:

Treasury also estimated it will need to borrow $515 billion in the July-September quarter, down slightly from the $530 billion borrowed during the year-ago period. The all-time high of $569 billion was set in the October-December period.

Here's a link to the latest Treasury Note, Bond and TIPS auction results.

How much should a Sovereign Borrow? - continued reasoning on the Treasury finances

Chapter 18 of 'Principles of Corporate Finance' authored by Brealey & Myers deals with the interesting topic 'How much should a firm borrow?'. I don't know of any slim volumes in the public domain that present a similar reasoning for Sovereign borrowers. However, King Financing is one of the biggest games in the world. I bet the King Financiers have batteries of private PhDs churning out reams of ring-binded reports to work out the considerations for them. So I'm left to deal with this important topic with my own wits.
First of all you need to reason with the different categories of expenses or 'outlays' that a Government has. A Government needs money to provide certain public goods, for which it will collect taxes. For instance, people pay taxes and the collected amounts may be utilized to pay salaries for cops who maintain the law and order. Then you have outlays that are intended to create a long term benefit. For instance, the US Government can provide an economic stimulus for Chinese laptop manufacturers by giving free computers to school kids. The Government hopes that the kid will utilize the computer to pick up various skills, in turn earning a better income when it grows. This will result in a higher income tax collection for the Government in future.
It's important to split the Government outlays into items that are like operating expenses they have to provide required public services, and items that are intended to provide a long term return in terms of future GDP expansion and increased future tax collections.
The next part of the reasoning is on the interest the Government pays on its outstanding debt. You have to remember that a Government Bond holder isn't a beneficiary in future higher tax realizations of the Treasury. The debt holder simply receives interest and hopefully, the principal back from the Government.
The Government financier's interest is to make sure that the interest being paid is out of the money the Government is levying on citizens on an ongoing basis, and not out of the money that is realized from the Government borrowings themselves. A Government debt holder will expect interest to be paid out of the annual earnings of the Treasury. The one year term is derived on the understanding that most levies are collected on an annual basis.
From this reasoning, it is clear that on a stand-alone basis a Sovereign can borrow to the extent that the excess of its annual levies over outlays for operating expenses to provide routine public services is sufficiently large to meet interest payment obligations on its outstanding debt.
In case of the US Treasury, foreign central banks have a compulsion to lend money to them due to the military-diplomatic hegemonic compulsions. This factor enables the US Treasury to create a 'safety bubble' if it so chooses. Also, the triangular debt trading in the Treasury securities amongst the Treasury, Fed and primary dealers constitutes a method of extracting contributions to Treasury debt through the secret concession embedded in the Treasury Supplementary Financing Account.
In this framework, you need to analyze whether the US Treasury interest outgo is coming out of an excess of Treasury Revenues over routine operating expenses or not. If not, the Treasury is completely dependent on foreign central banks for financing. The day China decides to stop buying Treasuries, all other foreign central banks will have no choice but to follow suit, and in this scenario the US Treasury will go bankrupt.
To be continued ...

Updated: Is it time to prepare Insolvency Accounts for the US Treasury?

Operating Cash Balance: The operating cash level of the US Treasury is mentioned in the daily Treasury statement to be $295,462 million as of 22-APR-2009. Out of this $199, 929 million is in the Treasury Supplementary Financing account.
Revenues and Outlays: The monthly Treasury statement contains the data on past revenues and outlays of the US Treasury. Last month, i.e. in March 2009, the US Treasury spent $192,273 million more than they earned. Since October 2009, their total excess of spending over revenue is $ 956,799 million - or nearly a trillion dollars.
Expected Deficits:
Here's a preliminary analysis of President Obama's budget proposals under the aegis of the Director of the Congressional Budget Office. Excerpt:
"CBO projects that if those proposals were enacted, the deficit would total $1.8 trillion (13 percent of GDP) in 2009 and $1.4 trillion (10 percent of GDP) in 2010. It would decline to about 4 percent of GDP by 2012 and remain between 4 percent and 6 percent of GDP through 2019.The cumulative deficit from 2010 to 2019 under the President’s proposals would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41 percent of GDP in 2008 to 57 percent in 2009 and then to 82 percent of GDP by 2019 (compared with 56 percent of GDP in that year under baseline assumptions). ”
The US Public Debt:
As of this writing, the US public debt totals $11.184 trillion.
Sources of financing:
One of the main sources of financing for the US Treasury is Chinese purchases of Treasury and other dollar denominated securities. Dr. Brad Setser at the Council on Foreign Relations is one of the world's foremost experts in the area of balance of payments and global capital flows; and he has taken a specialized interest in studying the size of holdings, currency composition and portfolio allocation of the world's central banks and sovereign wealth funds.
In this paper written along with Arpana Pandey for the CFR Center for Geoeconomic Studies, Dr. Setser has described estimation methodology and data to understand the activities of the People's Bank of China and its associated Sovereign entities.
Yesterday, China revealed its holdings of gold, and here's an article in the Financial Times on that topic.
Note on the United States Public Debt:
Here's a link to the Bureau of the Public Debt web site and on the site if you go to the link "see the U.S. Public Debt to the penny" - the total as of this writing is $11, 184, 922,662,862.85. Of this total, "Intragovernmental holdings" form $4.299 Trillion, and "Debt Held by the Public" forms $6.885 Trillion. In most media and official reports, only the $6.885 trillion is taken into account as US public debt. Typically, that calculation yields around 40+ % of GDP as the US Public Debt.
Understanding the correct nature of "intragovernmental holdings" provides you the accurate, and more practical picture. The contribution made by US citizens towards social security, and other sources of revenue of US government departments, was added to the Congressional Budget as an appropriation. The US Treasury then spent those amounts and issued debt securities to those other US Government entities. Mostly, the $ 4.3 trillion is US Treasury debt held by the Social Security Fund.
The common reasoning provided for not taking the Social Security appropriations into the Us public debt calculation is that that debt is simply not held by the public, and not settled in the market. The US Treasury has payables and liabilities towards Medicare and Social Security that are as yet unfunded.
My view is that what really matters is the cash flow situation. The $4.3 trillion owed to Social Security Fund can be seen as "flexible debt". As long as the Treasury is able to meet the outflows towards its unfunded liabilities, the intragovernmental debt holdings aren't that much of an issue.
Note: I've updated my comment on the US Public Debt after some further serious thinking.
To be continued ...

Governor Zhou's Proposals and Geithner's reaction - the World's Future Reserve Currency System

Zhou Xiaochuan, Governor of the People's Bank of China made concrete, long term proposals to reform the international monetary system. Timothy Geithner's reactions to Governor Zhou's proposals caused a big stir amidst market participants. One of the constraints that leaders have while writing and speaking in public is that issues with strong geo-political overtones, especially those that touch on or highlight international competition or conflict; need to be discussed indirectly. The purpose of my essay below is to present the implications of Governor Zhou's proposals in a slightly more transparent manner so that market participants can understand more clearly and draw the right conclusions to guide their decisions. At this link you can watch the full video of Geithner's remarks at the Council on Foreign Relations.

The Hollywood Economy

Here's an interesting article by Gloria Goodale in the Christian Science Monitor on America’s new-found obsession with summer blockbusters. Michael Cieply in the New York Times also wonders at Americans flocking to movies in the downturn.
And here’s a link to weekend by weekend box office numbers for late 2008 and early 2009.
And here's another article on the movie ticket boom from boston.com.

If Americans don't consume, will global trade crash and burn to the ground?

A couple of comments I made on another blog page:
One of the big lenses through which most Americans view the world’s trade is very approximately as follows: “If Americans don’t consume, global trade will crash and burn to the ground.” I expect that Fabius Maximus would have followed the reasoning in Brad Setser’s explanation for China’s February trade data. China’s exports are showing a decreasing year on year rate of decline in February versus January. The Chinese Lunar New year dates are used by Setser, Macroman, and other commentators to explain this trend. They’re unable to accept that China’s overall export volumes are not responding as expected to the fall in US aggregate demand.Another lens through which several people view the US status is that might be possible to reduce the import dependence through a “divide and rule” policy. For instance, one of the themes I’ve come across is that you can massively do away with imports from China through tariffs, etc, while the oil-exporters continue to hold dollar assets. Thus a currency crisis is prevented, and an imaginary “rapid and orderly rebalancing” can ensue, even as millions more are laid off abroad and political crises emerge there. The divide and rule advocates are unable to see the new alliance amongst the Eurasian powers, consisting mainly of Germany, Russia and China. Despite various differences amongst countries, the US dollar hegemony has become a rallying cry, and the US is now more widely seen in the world as the common enemy of all. (246 words)
What FM seems to be thinking about is a gradual import substitution, sector by sector, whatever. This is radically different from the “rapid and orderly” fantasies.The ruse here is very simple. Most people, unless they’re specialized in economics, or naturally very bright, have a belief that doing away with imports will result in higher local employment. For instance, people seem to imagine that, if you ban imports from China, local companies will come up rapidly, and local people will get jobs to manufacture things imported from China. The fact is that real wages of US workers are much higher than almost anywhere else. Consider a situation where all kinds of items, from textiles, nail clippers, electronics, etc are produced locally, and have to be priced accordingly. This provides two choices; either reduce the wages of US workers, or increase the prices of those goods. Neither of these choices results in a better economy or a better standard of living for people. Apart from reducing people to consuming only the barest essentials, the other effect is that aggregate employment will drop drastically. There’s no way to employ lots of high-paid Americans and hope to sell the same volumes at high prices. If you don’t pay the Americans well enough, despite lower prices, they won’t buy so much, so the factories will be unviable. As for hoping to increase exports, which country will buy US exports in the presence of a huge US Tariff? (245 words)

Fall of the Berlin Wall - Has the American Empire Collapsed?

Have a look at this video , showing a historic moment - the bulldozer gores into the Iron Curtain on the Bornholmer Strasse. And here's the official video from BBC archives.

Dollar Funding of Foreign Banks - some notes

I looked at line item 5) in the TIC data on “Claims on Foreigners by Type and Counterparty”. The item is called “Foreign Banks, including own foreign offices”.The claims peaked at $2.170 Trillion in August 2008. The claims declined to $1.937 trillion by December 2008, the latest data available at the link below. The decrease of $233 billion in claims payable in dollars by foreign banks and foreign branches of US banks is better reflected in the TIC data.Also, the level of around $2 trillion tallies more closely with the BIS estimate of the dollar funding gap faced by foreign banks. The total liability of US banks to foreign banks by end 2008, $ 637.6 b is probably not reflective of the total amount of dollar funding circulating in foreign banking systems.
http://www.treas.gov/tic/bctype.txt
@Brad: The negative liability line probably represents transfers from branches of foreign banks located in the US to their branches outside the US.Liabilities of US Chartered banks to foreign banks grew from $293.8 b at the end of 2004 to $637.6 b at the end of 2008. This growth creates a picture of increasing borrowings of US banks from foreign banks. Also, the growth in US banks liabilities to foreign banks doesn’t explain the increase in liabilities of foreign bank branches to foreign banks. US Banks liabilities to foreign banks grew from $ 420.3 b at the end of 2006 to $478.2b at the end of 2007, an increase of only $ 57.9 b. The liabilities of foreign branches to foreign banks grew from -$255.3b to -$424.50b between 2006 and 2007, an increase of $ 169.20 billion in owings from foreign banks to their branches here.I remember seeing a line item in the TIC data reflecting something like claims on foreign banks payable in dollars.I think that might be a better indication of the amount of dollar loans not rolled over/withdrawn from foreign banks.

