by Satyajit Das December 15, 2008
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).
In recent years, money was cheap and other assets were expensive. But as each of the global economy’s credit creation engines breaks down and systemic leverage declines, money becomes scarce and expensive, triggering adjustments that are reversing the run-up in asset prices.
In this current financial crisis, the quantum of available capital, the munificent resources of central banks and sovereign wealth funds, and the globalization of capital flows may be some of the accepted "facts" that are revealed to be grand illusions. As Mark Twain once advised: "Don’t part with you illusions. When they are gone, you may still exist, but you have ceased to live."
Reserve Illusions
In recent years, there has been speculation about the amount of capital or liquidity available for investment globally. The substantial reserves of central banks and their acolytes, sovereign wealth funds, were frequently cited in support of the case for a large pool of "unleveraged" liquidity − that is, "real" money. In reality, the available pool of money may be more modest than assumed.
For example, China has close to $2 trillion in foreign exchange reserves. The reserves arise from dollars received from exports and foreign investment into China that are exchanged into Renminbi. The central bank generates Renminbi by printing money or borrowing through issuing bonds in the domestic market. On China’s "balance sheet," the reserves are essentially leveraged using domestic "liabilities."
In order to avoid increases in the value of the Renminbi that would affect the competitive position of its exporters, China undertakes "currency sterilization" − operations where it issues bonds to mop up the excess liquidity. China incurs costs – effectively a subsidy to its exporters − of around $60 billion per annum (the difference between the rate it pays on its Renminbi debt and the investment income on its reserves).
The dollars acquired are invested in foreign currency assets, around 60% in dollar-denominated U.S. Treasury bonds, government-sponsored enterprise (GSE) paper such as Freddie and Fannie Mae debt, and other high quality securities. China is exposed to price changes in these investments and currency risk because of the mismatch between foreign currency assets funded with local currency debt.
Deterioration in the U.S. economy and the need to issue additional debt to support the financial sector may place increasing pressure on the U.S. sovereign rating and the dollar. U.S. government support for financial institutions is already approaching 6% of Gross Domestic Product (GDP), compared to less than 4% for the savings and loan crisis.
Deterioration in the credit quality of the United States results in losses on investment through falls in the market value of the debt and a weaker dollar. The credit default swap (CDS) market for sovereign debt is increasingly pricing-in increased funding costs for the United States. The fee for hedging against losses on $10 million of Treasurys was about 0.58 per annum for 10 years (equivalent to $58,000 annually) in December 2008. This is an increase from 0.01% ($1,000) in 2007 and 0.40% ($40,000) in October 2008.
It is also not easy to tap this liquidity pool. Given the size of the portfolios, it is difficult for large investors such as China to rapidly mobilize a large portion of these funds by liquidating their investments and converting them into the home currency without substantial losses. This means that this money may not, in reality, be available, at least at short notice. If the dollar assets lose value or cannot be accessed, then China must still service its liabilities. It can print money but will suffer the economic consequences including inflation and higher funding costs.
The position of emerging-market sovereign investors with large portfolios of dollar assets is similar to that of a bank or leveraged hedge fund with poor quality assets. China’s Premier Wen Jiabao recently expressed concern: "If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital …." In December 2008, Wang Qishan, a Chinese vice premier, noted: "We hope the U.S. side will take the necessary measures to stabilize the economy and financial markets as well as guarantee the safety of China’s assets and investments in the U.S."
There are other factors affecting the availability of the reserves at central banks and sovereign wealth funds. In recent years, sovereign wealth funds have also suffered losses on some of their investments, most notably in U.S. and European financial institutions.
Some central banks have been forced to utilize reserves to support the domestic economy and banking system. For example, South Korea has used a portion of its reserves to provide dollars to banks unable to refinance short-term dollar borrowings in international money markets.