Brad: the combined assets of the broker-dealers and funding companies rose by around $325b (if I got the math and netting right)

Me: From L129 and L130 I got an increase of $326.60 b. I took the funding cos investments in broker dealers out of the total assets for 2008 and 2007. The difference could be rounding.

IMF quotas analysis with links

The link below has the voting power shares at the IMF.
http://www.imf.org/external/np/sec/memdir/eds.htm
In simpler terms, a voting/quota share determines the amount of forex that each country is eligible for out of a total increase in SDRs. SDRs are electronic credits from the IMF to countries, that can used for foreign exchange. This is like an equity stake that each member country gets in IMF combine.
The link below takes you to an FT Op-ed by Edwin M. Truman, after he took office as the US Treasury’s IMF person. (Title: ‘How the IMF can help save the world economy’)
http://www.ft.com/cms/s/0/ccafa8d4-09b8-11de-add8-0000779fd2ac.html
And here’s a link to another Op-ed by Ted Truman on IMF Reform:
http://www.petersoninstitute.org/publications/opeds/oped.cfm?ResearchID=1106

Ted Truman proposes overall, an increase of $250 billion in the world’s foreign exchange through SDR credits from the IMF. And, somewhere between 5 and 10 percent of voting rights will be re-distributed away from “traditional industrial countries” to others (as a best case).

Currently the United States has 16.77 % of IMF voting rights, and China has 3.66%. Australia has only 1.47%. Geithner was the US Treasury's representative to the IMF during the 1998 Asian crisis. He personally made sure with his program then, that all those countries would learna lifelong lesson not to depend too much on foreign loans, and to build a large enough forex reserve.

IMF Quotas

The IMF’s list of Directors and Voting Power provides data on the IMF Quotas.

For reference - buffer against possible censorship by Brad Setser

Consider this confusing sentence from the Baba/Ramaswamy paper:
“US banks’ need for European currencies is much smaller because US banks have leveraged their domestic operations with foreign assets much less.”
When you’re telling lies with statistics, it requires the use of complicated terminologies with clever twists in them as well. Such as, for instance, Brad Setser’s phrase “financing the US current account deficit”.
There is, in fact, no such thing as a European bank “leveraging domestic operations with foreign assets”. The more you think about this, the more confused you will be.The financial laws of gravity are simple. A global bank will source funds where interest rates are low; and lend where interest rates are high. Given that both short term and long term rates were much lower in the US, European banks borrowed in dollars and lent in local currencies.“Interbank market” is a euphemism for a bank HQ’ed, say, in Germany, borrowing USD from a local US bank. When this type of source is disrupted, the dollar funding can’t go on any more.Secondly, the existing USD loans weren’t rolled over.Which is why there had to be inter-central bank currency swaps.Apart from the US and the UK, I haven’t seen many reports of retail mortgage borrowers in any geography defaulting in large numbers. Of course, a liquidity crisis can transform into a solvency crisis rapidly.But the BIS papers are a clever attempt to confuse readers on the topic of “European banks’ need for dollar funding”. That ‘need’ developed as a result of lower US rates; and persisted due to non-rollover of existing dollar debt.

Reasoning out how the crisis spread around the world

The BIS paper on the dollar funding shortage doesn’t clearly explain how the crisis was transmitted from the United States to Europe.It’s easier to begin with understanding as to how the American problem was transmitted to different emerging markets. For several years emerging markets around the world had high interest rate regimes and had good growth due to secular strucutural changes in their domestic economies. Banks headquartered in New York,London made out loans denominated in USD to say, banks headquartered in BRIC countries. Rolling over the shorter term lower interest rate USD loans was the source of funding for a number of banks in the BRIC countries, who were able to profit from the interest rate spread across the currencies. Secondly a number of foreign institutional investors held equities in these markets, sometimes more than 20% of the total local market cap. These investments were made by using the integration of i-banking and commercial banking; and used the same source of funding - the New York/London interbank/FX Swap/Central bank dollar funding sources.Once the credit crisis broke loose in the US, the disruptions led to a vary large correction in these exchanges, and a local liquidity crisis due to inability to roll over the USD loans.The BIS paper classifies banks by their headquarters in different European countries. It totals up the “dollar denominated claims” of those banks, and totals up their “local currency assets”. Then it shows that the excess of the dollar denominated claims over the local currency assets was funded through the above three sources of USD funding.There are two important aspects here. A “dollar denominated claim” might perhaps be held in any geography, and not only in the US. This is because banks might lend to say I-Banks that might then go and invest in EUR denominated equities. Or a bank HQ’ed in Germany might make out a dollar-denominated loan to a bank HQ’ed in Eastern Europe; and the Eastern European bank might then lend to the local emerging market in its own currency. And so on.This requires a lot of further analysis and thinking. To be continued…

Brad Setser propagates H1B myths by blocking visa info at his blog

In the middle of another discussion some commentators at Brad Setser's blog started discussing BofA's decision not to recruit foreigners on H1B any more. Specifically the discussion was from some people with European MBAs. I made a comment highlighting the problems associated with the H1 B visa. Namely, the inordinate amount of time it takes to get basic employment freedom in the United States - the defender of the free world. Also, the near bonded labor status of people working on H1B visas.
Also, I highlighted the highly expensive nature of any kind of technical training in the US, and the lack of programs in US corporations to improve skills of workers. Thirdly, I highlighted the bloated bureaucracy in most American Fortune corporations, and compared them unfavorably with State run bureaucracies in countries like India.
Brad Setser had no problem with wide eyed foreigners breathlessly discussing Bank of America's decision not to recruit bonded laborers on H1Bs. But as soon as some real information about the evil H1B visa modern slave-trading scheme was made available to his reading public, he deleted the comment.
H1B visas are just a form of modern slave trade. You get a H1B visa, then every time you think of changing your job, the new employer has to pay $10,000 to transfer it.Secondly, you can’t change your job without losing status if you have a parallel employment based immigration petition.It takes something like 7-10 years before you can get a permanent residence on this track. Then, another 5 years of maintaining residence before they finally give you American citizenship.Meanwhile anything from 10 hours to 15 hours of every weekday of your life is mortgaged to the folks who filled in your H1B forms. And in a recession if you lose your H1B job and stay back in the US to look for another one; you could end up arrested, jailed and tortured by the Homeland Security Police.Immigrating to the US is a good way to lose your job flexibility; also most people working in the US don’t have access to train for new skills; you become a typical overspecialized American worker. What you knew technically when you landed in the US is what you’ll know 15 years later, when you get an American passport.There are some chances that you can become a typical American corporate bureaucrat meanwhile. American Fortune Company bureaucrats are technically behind even bureaucrats in Indian State Governments manning Animal Husbandry departments. Using a blackberry is a skill you can pick up in any country in less than a month; and that’s just about what you can learn professionally by working in the US.

The Lehman collapse and its connection with the European banking collapse

The Lehman collapse and its connection with the European banking collapse is examined in this Baba/Ramaswamy paper at the BIS.

More on the US Dollar Shortage in global banking

As part of its latest quarterly review, the BIS has examined the shortage of US dollars in the international banking system.
Excerpts:
"
Global banking activity had grown remarkably between 2000 and mid- 2007. As banks’ balance sheets expanded, so did their appetite for foreign currency assets, notably US dollar-denominated claims on non-bank entities, reflecting in part the rapid pace of financial innovation during this period.
European banks, in particular, experienced the most pronounced growth in foreign claims relative to underlying measures of economic activity.
We explore the consequences of this expansion for banks’ financing needs. In a first step, we break down banks’ assets and liabilities by currency to examine cross-currency funding, or the extent to which banks fund in one currency and invest in another (via FX swaps). After 2000, some banking systems took on increasingly large net on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of large net US dollar positions exposed these banks to funding risk, or the risk that their funding positions could not be rolled over.
To gauge the magnitude of this risk, we next analyse banks’ US dollar funding gap. Breaking down banks’ US dollar assets and liabilities further, by counterparty sector, allows us to separate positions vis-à-vis non-bank end users of funds from interbank and other sources of short-term funding. A lowerbound estimate of banks’ funding gap, measured as the net amount of US dollars channelled to non-banks, shows that the major European banks’ funding needs were substantial ($1.1–1.3 trillion by mid-2007). Securing this funding became more difficult after the onset of the crisis, when credit risk concerns led to severe disruptions in the interbank and FX swap markets and in money market funds. We conclude with a discussion of how European banks, supported by central banks, reacted to these disruptions up to end- September 2008. "
...
On the European Banks' reactions to the crisis:
"
Banks reacted to this shortage in various ways, supported by actions taken by central banks to alleviate the funding pressures. Since the onset of the crisis, European banks’ net US dollar claims on non-banks have declined by more than 30% . This was primarily driven by greater US dollar liabilities booked by European banks’ US offices, which include their borrowing from the Federal Reserve lending facilities. Their local liabilities grew by $329 billion (13%) between Q2 2007 and Q3 2008, while their local assets remained largely unchanged.
This allowed European banks to channel funds out of the United States via inter-office transfers (right-hand panel), presumably to allow their head offices to replace US dollar funding previously obtained from other sources.
"

Ted Truman and new IMF Dreams - watch this carefully!

At this post on Dr. Paul Krugman's blog, Ted Truman is reported to have joined the US Treasury to reform the IMF. An article on Ted Truman's joining the Treasury has links to his writings. Hmm...let's see what Ted Truman has been advocating for the IMF.

Thomas Hoenig, President of Kansas Fed - mulls pre-privatized "bridge bank" resolution of insolvent US banks

Calculated Risk reports on the Koenig speech with characteristic alacrity.

Dr. Brad Setser on Sovereign Wealth, Sovereign Power and Foreign Official Agency Purchases

Here's an extract from Dr. Brad Setser's paper titled Sovereign Wealth and Sovereign Power. (the emphasis is mine)
"
For U.S. policymakers today, complacency is tempting because of comforting arguments that it is not in creditors’ interests to precipitate a crisis. One comforting argument is that it would take a decision by a major creditor to dump all dollar reserves to cause a run on the dollar — and that this sort of decision is so drastic as to be unlikely.
But history contradicts this argument. During the Suez crisis, both British chancellor Harold Macmillan and Prime Minister Anthony Eden were convinced that the U.S. government was behind the run on the pound. But the U.S. government actually reduced its sterling holdings by only four million pounds—or around $11 million dollars—between the end of September 1956 and the end of December, a fraction of the $450 million drain from September through November with which HM Treasury had to contend.43 The United States did not need to sell pounds to put pressure on Britain, just as Russia, China, or Saudi Arabia might not need to sell dollars to put pressure on the United States today. As W. Scott Lucas writes: "The Americans did not have to sabotage the pound to influence Britain ... they merely had to refuse to support it."
Contrary to what the comforting narrative might suggest, a country seeking to use its holdings of dollars to influence U.S. policy has options that fall short of the "nuclear option" of dumping large quantities of dollar reserves.
– A creditor government could sell holdings of "risk" assets and purchase "safe" U.S. assets, creating instability in certain segments of the market. This could be done without triggering the appreciation of its own currency against the dollar or directly jeopardizing its exports.
- A creditor government could change how it intervenes in the currency market. A country, for example, could halt its accumulation of dollars without ending all intervention in the currency market if it sells all the dollars it buys in the market for other currencies.
– A creditor government could stop intervening in the currency market, halting its accumulation of foreign assets, whether in dollars or other currencies.
– A creditor government could halt its intervention and sell its existing stocks of dollars and dollar-denominated financial assets, the "nuclear option." If it held a large equity portfolio, this could include large stock sales.
"
In this essay at his blog Brad Setser says "And now even government-backed Agencies are too risky. " (He's discussing the Russian Federation's 2008 action to offload all holdings of Agencies, while accumulating increased volumes of Treasuries.)
There have also been other essays from Dr. Brad Setser, comparing the Fed's willingness to take a higher level of risk, to provide stability during the crisis; against the de-stabilizing influence exercized by foreign central banks, such as the People's Bank of China when they dumped Agencies during the crisis. (I'll try to provide more links to Brad's blog essays and excerpts as time permits)
While he doesn't explicitly state this in his latest essay, Dr. Brad Setser has been advocating increased Agency purchases from foreign central banks for some time now.
If foreign official creditors were excessively concerned about exercising influence on US policies; they could have done that by making conditions in return for continued lending to the US Agencies in 2008. Setser's data clearly shows they massively exited their Agency holdings, and exchanged them for Treasuries. Since there is no information about any conditions made by them that the US Government did not meet, the foreign official Agency debt sell off is an indication that foreign official creditors, in 2008, did not pursue the agenda postulated in Dr. Brad Setser's paper on Sovereign Wealth and Sovereign Power.
In September 2008, the Henry Paulson announcement of a conservatorship for the Agencies made it abundantly clear that though they are known, till date as "Government Sponsored Enterprises" or alternatively as "Agencies" of the US Government; in fact, they are private entities enjoying only a limited guarantee from the US Treasury. Clarification of the non-Governmental status of the Agencies, clearly, was the main cause of the foreign official sell-off in Agencies.
If foreign central banks were to buy Agencies now, that would in fact signal some nefarious intentions on their part, as long as you still accept the risk of foreign official creditors wanting to use their creditor status to influence US policies. So I see a discrepancy here between the recognition of that risk in Brad Setser's paper linked above; and his on going advocacy of a stabilizing influence from foreign official Agency purchases.

Trans-Pacific Geopolitical Relations

Brief Background:
The war in Iraq, that is still being unwound, led to the loss of life for an estimated more than 100,000 Iraqis, and more than 4,000 US soldiers. The war was provoked by what turned out to be wrong information indicating a massive build up of WMD in Iraq, and suspicions that the Iraq regime was complicit in the 09/11 attack. This war contributed a great deal to the failure of the incumbent and the Republican candidate in the recent US Presidential elections. The process by which this war came about has been highlighted in various forums, as being a simple result of wrong judgements and evaluations by military intelligence experts.
Another, separate, unconfirmed, reason postulated is that the war was provoked deliberately to deal with the Iraq regime's actions to change the composition of their reserve currency from USD to EUR; and to propose exports of their crude output denominated in a currency other than USD; thereby threatening the US geopolitcal influence over the Middle East and the petroleum trade.
Similar ideas about moving away from the USD status as a reserve currency, and the denomination of international trade settlements in USD have been expressed by the leaders of Iran,Germany,Russia, France and Venezuela, according to various press reports. Also, there are reports that China plans to get the RMB accepted in its region as a reserve/trade settlement currency in a very limited way. At the same time, with the exception of Iran, the intention of the other central banks seems to be to gradually re adjust away from holding mainly USD to holding a combination of USD and other currencies.
In this context, it is likely that the USD exchange rate will gradually decline, leading not only to a more multipolar geoeconomic order, but most importantly, an opportunity for the United States to gradually rebalance its trade with several large economies. If things go according to plan, the United States will most probably emerge from the 2008 crisis with a much stronger economy, increased exports, a more feasible and sustainable USD exchange rate; and still retain its military strength and all other aspects of soft power and geopolitical influence.
Note 1) While most people write very dreamily about a "New World Order" I tend to think that the only notable changes are likely to be economic, rather then geopolitical; a weaker dollar, and increased US exports to other countries, in my view, increase US influence rather than decrease it.
2) Though we're already in the third month of 2009, I'm yet to accept the popular notion that the rest of this year will continue to be a 'crisis'. In my view, even the emergence of a clear direction towards economic recovery should lead to declassification of the global economy as being in a 'crisis' of some sort. Recessions are in the mind, as Dr. Amartya Sen pointed out recently. (Amartya Sen is well known for proving, for instance, that many aspects of social development, such as literacy, are independent of economic development, such as per capita GDP' through comparison of these variables across different Indian states.Also, his research in economic history on the Bengal Famine showed that in fact, there was no physical shortage of foodgrains during that famine. Traders hoarded foodgrains due to the widespread belief and expectation of a famine, leading to massive starvation and loss of life for humans and cattle, in the his analysis of the history. If cows can die in the Bengal Famine history, as Amartya Sen showed, due an imaginary shortage of food grains in traders' minds; US banks can refuse to lend money to anyone, due to an entirely imaginary 2009 Global Depression)
To be continued ...

RMB as a reserve currency, the size of China's stimulus and a comment on current account imbalances

Here's a link to my post below on the RMb as a reserve currency.
Also here's a link to Dani Rodrik's accurate statement of world stimulus packages.
China's stimulus is $586 billion, or 6.9% of GDP; the US stimulus is $787 billion, or 5.5% of GDP.

Here is a comment I made to one Rudiger von Arnhim at Brad Setser's blog:
@Rudiger von Arnhim: I noticed you have a Ph.D in economics from a US university, specializing in international economics. Is it possible for you to define “external imbalances” for me? e.g. if US consumers import 10 widgets from China, and China imports 1 widget from the US. If exchange rates adjust freely, will this result in an “external imblance”?When exchange rates DON’T adjust, who’s to blame; the petrodollar recycling scheme since 1971, the 1944-1971 Bretton Woods, or China’s ‘dollar peg’ since 2000? And where will exchange rates be if you remove China’s dollar peg?Who asked the Federal Reserve not to regulate on loan eligibility by monthly income? Was that the People’s Bank of China?When RMB strengthens against USD, how much will US exports increase to China, or elsewhere?There are 20 millions jobless and social-security-less workers in China as of today, by Government estimates. Has this led to even ONE more American job anywhere?
Update: I made some changes to this post and removed another one I made after this.

RMB as a Reserve Currency: Links to two reports: Reuters and China Daily

Sources: China Daily, China State Council, Zhao Deming, official in charge of finance in Guangxi province.
China Daily reports internationalization of the yuan

Reuters Report on XE.com about using RMB as a reserve currency

The Dollar Funding Crisis in the International Banking System

Here's a link to this Interesting Paper from the Latest BIS Quarterly Review

PS: The link was posted by an anonymous blogger by nickname RE on Brad Setser's blog page, that is otherwise mainly concerned with current account imbalance propaganda and rarely looks at objective material such as this.

Update: In a comment today Brad Setser says he will comment on the BIS papers/articles about the dollar funding crisis

Will the Us dollar get weaker or stronger now?

Here's my view:
Yen and USD-funded carry trades will be put on massively once the credit crunch eases. I’m not sure what level the yen and USD exchange rates will settle down at.As the RMB gets acceptance as a reserve currency, Russia, Germany, France, Iran, Venezuela all continue to shift their forex reserves composition to a combination of RMB, JPY, Russian roubles, EUR, etc. The USD will draw strength mainly from its RMB peg.The US still has a perhaps 4-5 years available to deal with an emerging balance of payments crisis. That period, according to Obama’s plan, is to be used to reduce dependence on imported oil, and build a more skilled workforce that can provide better export performance in a weaker dollar world. These two factors can actually be expected to mitigate the effects of an emerging external finance solvency crisis for the US.In between, there are old-style trade protectionists in the guise of current account imbalance theorists; calling for an immediate disruption to the external financing flow to the US. If this goes through, the US will definitely face a sovereign default before the end of this year or the middle of next year.

PS: I posted this as a comment on Brad Setser's blog. As anybody can see, it is quite relevant to the topic of his blog post today;but you should wonder if he will be able to tolerate such a radical difference with his views.

My comment below has been approved on Dr. Krugman's blog!

Showing, therefore, that I'm allowed there ...

This Comment at Paul Krugman's New York Times Blog

I just uploaded this comment to Dr. Krugman's post titled hey-who-you-callin-neo-wicksellian?
I read an interesting paper on quantitative easing written by a couple of economists at the Fed. Apart from citing the Japanese case, they also go into something called a “floor price system”, that was an innovation of the New Zealand Central Bank. It would be nice to get some further explanation of the use of the short term interest rate and other factors that can be used to influence money supply. Here, I notice the argument that if the money supply increases in the presence of a ZIRP, you’re just substituting cash for short term debt. This is something I’ve never come across and it would really be useful if this can be expanded on further, either by Dr. Krugman or other knowledgeable commentators.— Indian Investor

This comment has nothing controversial in it; it just asks for further explanation that would be useful to understand better. There's a surprising change today. Previously for several days, as I noted before, my comments there wouldn't appear in the status "awaiting moderation" after I uploaded but today this comment does appear in that status!

The Indian Economy

The latest press release from the Central Statistical Organization, which is part of the Ministry of Statistics and Programme Implementation, Government of India contains the latest official estimates of GDP for the quarter ended December 2008.

I recommend reading the complete 6-page press release.Following are the components of GDP on the output side; the percentages of GDP are calculated from the GDP at market price estimates for Q3 FY 2008-2009 at current prices.