Russia has similarly used a significant portion of its reserves to support financial institutions and also its domestic markets. Russia’s reserves, which rank third after China’s and Japan’s reserves in size, have fallen $122.7 billion, or 21 percent, since August 2008. The reserves, including oil funds that exclusively act as a safety cushion for the budget, stood at $475.4 billion on November 2008.
Capital Illusions
The substantial buildup of foreign reserves in central banks of emerging markets and developing countries, as identified by David Roche (see David Roche and Bob McKee, 2007, "New Monetarism," Independent Strategy Publications), is really a liquidity creation scheme that relies on the dollar’s favored position in trade and as a reserve currency.
Many global currencies are pegged to the dollar at an artificially low rate, like the Chinese Renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that is driven by excess U.S. demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase U.S. debt with dollars to mitigate upward pressure on their domestic currency.
Facilitating this process are the large, liquid markets in dollars and dollar investments capable of accommodating the very large investment requirements and the historically unimpeachable credit quality of the U.S. sovereign assets. The recycled dollars flow back to the United States to finance the spending.
This merry-go-round is a significant source of liquidity creation in financial markets. It also kept U.S. interest rates and cost of capital low, encouraging further borrowing to finance consumption and imports to keep the cycle going. This process increased the velocity of money and exaggerated the level of global liquidity.
The large buildup in reserves in oil exporters from higher oil prices and higher demand from strong world growth was also recycled into U.S. dollar debt. The entire process was reminiscent of the "petrodollar" recycling of the 1970s.
The central banks holding reserves were lending the funds used to purchase goods from the country. In effect, the exporter never got paid − at least until the loan to the buyer (the finance vendor) was paid off. As the debt crisis intensifies and global growth diminishes with increased defaults, it is increasingly likely that this debt will not be paid back in it entirety.
This liquidity circulation process supported, in part, the growth in global trade. This too may have been an illusion as the underlying process is a gigantic vendor financing scheme.
Trade Illusions
An accepted article of economic faith is that failure of economic cooperation and resurgent nationalism in the form of trade protectionism (for example, the Smoot-Hawley Tariff Act) contributed to the global financial crisis of the 1930s.
The stock market crash of 1929 and the subsequent banking crisis caused a collapse in financing and global demand, resulting in a sharp decrease in the U.S. trade surplus. Smoot-Hawley was passed in 1930 to deal with the problem of overcapacity in the U.S. economy through higher tariffs designed to increase domestic firms’ market share. The higher U.S. tariffs led to retaliation from trading partners affecting global trade.
The slowdown in central bank reserve recirculation affects global trade by decreasing the availability of financing for purchasers to buy goods and services. This is apparent in the sharp slowdown in consumer consumption in the United States, United Kingdom and other economies. It should be noted that it was the availability of cheap financing that fueled consumption by helping drive up asset prices which, in turn, allowed excessive borrowing against the inflated value of the assets.
Weakness in the global banking system (in particular, loan losses, the lack of capital and concerns about counter-party risk between large financial institutions) contributes to restricted availability of trade letters of credit, guarantees and trade finance generally. This exacerbates the problem. The restrictions, in turn, further impact the level of trade flows and capital recirculation, resulting in a further decrease in trade activity that in turn further slows down international credit creation.
It is not easy to fix the problem. Redirection of capital held in central banks and sovereign wealth funds to domestic economies affects the global capital flows needed to finance the debtor countries, such as the United States, and recapitalize the banking system. Maintenance of the cross border capital flows to finance the debtor countries budget and trade deficits slows down growth in emerging countries and also perpetuates the imbalances.
Trade has become subordinate to and the handmaiden of capital flows. As capital flows slow down, global trade follows. Indirectly, the contraction of cross border capital flows and credit acts as a barrier to trade. In each case, deleveraging is the end result.
This opens the way to "capital protectionism." Foreign investors may change their focus and reduce their willingness to finance the United States. Wen Jiabao, the Chinese prime minister, indicated that China’s "greatest contribution to the world" would be to keep its own economy running smoothly. This may signal a shift whereby China uses its savings to invest in the domestic economy rather than to finance U.S. needs.