Agriculture, Forestry & Fishing 20.98%
Mining and Quarrying 2.53%
Manufacturing 14.79%
Electricity, Gas and Water Supply 1.52%
Construction 8.49%
Trade, hotels,transport and communication 24.40%
Financing, insurance, real estate and business services 13.60%
Community, Social and Personal Services 13.67%

What views do Michael Pettis and others censor?

1) I expressed a view at Michael Pettis blog that China has, in fact bottomed out, when he wrote his essay on “Hooray! China has bottomed out” (which was a sarcastic title). Immediately, I was banned from the Michael Pettis blog! I didn’t even realize it for some time, but his website just wouldn’t load on my system. I thought this was because of some temporary problem with his site. Then one day I tried loading his site from other systems and it was perfectly accessible.And note that I hardly made 2-3 comments in all at Pettis’ and none of them had anything with good or bad manners.
2) At Paul Krugman’s blog on the New York Times web site, I pointed out that nationalizing US banks can make unfriendly foreign governments nationalize the overseas subsidiaries of those banks. Prior to making this comment, my comments - again, very few - would appear as ” awaiting moderation” by default. Some of them would later get approved and published or not; but all of them on my upload would appear as "awaiting moderation". After I uploaded this view on bank nationalization, I no longer see my uploaded comments pending moderation at Krugman’s New York Times blog.
Both of these illustrate to me that I’m touching on topics that are perhaps too sensitive. Pettis probably has an agenda to propagandize against the Chinese exchanges rising, and Krugman to demand nationalization of banks. Though I’m just an individual investor my views were too controversial to be allowed on those sites.
In Setser’s case it appears to me that the objection is from the Council on Foreign Relations mandarins, and less from Setser; though again I could be wrong.
In any case, one thing I’m very sure of is that my particular IP has been pinpointed and banned by Pettis.
Update: I've edited this post to reflect that Paul Krugman writes for the New York Times, so the newspaper might be exercising at least as much control over content at his blog as he does. This insight is based on the comment below.

Brad Setser Censors pro-equities comments

Dr. Brad Setser runs a propaganda blog where the main point is something that goes like:
1) There can't free trade, there can only be 'balanced trade'.
2) Even if the US dollar is just a legal tender currency, China accumulates US dollars in lieu of gold, in a mercantilist manner.
3) Countries use money to 'finance the current account deficit', even when they're spending it mainly on military contracts.
Here are some objectives views about markets; these are just a small subset of various opposite views that have been censored by Dr. Setser. Since Setser runs a propaganda blog, he can't afford to have views opposing his malinterpretations gain traction at his blog page.
The Nifty peak was around 6300 in 2008, and its trough was at 2500 which was hit in October and then again in November after a dead cat bounce. The Q3 FY 2008-2009 results didn’t lead to fall below the October lows. Today’s Sensex close is lower than its October low and the Nifty is a few percent above 2500 because of different weightages.What caused the fall from 6300 to 2500? India’s exports, both merchandise and services have fallen. Imports, on the other hand have been rising, especially fertilizer and capital equipment.The real reason for the Nifty fall was that FIIs steadily sold out each month in 2008, while Domestic IIs were net buyers each month. The last two days’ fall is also a result of massive FII outflows.The INR/USD has shown a strengthening of USD against INR. Private sector banks like ICICI have something like 50% of their borrowings abroad. That has been unwinding, and not rolled over. Add up the effect of not rolling over foreign currency loans, and a sell-off of FII holdings in local equities; In my humble opinion, that explains much more of the fall in equities and weakening of the INR than a fall in real economy exports, etc.I’m expecting a functioning credit system to emerge in the US, which will lead to the reverse of the above flows.Outstanding credit has been growing in India, just as it has been in China. India is an exception to the theory that emerging markets grew mainly through exports, especially exports to the US.India’s external sector has been making a net negative contribution to GDP, while the GDP has been growing at 8-9%. While falling exports will have a negative effect, India’s GDP growth wasn’t ‘export-led’ by comparable standards.Also, this should make you think about the component of China’s growth that came from domestic expansion, though China does have a much larger share of exports in GDP, and a sizeable trade surplus, justifying the notion that exports contributed a lot to China’s GDP growth.All this doesn’t mean that India is shining. The policy makers in every country give statistical nostrums to the people. In a country with millions of uneducated or undereducated people; an agricultural sector that depends on rainfall because of the government’s inability to dig irrigation channels;etc … Consider an African American who is now paid 5 cents a day in addition to food and shelter because Lincoln abolished slavery. When his income grows to 6 cents a day over 5 years, his macroeconomy has grown 8% percent over those years!

Can Paul Volcker get away with talking nonsense at Canadian bankers?

The short answer seems to be, yes.
Here's an excerpt from a Paul Volcker speech:
"This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it."
Is Paul Volcker reasoning accurately here? Suppose, for instance, that Indians acquire an increased penchant for importing more and more electronic gadgets from China. And China decides to buy a lot of Government of India securities to artificially strengthen the Indian Rupee. How would this turn out? The FRBM target is to reduce the fiscal deficit to around 3% by next year. As long as the Government maintains a strong fiscal path, and spends in tune with its income; it wouldn't matter whether the G-Secs are held by locals or foreigners; or the People's Bank of China.
PBoC INR denominated forex reserves would in this example strengthen the INR artificially, and that will make life easy for Indian consumers of China's electronics. But as long as the Government finances are strong, we would never go bust as a result of consuming those electronics at those cheap prices. In fact, the more the PBoC buys INR securities, the happier we would have been at this free Chinese giveaway of their electronics.
Paul Volcker is diverting attention from the simple fact that it was the US Treasury that borrowed huge amounts, far in excess of its income, and spent it on various items. The US Treasury is directly responsible for this whole mess. And by having these kinds of speeches, they're proceeding in the direction of more and more Government debt, rather than less, creating a dangerous situation where the Sovereign itself can be forced into default.
Here's the full speech: (I got it from a comment posted at Brad Setser's blog)
I really feel a sense of profound disappointment coming up here. We are having a great financial problem around the world. And finance doesn’t work without some sense of trust and confidence and people meaning what they say. You take their oral word and their written word as a sign that their intentions will be carried out.
The letter of invitation I had to this affair indicated that there would be about 40 people here, people with whom I could have an intimate conversation. So I feel a bit betrayed this evening. Forty has swelled to I don’t know how many, and I don’t know how intimate our conversation can be. But I will, at the very least, be informal.
There is a certain interest in what’s going on in the financial world. And I will disappoint you by saying I don’t know all the answers. But I know something about the problem. Let me just sketch it out a little bit and suggest where we may be going. There is a lot of talk about how we get out of this, but I think it’s worth remembering, or analyzing, how this all started.
This is not an ordinary recession. I have never, in my lifetime, seen a financial problem of this sort. It has the makings of something much more serious than an ordinary recession where you go down for a while and then you bounce up and it’s partly a monetary – but a self-correcting – phenomenon. The ordinary recession does not bring into question the stability and the solidity of the whole financial system. Why is it that this is so much more profound a crisis? I’m not saying it’s going to get anywhere as serious as the Great Depression, but that was not an ordinary business cycle either.
This phenomenon can be traced back at least five or six years. We had, at that time, a major underlying imbalance in the world economy. The American proclivity to consume was in full force. Our consumption rate was about 5% higher, relative to our GNP or what our production normally is. Our spending – consumption, investment, government — was running about 5% or more above our production, even though we were more or less at full employment.
You had the opposite in China and Asia, generally, where the Chinese were consuming maybe 40% of their GNP – we consumed 70% of our GNP. They had a lot of surplus dollars because they had a lot of exports. Their exports were feeding our consumption and they were financing it very nicely with very cheap money. That was a very convenient but unsustainable situation. The money was so easy, funds were so easily available that there was, in effect, a kind of incentive to finding ways to spend it.
When we finished with the ordinary ways of spending it – with the help of our new profession of financial engineering – we developed ways of making weaker and weaker mortgages. The biggest investment in the economy was residential housing. And we developed a technique of manufacturing class D mortgages but putting them in packages which the financial engineers said were class A.
So there was an enormous incentive to take advantage of this bit of arbitrage – cheap money, poor mortgages but saleable mortgages. A lot of people made money through this process. I won’t go over all the details, but you had then a normal business cycle on top of it. It was a period of enthusiasm. Everybody was feeling exuberant. They wanted to invest and spend.
You had a bubble first in the stock market and then in the housing market. You had a big increase in housing prices in the United States, held up by these new mortgages. It was true in other countries as well, but particularly in the United States. It was all fine for a while, but of course, eventually, the house prices levelled off and began going down. At some point people began getting nervous and the whole process stopped because they realized these mortgages were no good.
You might ask how it went on as long as it did. The grading agencies didn’t do their job and the banks didn’t do their job and the accountants went haywire. I have my own take on this. There were two things that were particularly contributory and very simple. Compensation practices had gotten totally out of hand and spurred financial people to aim for a lot of short-term money without worrying about the eventual consequences. And then there was this obscure financial engineering that none of them understood, but all their mathematical experts were telling them to trust. These two things carried us over the brink.
One of the saddest days of my life was when my grandson – and he’s a particularly brilliant grandson – went to college. He was good at mathematics. And after he had been at college for a year or two I asked him what he wanted to do when he grew up. He said, “I want to be a financial engineer.” My heart sank. Why was he going to waste his life on this profession?
A year or so ago, my daughter had seen something in the paper, some disparaging remarks I had made about financial engineering. She sent it to my grandson, who normally didn’t communicate with me very much. He sent me an email, “Grandpa, don’t blame it on us! We were just following the orders we were getting from our bosses.” The only thing I could do was send him back an email, “I will not accept the Nuremberg excuse.”
There was so much opaqueness, so many complications and misunderstandings involved in very complex financial engineering by people who, in my opinion, did not know financial markets. They knew mathematics. They thought financial markets obeyed mathematical laws. They have found out differently now. You know, they all said these events only happen once every hundred years. But we have “once every hundred years” events happening every year or two, which tells me something is the matter with the analysis.
So I think we have a problem which is not an ordinary business cycle problem. It is much more difficult to get out of and it has shaken the foundations of our financial institutions. The system is broken. I’m not going to linger over what to do about it. It is very difficult. It is going to take a lot of money and a lot of losses in the banking system. It is not unique to the United States. It is probably worse in the UK and it is just about as bad in Europe and it has infected other economies as well. Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go.
So I’ll jump over the short-term process, which is how we get out of the mess, and consider what we should be aiming for when we get out of the mess. That, in turn, might help instruct the kind of action we should be taking in the interim to get out of it.
In the United States, in the UK, as well – and potentially elsewhere – things are partly being held together by totally extraordinary actions by a central bank. In the United States, it’s the Federal Reserve, in London, the Bank of England. They are providing direct credit to markets in massive volume, in a way that contradicts all the traditions and laws that have governed central banking behaviour for a hundred years.
So what are we aiming for? I mention this because I recently chaired a report on this. It was part of the so-called Group of 30, which has got some attention. It’s a long and rather turgid report but let me simplify what the conclusion is, which I will state more boldly than the report itself does.
In the future, we are going to need a financial system which is not going to be so prone to crisis and certainly will not be prone to the severity of a crisis of this sort. Financial systems always fluctuate and go up and down and have crises, but let’s not have a big crisis that undermines the whole economy. And if that’s the kind of financial system we want and should have, it’s going to be different from the financial system that has developed in the last 20 years.
What do I mean by different? I think a primary characteristic of the system ought to be a strong, traditional, commercial banking-type system. Probably we ought to have some very large institutions – or at least that’s the way the market is going – whose primary purpose is a kind of fiduciary responsibility to service consumers, individuals, businesses and governments by providing outlets for their money and by providing credit. They ought to be the core of the credit and financial system.
This kind of system was in place in the United States thirty years ago and is still in place in Canada, and may have provided support for the Canadian system during this particularly difficult time. I’m not arguing that you need an oligopoly to the extent you have one in Canada, but you do know by experience that these big commercial banking institutions will be protected by the government, de facto. No government has been willing to permit these institutions, or the creditors and depositors to these institutions, to be damaged. They recognize that the damage to the economy would be too great.
What has happened recently just underscores that. And I think we’re at the point where we can no longer fool ourselves by saying that is not the case. The government will support these institutions, which in turn implies a closer supervision and regulation of those institutions, a more effective regulation than we’ve had, at least in the United States, in the recent past. And that may involve a lot of different agencies and so forth. I won’t get into that.
But I think it does say that those institutions should not engage in highly risky entrepreneurial activity. That’s not their job because it brings into question the stability of the institution. They may make a lot of money and they may have a lot of fun, in the short run. It may encourage pursuit of a profit in the short run. But it is not consistent with the stability that those institutions should be about. It’s not consistent at all with avoiding conflict of interest.
These institutions that have arisen in the United States and the UK that combine hedge funds, equity funds, large proprietary trading with commercial banks, have enormous conflicts of interest. And I think the conflicts of interest contribute to their instability. So I would say let’s get rid of that. Let’s have big and small commercial banks and protect them – it’s the service part of the financial system.
And then we have the other part, which I’ll call the capital market system, which by and large isn’t directly dealing with customers. They’re dealing with each other. They’re trading. They’re about hedge funds and equity funds. And they have a function in providing fluid markets and innovating and providing some flexibility, and I don’t think they need to be so highly regulated. They’re not at the core of the system, unless they get really big. If they get really big then you have to regulate them, too. But I don’t think we need to have close regulation of every peewee hedge fund in the world.
So you have this bifurcated – in a sense – financial system that implies a lot about regulation and national governments. If you’re going to have an open system, you have got to get much more cooperation and coordination from different countries. I think that’s possible, given what we’re going through. You’ve got to do something about the infrastructure of the system and you have to worry about the credit rating agencies.
These banks were relying on credit rating agencies while putting these big packages of securities together and selling them. They had practically – they would never admit this – given up credit departments in their own institutions that were sophisticated and well-developed. That was a cost centre – why do we need it, they thought. Obviously that hasn’t worked out very well.
We have to look at the accounting system. We have to look at the system for dealing with derivatives and how they’re settled. So there are a lot of systemic issues. The main point I’m making is that we want to emerge from this with a more stable system. It will be less exciting for many people, but it will not warrant – I don’t think the present system does, either — $50 million dollar paydays in that central part of the system. Or even $25 or $100 million dollar paydays. If somebody can go out and gamble and make that money, okay. But don’t gamble with the public’s money. And that’s an important distinction.
It’s interesting that what I’m arguing for looks more like the Canadian system than the American system. When we delivered this report in a press conference, people said, “Oh you mean, banks won’t be able to have hedge funds? What are you talking about?” That same day, Citigroup announced, “We want to get rid of all that stuff. We now realize it was a mistake. We want to go back to our roots and be a real commercial bank.” I don’t know whether they’ll do that or not. But the fact that one of the leading proponents of the other system basically said, “We give up. It’s not the right system,” is interesting.
So let me just leave it at that. We’ve got more than 40 people here but they’re permitted to ask questions, is that the deal?

Brad Setser's "China Yoke" Theory - replete from direct quotes

Here’s one link to Brad Setser’s analysis on what led to the ongoing crisis:
According to Brad Setser, the People's Bank of China encouraged Americans to "turn a home into an ATM":
“Absent a large savings surplus in Asia and the oil exporters, rising US rates would have choked off the housing bubble much earlier. High long-term rates aren’t conductive to rising home prices — and without rising home values it is hard to turn a home into an ATM.…Central banks reserve growth in the savings surplus countries carried this surplus to the US. … The process that led to the boom in risky assets was indirect: Central bank demand for safe assets drove down the return on safe assets and encouraged private sector risk taking. Private banks, famously, didn’t want to sit out the dance.”
APART from blaming the PBoC for the mortgage boom (you need to closely follow each of his essays to know that he’s actually referring mainly to the PBoC in the above paragraphs) Brad Setser also blames the United States Public Debt on imports from China here:
“Remember this the next time someone argues that the US will be borrowing more from the rest of the world to finance its fiscal deficit: the total amount the US borrows from the world is defined by the current account deficit and the current account deficit clearly went down in the fourth quarter even as the US fiscal deficit (and the Treasury’s borrowing need) soared.”
Here Brad Setser revises economic history by claiming that the excessive lending by private banks that weren’t regulated properly by the Federal Reserve was actually a result of China’s exchange rate policy. Excerpts:
“By holding US interest rates down and the dollar up, China’s policies discouraged investment in tradables production in the US while encouraging investment in the interest-rate sensitive sectors that weren’t competing with Chinese production. This isn’t too say that the US didn’t already have a slew of policies in place to encourage investment in housing. It did — from the Agencies to ability to deduct mortgage interest from tax payments. But the surge in demand for US bonds from the world’s central banks reinforced those policies.…More money was allocated to home construction (for a time) and less to investment in the production of goods for export than otherwise would have been the case.…Those who attribute the growth of the past several years solely to the market miss the large role the state played in many of the world’s fast growing economies. Conversely, those who attribute all the excesses of the past few years to the market miss the role that governments played in financing many of those excesses …”
Me: So you see, Brad Setser also blames China for the fact that there wasn’t much investment in industrial production facilities in the US the last several years. Either you need to follow Brad Setser’s “China Yoke” theory of the crisis, or get down to brasstacks and fix some simple lending norms for retail loans in the US to prevent this sort of thing from happening again.

My Comments and views censored by Dr. Brad Setser (the latest set)

Following is a set of comments I posted on the blog page of Dr. Brad Setser. They have been deleted and now I'm pasting them here so anybody who's interested can read them here.

Here's Brad' Setser's advocacy on financing US Treasuries from a small private cartel instead of the PBoC

Brad Setser:That implies, if the Pandey/Setser estimates for official purchases are right, that private investors snapped up more Treasuries than the world’s central banks…My guess is that the Treasury market will be driven by developments in the US – not developments in China – in 2009.
Me:What will any reasonably smart, thinking person, think when they read this?
When we discussed how China’s purchase of Treasuries affects the $11 trillion home mortgage boom, we reasoned how flows matter. Mostly, the $11 trillion boom was fueled by flows from China’s Treasury purchases.Now we’re looking at the impact of China’s Treasury purchases on the market for Treasuries itself - and we aren’t seeing much of an impact there.
Most of those smart people who’re thinking this will also type in that you’ve made a great, wonderful analysis, and never raise this point. Some of them might actually even cheerlead your post here.

Let’s hope private market participants don’t bet on high Treasury Bond prices now. Jansen’s post suggests the classic rupture of Government Bond prices. Central Bank demand for Treasuries remained high on the day he reports on, yet prices crashed and yields rose. This is very good news for equity markets and home prices.People are clearly demanding higher yields now.

Here are some comments I made in response to comments from other blog participants:
@ KT Cat - can you consider not interpreting things as “horrible”,”dreadful”, and “shrinking” without more reasoning than you present above?
Banks are trying to dispose of a large set of foreclosed homes together, say, in a block worth around $30 million, to small groups of private investors. Sales volumes are a bit down because these negotiations take more time than a fire sale.Banks are also disposing of foreclosed properties in some areas individually; that typically goes faster.
Lower demand for Treasuries at higher Treasury prices is again very good news for the US economy.
I don’t understand what you mean by“Japan’s economy is getting killed”.
I explained yesterday that Japan’s exports and imports are down more than China’s because of lesser credit growth in the Japan economy than China, but Brad deleted my post.Once the credit problems are solved things will be much better for Japan.

jim:…they invest on fundamental strengths that are dominating the market place …
Me: Fundamental analysis based on earnings, etc in my opinion is like a relative grading system. You can put a buy,hold or sell recommendation on a particular equities by comparing them with others. The underlying assumption is that your analysis is largely to allocate a certain fixed amount of capital amongst different equities. You can also account for the differential impact of macroeconomic or other ‘market risk’ events on different equities.But in terms of determining the overall direction of indices, that part of fundamental analysis isn’t particularly useful. It’s not easy to discount future cash flows, arrive at a fixed number for the ‘present value’ of the stock and use that as a basis to be a successful investor. Your ‘present value’ rarely ties in with the market’s, especially with wide fluctuations in multiples. It’s best to recognize that, even by the conceptualization of capital market theory, market risk can at best be diversified away to reduce its impact,not eliminated. Successful investment therefore requires understanding the full spectrum of fundamental analysis, macroeconomic analysis and most importantly, the geopolitical underpinnings of international finance.Earnings are definitely weak in US equities and will probably grow slowly for some time. But the reason to go long is a market bottom, a shift in the debate to when things will get better, from how much worse things will get before they get better.Of course my actual strategy is long in the Nifty, and not the Dow, and the two things are quite different.Nomura Holdings recently hired 50 team leads with long expertise in US equities and they’re rapidly setting up a sizeably large US equities unit. If they don’t have plans to invest in US equities, or advise clients to do so, these hiring decisions wouldn’t be rational.