China and other emerging countries with large reserves were motivated to build surpluses in response to the Asian crisis of 1997-98. Reserves were seen as protection against the destabilizing volatility of short-term capital flows. The strategy has proved to be flawed.
It promoted a global economy based on "vendor financing" by the exporting nations. The strategy also exposed the emerging countries to the currency and credit risk of the investments made with the reserves. Significant shifts in economic strategy are likely. Zhou Xiaochuan, governor of the Chinese central bank, commented: "Over-consumption and a high reliance on credit is the cause of the U.S. financial crisis. As the largest and most important economy in the world, the U.S. should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits."
More ominously, Chinese President Hu Jintao recently noted: "From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies."
There is also the risk of "traditional" trade protectionism. The end of the current liquidity cycle, like the one in the 1930s, may cause a sharp fall in exports. Exporting countries, seeking to maintain domestic growth, may try to boost exports by devaluation of the currency or subsidies. Import tariffs are less effective unless there is a large domestic market. Recently, the Chinese central bank did not rule out China depreciating its currency.
The change in these credit engines also distorts currency values and the patterns of global trade and capital flows. The current strength in the dollar, particularly against the euro, reflects repatriation of capital by investors and the shortage of dollars from the slowdown in the dollar liquidity recirculation process. It is also driven by the reliance on short-term dollar financing of some banks and countries and the need for refinancing. This is evident in the persistence of high interbank dollar rates and dollar strength.
The strength of the dollar is unhelpful in facilitating the required adjustment in the current account and also financing of the U.S. budget deficit.
The slowdown in the credit and liquidity processes outlined may have long-term effects on global trade flows. The volume of world traded, according to the World Bank, may contract by 2.1% in 2009. This contrasts with growth of 9.8 % 2006 and an estimated 6.2 % in 2008. The expected drop for 2009 is more severe than the last major contraction in trade volume of 1.9 % in 1975.
End of "Candy Floss" Money
Gillian Tett of the Financial Times coined the phrase "candy floss money" (see "Should Atlas still shrug?" January 15, 2007 Financial Times). New financial technology spun available "real" money into an exaggerated bubble that, like its fairground equivalent, collapses ultimately.
The global liquidity process was multifaceted. There was traditional domestic credit creation system built on the fractional reserve system that underpins banking. The leverage in the system was pushed to extreme levels. Losses and renewed regulation are forcing this system of credit creation to shut down.
The foreign exchange reserve system was another part of the global credit process. Dollar liquidity recirculation has also slowed as a result of reduced trade flows (driven by declines in U.S. consumption and imports), losses on dollar investments, domestic claims on reserves and the inability to readily mobilize large amount of reserves.
Another credit process − the export of yen savings via the yen carry trade and acquisition of foreign assets by Japanese investors − has also slowed.
The focus of the November 2008 G-20 meeting was firmly on financial sector reform. Stabilization of global capital flows in the short term and addressing global imbalances over the medium to long term barely merited a mention. It may well come to be seen in coming weeks and months as a major missed opportunity to address these issues.
Markets placed great faith in the volume of money available to support asset prices and assist in alleviating shortages of liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage as well as the structure of global capital flows. As the financial system deleverages, it is becoming clear, unsurprisingly, that available capital is more limited than previously estimated.
As Sigmund Freud once observed: "Illusions commend themselves to us because they save us pain and allow us to enjoy pleasure instead. We must therefore accept it without complaint when they sometimes collide with a bit of reality against which they are dashed to pieces."
There is an apocryphal story about a disgraced rock star who ended up in bankruptcy court. When asked what happened to his fortune of several million dollars, he responded: "Some went in drugs and alcohol, I gambled some of it away, some went on women and the rest I probably wasted!" Financial markets have "wasted" a staggering amount of money that ironically probably did not "exist" in the first place.
Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).
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