@DOR: Residential investment in the US was at levels of $600+ billion, out of a $14 trillion economy, even at inflated prices.The direct output effect of a collapse in residential investment is small. The US was perhaps just as much of a Hollywood Economy, rather than a Home Building Economy during the boom.That would be consistent with a 43% share of services in GDP.Home Equity Withdrawals financed 3-4% of PCE. Annual increases in o/s consumer credit were 1% of GDP.US consumption wasn’t mainly driven by using homes as ATMs,though that conceptualization is attractive.35% of US homes were owned outright in 2007. 5% of the remaining 65% homes had mortgages that were both ARMs and subprime. The mythical American risky borrowers were therefore few.The recent collapse can be explained by the non availability of normal credit. For instance, even qualifying home buyers may not get a mortgage loan. People with a good income and finances may not get approved for a car loan. Similarly, difficulties in segments like student loans, corporate working capital loans, export credit, letters of credit, etc have disrupted the US economy.A certain level of credit is neither good or bad by itself, but only in comparison with income and overall balane of assets and liabilities. Once normal credit flows are re started, things will be much better for the US economy.But growth will be slow because the destruction of personal net worth due to fall in home prices needs to be worked off by US consumers.

A few (seemingly forgotten) basic characteristics of the US economy

1) The US economy is more of a services economy than a products economy.In 2008, services totaled $ 6139.8 b out of the GDP of $14264.4 b, which is 43.04% of GDP.Durable goods were $ 944.40 b and non durable goods were $ 2846 b, giving a total of only 26.57% of GDP for goods altogether.
2) Services exports from the US are more than services imports, and the US has a trade surplus in the services category.Services exports were $551 b and imports were 407 b, giving a surplus of $144 b or so, which tho isn;t a major percentage of GDP.
3) Trade deficit is a small percentage of GDP for the US: The overall trade deficit including goods and services was $ 529 b in 2008 (according to above NIPA tables). (I noticed another table in which the non seasonally adjusted balance for 2008 overall is -$677 b). Overall, the US trade deficit is only 3.71% of GDP.
4) The goods deficit is insignficant in comarison to the total size of the US economy. For 2008, the goods deficit is around $ 821 b, which is around 5.76% of the US economy.
5) In 2008, Government consumption expenditures and gross investment (including Federal, State, local, defense, etc) totaled $ 2914.9 b. The US Government is therefore ~20.43% of the US economy.
Link to BIPA tables

Anlaysis of US Consumer Credit Growth - Thank Paul Swartz

Here’s another essay from Paul Swartz at Brad Setser’s blog analyzing recent changes in US consumer credit from the Fed’s g19 release.
Following is my comment on the Q4 2008 consumer credit levels:
In the g19 release, it’s clear that absolute total consumer credit o/s. contracted from $2585.3 billion in October 2008 to $ 2582.6 billion in November 2008. Then, in December 2008, it increased to $ 2596.0 billion. So I think Paul’s interpretation that consumer credit grew after the TARP I funds sank in, albeit slowly, is correct.The summary at the top of the Fed’s g19 release probably deals with decreases at ‘annual rate’; which might be some statistical measure other than the absolute o/s numbers in Q4 ‘08.
Personal Consumption Expenditure levels in the United States between 2004 and 2008, according to the National Income and Product Tables from BEA:
2005 $8,893.70
2006 $9,357.00
2007 $9,892.70
2008 $9,930.20
The total PCE 2005-2008 was $38,073.60 billion.
From the Fed’s g19 release linked above, total consumer credit outstanding grew from $2191.60 billion at the end of 2004 to $2562.30 at the end of 2008, an increase of $ 370.70 billion. Increases in consumer credit funded only 0.97% of total US PCE between 2005 and 2008.
Here's a link to the Fed’s Flow of Funds release for reference to the general credit growth data for all sectors.

Revisting the Yen Carry Trade Mechanics

At this post on Brad Setser's blog in February 2007, you see an interesting discussion of the yen carry trade size and mechanics, which I’m re producing below. (The content is from the RGE monitor web site)

Andrew Rozanov of State Street knows a thing or two about how official institutions manage their money (that is a big part of his current job) and a thing or two about Japan (he was based in Tokyo for some time). In response to my previous post, he noted that much of the yen carry trade is now done through the swaps market – or off balance sheet. Hedge funds don’t really need to “borrow” yen and then buy higher yielding currencies – they do the same thing in the derivatives market, or pay a bank to do it for them. I have – with his permission – reprinted his comment below. It inspired a nice discussion.
UPDATE: State Street also seems to know a thing or two about the size of the carry trade. See the FT.
I took a number of things away from the discussion:
1) The obvious, what happens off balance sheet matters. The absence of strong growth in cross-border yen lending isn’t evidence that folks aren't betting on continued yen weakness – or that interest rate differentials will remain large enough to offset any uptick in the yen.
2) A trillion is probably a bit too high an estimate of the size of the yen carry trade, at least if we are talking about bets from the “leveraged” hedge fund community.
3) We shouldn’t forget about leveraged Japanese day traders … who, in aggregate, have become big players. Fx accounts with generous margin are the rage in Tokyo.
4) It is hard for competitive money managers to be on the sidelines and avoid putting on various kinds of carry trades right now.
Andrew Rozanov writes:
“as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...”
I would note that volatility is also low for some emerging market currencies. Volatility in the Brazilian real/ dollar, for example, has collapsed – because the central bank has resisted market pressure for further appreciation in the real. The same thing incidentally happened in Turkey in 2005. Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money. It probably isn’t an accident that Brazil added over $5b to its reserves in January. There are a lot of different cross-currency carry trades out there that have attracted a lot of attention.
Andrew Rozanov’s comments are reprinted in full below
Andrew Rozanov:
I would like to commend those astute commentators who pointed out the direct relevance and central role of the forward currency swaps market in facilitating carry trades. It is arguably the easiest and most preferred method to put on a 'carry trade' by the leveraged community. It was described several years ago in a book written for a Japanese audience by a former Moore Capital trader, Ken Shibusawa, who currently runs his own hedge fund advisory firm in Tokyo (Japanese website for his company: http://www.shibusawa-co.jp/index.html). According to him, essentially the press has got it all wrong. Yes, the underlying economics of a typical carry trade is to 'borrow' in low-yielding currency (e.g. the yen) and then 'lend' on in higher-yielding currency (e.g. the dollar), but when we discuss the actual mechanics of it, hedge funds and other highly leveraged players typically would not engage in any actual borrowing or lending. To the extent a hedge fund would consider putting on such a trade at all, it would most likely do it in the following way, or some variation thereof (we use US$/JPY levels as in Ken Shibusawa's example in the Japanese book): Step 1. Buy US$ / Sell JPY in the spot market (say, at 120) Step 2. Buy JPY/ Sell US$ in the spot market (again, at 120) Step 3. Buy US$ at a discount / Sell JPY at a premium in the forward market (say, 3 months forward at 118.50) Step 4. Buy UST in the spot market Step 5. Borrow US$ against UST in the repo market Some comments are in order. 1. A typical currency forward swap is step 2 + step 3. However, if that's all you do, you will be expected to deliver your US$ for settlement on T+2. But remember, we are looking at a hedge fund, who does not have the money to deliver and who wants leveraged carry. Thus, he needs to create this exposure with as little initial cash outlay as possible. The best way to do that would be to take an outright forward position in the market. 2. An astute observer will have noticed that the cumulative effect of steps 1 through 3 is precisely to create such an outright forward position, whereby our hypothetical hedge fund is now short the yen and long the dollar at 118.50 on a 3-month horizon (in other words, the hedge fund promised to pay 118.50 in 3 months time for an asset which is currently trading at 120 - and the lower the US$/JPY volatility, the higher the chance that the forward contract will have converged at or around the original spot price of 120). 3. But if a hedge fund wants an outright forward position, why go through the hassle of steps 1-3? Well, it all has to do with costs and liquidity. Apparently, it is cheaper and easier to put on such a position in the currency swap market rather than as an outright forward - as the market supporting corporate and 'real money' hedging activity, it is the most liquid. 4. Notice how the trade is structured in two separate legs. There is the FX market leg, where the hedge fund puts on a position to earn the carry from the interest rate differential in the two short-term markets. Then there is the UST leg, which is a completely separate transaction: longer duration US Treasuries are purchased to earn a higher yield, but they are financed in the repo market (of course, this example assumes a 'normal' upward sloping yield curve in the US). So if (and it IS a huge if) all goes as planned in the US$/JPY and UST markets, the total carry earned on the trade is the sum of FX market carry (i.e. short term interest rate differential) and UST market carry. Another way of putting it: the hedge fund earned money from two major risk sources: currency mismatch risk and duration mismatch risk. 5. In his book, Ken Shibusawa makes an interesting observation: many press commentators focus on what they can trace in the spot markets (i.e. step 1 and step 4), and often do not pick up on simultaneous transactions in derivative markets (i.e. combination of step 2 & 3, step 5). Thus, the tendency is to interpret this as hedge funds borrowing yen and selling yen spot, thus procuring dollars and then investing these dollars in long maturity UST). While the underlying economic logic and principle is the same, the mechanics are totally different. 6. Ken Shibusawa quips in the book that while much press attention at the time was focused on global macro hedge funds, it was probably relative value shops that were particularly keen on putting on massive yen carry trades in 1997-98, following the relative success of their "Japan risk premium" carry trades in the previous years. One final comment from me: as volatility remains low and carry keeps being profitable, for a commercially driven fund management shop it is becoming more and more painful to stay away from these trades, certainly if you are in competition with others in raising money from investors. Just plot the returns from a simple carry basket on Bloomberg's FXIP (I suggest using long GBP at 50% and long EUR at 50%, while short JPY 50% and short CHF 50%) -- and then look at the statistics below for one-year return, volatility and the Sharpe ratio. They are phenomenal! And what do investors more often than not look for when comparing and choosing hedge fund managers? Why, high and stable returns at relatively low volatility - strategies with very high Sharpe ratios! Never mind the higher moments and fat tails...

And, for those of us without the financial sophistication to understand why anyone would both buy US$ for yen and sell US$ for yen in the spot market, Andrew noted:
Let me try and answer your question about why go through steps 1 and 2 by considering the other options. 1. If you do only step 1, you are going long USD and short JPY in the spot market. There are two problems with this approach as far as leveraged carry trades go. First, it's not leveraged - you will need to come up with the entire notional amount of JPY to settle this trade in two working days (T+2), so you're not really 'borrowing' anything. Secondly, you're not really trading for carry. Instead, you're putting on a directional bet: you buy US$ at 120 and hope it appreciates (or JPY depreciates), but you're not picking up any interest rate differentals. Incidentally, this type of trade typically favours high volatility environment - remember, volatility cuts both ways, so if you want to make money from a large swing up in the dollar (or swing down in the yen), you would be implicitly betting on high, not low vol. Carry trades, on the other hand, are typically low vol trades: any additional depreciation of the yen would be icing on the cake, but your main bet is that the world stays stable and predictable while you earn your carry on a leveraged basis (i.e., interest rate differential multiplied by leverage). 2. What about taking only steps 2 and 3 - i.e., the foreign exchange swap? The good news is this gives you carry: you buy 120 yen for every dollar now (on T+2) and at the same time contract to sell the newly acquired yen in 3 months' time, such that 118.50 buys you a dollar - in other words, you sold the dollar now at 120 and bought it back in 3 months at 118.50, earning the carry in the process. But the bad news is that, just like in the first comment above, you do not get any leverage, since you will need to provide an initial cash outlay on T+2 to settle the leg in step 2. 3. Why not forget steps 1 and 2 altogether, and just go for step 3? This is entirely legitimate and certainly doable. In the FX market, such a transaction is called an 'outright forward'. You agree with your counterparty bank to go long USD and short JPY based on today's spot price, but with settlement in 3 months' time - you will negotiate and agree the spot price, and then the bank will adjust it by the interest rate difference. No cash flows occur on T+2, you have effectively secured a leveraged position, and you've bought US$ at 118.50 in 3 months. Voila! The only reason you would consider doing something a bit more convoluted (like going through steps 1 to 3 above) is if it helps you save costs and earn even more money. And in competitive markets like FX you get the best prices and execution where the liquidity is the deepest. And the liquidity of spot and FX swap markets has always been (and I believe still is) much better and deeper than in the outright forward markets. Just have a look at Table B1 on page 5 of the BIS Triennial Central Bank Survey at the following link (last survey done in 2004): http://www.bis.org/publ/rpfx05t.pdf
Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee argued that these are notional numbers, so they only give a loose idea of real exposure. He also noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.

Hellasious and Tmcgee also chimed in; Hellasious noted the growth in outstanding yen forwards. Tmcgee noted that these are notional numbers, so they only give a loose idea of real exposure and noted the role of Japanese fx margin traders – something that the FX team at Citi also likes to highlight.
Hellasious:
I urge everyone to visit the BIS site and look up the relevant FX forward data for yen. The amounts have jumped very substantially from $2.3 trillion to $3.8 in 5 years. A big part of the increase has come in just 6 mos., going from $3.1 to $3.8 trillion between Dec. 2005 and June 2006 (latest available data).
Tmcgee cautioned:
I think $1 trln is a slightly ridiculous number, even if you include the sheer Japanese foreign asset holdings that don't really constitute carry trades per se, just a hunt for higher yields. Also, the BIS derivatives data gives some clues on potential size of carry trades. But I believe they also are all notional numbers, like the US OCC data, which means they're always growing at a fairly rapid pace -- because both sides of the trade are counted. The funny thing is now people are freaking about the size of the carry trade even though one of the supposed culprits of the unwinding of carry trades last april/may (incorrectly) -- a drop Japan's monetary base from the BOJ ending quantitative easing -- is still shrinking 21% yr/yr. and other BIS data -- reporting banks' cross-border positions vis-a-vis all sectors, by domestic and foreign currency -- shows no explosion of yen liabilities among major global banks.
Reporting bank yen cross-border positions vis-a-vis all sectors (blns USD) liabilities:
Domestic currency: December 04: $240.9; Sept 06: $235.9Foreign currency : December 04 $433.1; Sept 06 $457.6 We know the IMM speculative yen short data, so we have a vague since carry trades are popular. But as the Wachovia anlaysis points out, the evidence is far from compelling. ….
Also, no one seems to mention the role of Japanese FX margin trades in the carry trade. Check out data from the Tokyo Financial Exchange, which gives just a small peek into the explosion of margin trading here. These margin traders are quick to take profits when cross/yen hits new highs, but also buy the higher-yielding currencies (like the Aussie, on serious leverage) on any sharp pull-backs. And since so much money is waiting in Japan for moments of yen strength to invest abroad, it tends to put a floor under not only dollar/yen, but also euro/yen and sterling/yen …
BSetser edits: Data presentation edited for clarity, punctuation added.
And Cassandra always has a thing or two to say about the yen and yen carry trades.
Even if Tmghee is right and total carry trade exposure is significantly under $1 trillion, it scale of the carry trade seems to have increased significantly recently. And a lot depends on how the capital outflow from real money Japanese accounts over the past few years should be interpretted. Is it international diversification, money that is unlikely to return to Japan should relative interest rates change and/ or the yen start to appreciate? Or is it a bit more fickle, and perhaps be inclined to act a bit like leveraged money should conditions change?
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Comments
In the FX forward swaps market there are no "notional" amounts. All amounts are real and outstanding. If you put on a dollar/yen swap trade for $100 million you have to deliver $100 million in cash and receive the equivalent in yen, in cash, on spot settlement date. When the forward date comes, you will return the yen and receive back the dollars, again real money flows. This is not an option or futures trade, but a real swapping of large amounts of money. The amounts outstanding are thus very important and indicative.
Reply to this comment By Hellasious on 2007-02-04 16:32:32
hellasious -- would you mind if i made use of your comments on the preceding post in this post? My sense was that tmghee was arguing that "notional" amount may not reflect the banks ultimate risk -- take an example I happen to know well. Turkish banks were keen (in 05) to swap $ for long-term lira. International investors took a generally unhedged lira position in this swap (the banks that did the swap did so more their hedge fund clients ... who wanted more lira duration than was available in the government bond market). The turkish banks had $ to swap from their domestic dollar deposits so they were hedged, and they used the swaps to finance a fraction of the long-term mortgage lending. So the turkish banks effectively had offset both legs of the swap -- they had $ and long-term lira liabilities on balance sheet, and they used the offbalance sheet swap to match the two. that may nor may not be relevant here -- i generally know more about how folks manage their EM exposure than about stuff among the g-10.
Reply to this comment By bsetser on 2007-02-04 17:23:12
Dear Brad, You are welcome to use any comments you find useful. The banks' ultimate risk may not be direct market risk, as such, but credit risk. Bank A's dealing room may be running a perfectly matched book, but a crucial question is who is on the other side of the trades. If other large banks, then they are 99% fine - but no one can make any money that way, of course. It would be as if a bookie laid every single bet he got against another reputable bookie, instead of running his own book. There are only two ways for a bank's dealing room to make money: taking proprietary positions for the bank's own risk (gambling) or taking advantage of customer flows to make a spread (acting as bookie). Under most circumstances, bank dealing rooms are not so much gamblers as bookies - they just want to make the vig. It is therefore crucial for them to pick their customers with care because, unlike the heavies, they cannot threaten their customers with permanent visits to the aquatic domain if they fail to make good on their losses. The phenomenal rise of hedge and private equity funds has increased the systemic appetite for risk - there are many more gamblers out there willing to bet and that is why, pari pasu, the price of risk has collapsed (low risk premiums). Many large banks, seeing an opportunity, have jumped in with "three feet": a) They act as bookies on more and larger bets (more vig). b) They loan margin money to their "prime" hedge fund and private equity customers to make more and bigger bets (loan sharking). c) They take advantage of large customer trade flows, trading along with them for their own account and risk (like a bookie betting alongside a large gambler). Obviously (b) generates more (a) - and that is where most of the risk resides. For as long as the customers keep winning the process generates huge and increasing fees, interest income and trading gains for the banks own P&L. But if, for whatever reason, gains become losses and the customers cannot meet margin calls then the downward spiral begins. Everyone can easily understand what this means. Even a cursory examination of how debt has exploded in the past few years, particularly that of the financial sector, points to serious leverage being responsible for pumping up all asset prices. The yen carry trade is but a part of this process. Regards
Reply to this comment By Hellasious on 2007-02-05 02:25:14
Call me dumb, but I still fail to see how doing step one and two will give any leverage? Assuming step one and two are equal and opposite (EaO) transactions, their aggregate effect will be 0 (in fact, less due to spread and internal processing costs). On T+2 I will still have both USD and JPY inflow and outflows (matching, assuming no spread). Transacting two EaO spot transactions and making money out of it seems to me like a financial perpetum mobile?
Reply to this comment By Guest on 2007-02-05 06:14:30
hey brad -- please feel free to use whatever you find helpful. and to andrew -- fair enough on the japanese household assets. i see that on the boj flow of funds data, the amount of household money in japanese investment trusts (mutual funds) rose 33.6% yr/yr as of sept 2006 to 59.68 trln yen ($493 bln at a Y121 rate), a record high. and most of the new growth is in foreign assets. so including such funds with that of margin traders (though still comparatively small), maybe $1 trln is not so far fetched. i just find the fears about the yen carry trade speculative fervor a bit far fetched, in part because there have been several shake-outs of such trades in the past two years to keep anyone holding such positions on their toes (and i'm talking purely in yen terms -- perhaps a wider basket of carry trades including yen/Swiss franc/etc helps protect such trades). on the BIS data, i'm still not sure. i can't see how the massive yen carry trade would elude such bank lending stats. which jibes in tokyo about the difficulties foreign banks have tapping the overnight call market at times, though that may just be the difference between on balance-sheet and off/OTC, as mentioned. what's also weird is how the gross market values of OTC FX derivatives have shrunk on the BIS data between 12/04 and 6/06 even as notional amounts have risen sharply. and the biggest risers notionally in percentage terms are the aussie and kiwi (+54.5% and +193%), and the yen at 34.4% even as the euro grew 29.0% and USD 23.5%. here's what the san francisco fed had to say about it: http://www.frbsf.org/publications/economics/letter/2006/el2006-31.html the BIS itself was more circumspect last year. i think the big fear is leverage. that's what 1998 was all about. i think there is leverage this time, but not nearly that severe. and there is a big japanese domestic story that explains the yen's weakness, that is getting branded a little too easily as the gigantic and potentially world-wrecking yen carry trade. cheers
Reply to this comment By tmcgee on 2007-02-05 07:15:20
Asian Central Banks attempt to combat Asset Bubbles http://www.bloomberg.com/apps/news?pid=20601089&sid=ajbIBdY0Pf7E&refer=china Not only did last year's higher interest rates fail to curb overinvestment, they may even have helped draw in all that cash. The People's Bank of China raised its benchmark rate twice last year; while higher rates kept consumer prices contained, they encouraged even more investment and growth by offering enhanced returns. China's M2, the broadest measure of money supply, rose 16.9 percent to 34.6 trillion yuan ($4.46 trillion) in December, the highest since figures became available in June 1998. In Thailand, M2 in November reached a record 6.92 trillion baht ($197 billion). China's rate increases last year failed to cool an investment boom that stoked the fastest growth since 1995. The central bank also increased the amounts banks have to set aside as reserves four times since June to discourage excessive lending. That helped slow money supply growth to 16.9 percent in December from 19.2 percent in January 2006. Even so, urban real estate prices in China rose faster. Prices for apartments and offices in 70 cities increased 5.4 percent in December from a year earlier, after a 5.2 percent gain in November, according to the National Development and Reform Commission. Central bank Deputy Governor Wu Xiaoling said Jan. 25 in Davos, Switzerland, that China will tighten environmental controls to rein in overinvestment. Such measures ``would only slow growth marginally,'' says David Cohen, an economist at Action Economics in Singapore. ``Short of establishing currency controls like we've seen in Thailand, I don't think measures to reduce property prices across the region will have much of an impact,'' says Eugene Kim, chief investment officer of Tribridge Investment Partners Ltd. in Hong Kong, a hedge fund managing about $100 million. ``The wealth out there needs to go somewhere.'' ``There is too much money globally chasing meager returns, and the liquidity has found its way to asset markets,'' says Arjuna Mahendran, chief Asia strategist at Credit Suisse Group in Singapore. ``There is no perfect solution. If the flows aren't absorbed, you'll have a crisis at some stage.''
Reply to this comment By Dave Chiang on 2007-02-05 08:12:01
"Low observed volatility makes the real-denomianted carry trade even more attractive. And that pulls in even more money." That's why I referred to the phenomenon as a strange attractor when I worked up my follow-up commentary on your post yesterday. Dave Iverson Economic Dreams-Nightmares
Reply to this comment By Guest on 2007-02-05 09:04:54
See also the blogger "Macro Man" and his possibly-sour-grapes antithesis (he went short Yen/$ recently) which pulls together a good amount of data to assert Yen carry is really no big deal right now. Viz http://macro-man.blogspot.com/2007/02/nouriel-roubini-is-big-fat-idiot.html and ignore the title.
Reply to this comment By wcw on 2007-02-05 09:56:58
Brad, you were puzzled by why the Chinese currency might become a carry currency rather than a target. Some reasons for the Yuan being used by some in the carry trade are pointed out in Bloomberg editorial: http://bloomberg.com/apps/news?pid=20601039&refer=columnist_mukherjee&sid=aTyGjtMJxPM4
Reply to this comment By OldVet on 2007-02-05 12:41:00
I saw the mukherjee piece, and was still a bit confused ... it feels like a mix of an onshore/ offshore artibtrage (offshore RMB pay less than onshore -- so a good funding currency; onshore = 2% plus and the currency appreciation) and a bet that the RMB will appreciate by less than other asian currencies (destination currencies) with a bit more carry. OK, fair enough. but it also seems like the investment and commercial banks have a lot of demand for folks who want RMB simply for the appreciation (now that the pace seems a bit stronger), and are looking for someone else who wants to, in effect, sell RMB ...
Reply to this comment By bsetser on 2007-02-05 13:34:04
Anyone care to explain "Guest's" question about they steps 1 and 2 offer leverage. I agree with Guest that they seem to offset at T+2 and it is not clear to me how leverage is achieved through the first two steps. If anyone truly understands this, an explanation would really be appreciated.
Reply to this comment By Gamma on 2007-02-05 15:26:33
a couple of comments on macroman -- (the content, not the title ... ) 1) Re: Why isn't Japan's trade surplus bigger -- a) lags -- yen wasn't so weak not so long ago (04). watch 07 b) oil c) yen is only weak v. rest of the g-3. it isn't obviously weak v. the yuan d) don't forget about japan's exploding income surplus 2) positioning the macro funds that I know of tend to fund their long Nikkei positions with yen ... their hedging as the Nikkei rose was supposedly a source of pressure on the yen (i.e. higher yen = more unrealized profits in $ that needed to be protected v. slides in the yen). but that was an 05 story, not an 06 story what strikes me as different this time around is that I get a sense that -- as a result of diversification -- there are a lot more Japanese short yen positions (long kiwi, long us bonds, long european stocks, long you name it) than before. Mostly real money. but still mostly unhedged. If folks suddently started to hedge v. $ weakness or euro weakness v. the yen, that could potentially move the market. and, as for the limited on balance sheet cross border yen lending, i trust andrew rozanov. this is now done primarily thru swaps. finally, there is a lot of anecdotal evidence and market evidence (look at the swiss franc as well as the yen, and at destination currencies like the real) that lots of folks woke up on January 1 and answered the how will i earn my 2/20 in 07 question with the "put on a nice little carry trade" and then as the trade performed well, well, it got harder to sit on the sidelines/ take the other side. anyone out there short brazilian real local rates? outright short -- not hedging v CDS? My guess is no. it costs too much.
Reply to this comment By bsetser on 2007-02-05 15:29:29
"...Net six-month fund flows into the yen, the lowest-yielding currency of the 19 in its basket, are at their most negative since March 2000. They have only been more negative for 5 per cent of the time since State Street started tracking them in 1995. Similarly, net flows into the Swiss franc, the 17th lowest-yielding currency, have only been more negative for 4 per cent of the time since tracking began. By contrast, net fund flows into the Brazilian real, the highest yielding currency, have only been more positive 6 per cent of the time..." http://www.ft.com/cms/s/fd5df8a2-b544-11db-a5a5-0000779e2340.html
Reply to this comment By Guest on 2007-02-05 17:23:14
actually short real brazil bonds is strongly positive carry for a leveraged investor. ntn-b's yield 7.80 or so + sub 4% inflation funded at 13%. i think the long inflation linked trade in brazil is popular for its compelling fundamentals despite carry.
Reply to this comment By pb on 2007-02-06 10:32:37
pb -- i fear that I wasn't clear, i wasn't thinking "real" as in inflation indexed but "real" as in denominated in Brazilian real. and, judging from the price action and the brazilian reserve growth, there aren't many who are short brazilian real denominated assets. http://www.bloomberg.com/apps/news?pid=20601086&sid=aJIVQ4OEnyBo&refer=latin_america
Reply to this comment By bsetser on 2007-02-06 14:34:59
Brad, Either way, carry in brl debt (real ot nominal) is negative due to the inverted curve, with the nominal debt less so than inflation linked, and shorting is a positive carry trade when funded locally. If funded in usd, it is positive carry, but less so than just a simple currency trade. In other words, you decrease your carry while taking on more volatility/duration/credit risk, etc. I would agree that carry is the story in brl ndf and the currency futures on the BM&F, while the bonds are a different story (structural change in inflation, expected rate cuts, improving credit) in which leveraged investors are willing to pay away carry to go long.
Reply to this comment By pb on 2007-02-06 14:49:42
Guest, Gamma - Looks like I'm not doing a very good job of explaining what I mean... Sorry about that! Let me try and go about it from a slightly different angle. Imagine you are a bank dealer who has various corporate and institutional customers. Let's say Customer A (who could be a hedge fund, but not necessarily) comes to you and asks you to quote US$/JPY outright forward for 3 months. You offer him a quote. Based on that, he sells you JPY and buys US$ (say, US$ 100 mn) for settlement in 3 months. What does this mean? This means that you are now long JPY / short USD on a 3-month horizon. This essentially has 2 risks for you: spot rate risk and term structure risk (or, in other words, risk related to changes in the interest rate differential). Of these two, the spot rate risk is by far the largest and most volatile. So, unless you want to take an active proprietary position of being long JPY / short USD 100 mn on a 3-months horizon, you need to hedge this position. Thus, the first thing you do is you sell JPY / buy USD 100 mn in the spot market. Now you have only one problem remaining: duration mismatch. And there are two possible ways to solve this. Option 1 - Theoretical: actual borrowing and lending Having sold JPY and bought 100 mn USD in the spot market, you can borrow yen which you'll deliver and settle on T+2, while taking physical delivery of the US$ 100 mn. This gives you the dollars you'll need to deliver based on your outright forward obligation in 3 months' time. But for now you place these US$ 100 mn on deposit. In 3 months' time, you get the US$ + US$ interest, deliver against the yen, and repay the yen loan + JPY interest. While you could do this in theory, nobody ever does this in practice - too impractical, too much of a hassle, but most importantly - every act of borrowing and lending expands your bank's balance sheet, with obvious consequences for regulatory capital, etc. Instead, banks do the following: Option 2 - Practical: hedging in the spot + FX swap markets Go back to the point when you just ended up with the risk on your book of long JPY / short USD 100 mn on a 3-month horizon. Again, you hedge it first in the spot market - buy USD 100 mn vs JPY. Then, you do an FX swap transaction. Remember, an FX swap has two legs: buy currency A and sell currency B spot, and AT THE SAME TIME sell currency A and buy currency B for future delivery, say, 3 months forward. If you do this, the first leg of the swap CANCELS OUT the spot transaction you just did previously to hedge your spot risk (i.e. buy USD 100 mn and sell JPY, then sell USD 100 mn and buy JPY at the SAME spot rate), so no physical cash flows are triggered on T+2. All you are left with is a 3-month obligation from your original transaction with Customer A to deliver US$ 100 mn and receive yen AND your new obligation to receive US$ 100 mn and deliver yen in 3-months' time from the second leg of your FX swap hedge. You are now fully hedged! Notice how your transaction in the spot market and the first leg of your FX swap transaction CANCEL EACH OTHER OUT, leaving just an outright forward, which hedges your original obligation to customer A. It is EXACTLY the same concept as in my previous carry trade example of Spot Trade + FX Swap Trade, where step 1 and step 2 cancel each other out, leaving only step 3 - the outright forward. The only difference is that in my earlier example you're not doing it to hedge your risk, but to take risk in the most efficient and cheapest way possible. Hope this helps explain it a little better. Regards, Andrew
Reply to this comment By Andrew Rozanov on 2007-02-06 18:42:07
Thanks Andrew for explaining that again.
Reply to this comment By Gamma on 2007-02-07 14:11:53
Thanks Andrew. What confused me was why making an explicit FX step with outright forward (if you can get an outright forwad with favourable rate). The way you describe it (FX spot + FX swap) now is what I thought of when looking at the article originally.
Reply to this comment By enderv (was:Guest) on 2007-02-08 01:35:28
I have been discussing the yen carry trade in my work for some long time and I have enjoyed this discussion.The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested. In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion. However, as has been noted here, it is not necessarily the case that carry trades will show up in these statistics. Carry trade transactions could be on the other side, for instance, of hedging by Japanese exporters in the forward currency market, which would not show up in bank balance sheet statistics. The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this. There are a number of connected reasons for believing this, which I will try to summarise briefly; 1) The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause. 2) Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness. 3) Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring). 4) The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view. 5)There seems to be a relationship between the yen and the enormous credit bubble which now completely dominates global financial markets and the economy. In my work I had a chart (mainly for fun) showing the very close relationship between Goldman Sachs share price in dollars and the S&P 500 in terms of yen. There are plenty of other similar relationships I think you could show. When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that. Tim Lee
Reply to this comment By Tim Lee on 2007-02-08 10:42:17
Can one actually capture the spread yen/dollar: ~5% leverage 2.7x = 13.5%/yr and have your original principle 100% safe?
Reply to this comment By Guest on 2007-06-08 17:36:56