Monday, April 16, 2007



The G7 statement was limp, as expected. There was no real change from February, and surprisingly little moaning on the sidelines: a classic non-event.

The IMF statement was limp. Sure, they provided a list of policy targets for the multilateral participants (US, Europe, Japan, China, and Saudi Arabia.) And sure, Hank Paulson said he really, really, really wants the IMF to strengthen its oversight capabilities on exchange rates. But as Brad Setser discusses, the policy goals are generally nebulous and toothless.

The problem, as it has been, is that the IMF has no “stick” with which to encourage cooperation. China, the Middle East, et al. have no need for the Fund’s monetary IV- quite the contrary! So if pleas like Macro Man’s have not fallen on deaf ears, they seem to have fallen on relatively powerless ears.

That China couldn’t give a hoot what the IMF had to say was evident by the fact that they sent jubbs to the meetings while the Finance Minister and PBOC Governor stayed at home. It’s hard to take China’s lip-service towards rebalancing its economy seriously when the relevant officials cannot even be bothered to give up their weekend barbecues.

A comment from one of the jubbs, PBOC deputy governor Hu Xiaolian, afforded Macro Man some modicum of amusement. She told the IMF steering committee that "Given the limitations of various exchange rate analytical tools, it is well known that the concept of exchange rate misalignment is subject to theoretical weakness, their estimates highly unreliable, and therefore could not serve as criteria or premises for surveillance."

Perhaps, but suggesting that the shortcomings of various models prevents one from identifying the RMB as undervalued given the trade surplus/reserve accumulation is like a birdwatcher stating that the absence of a DNA sample prevents one from correctly identifying a waterfowl that looks like a duck and quacks like a duck.

Anyhow, it looks very much like an “as you were.” The dollar should trade poorly against most things that pay 3% or more, and decently against the other stuff. It was amusing yet predictable to see PBOC ensure that USD/CNY closed higher on the day- Zhous must have had a nice giggle over that at his weekend barbie.

The entry signal on the FX carry beta plus portfolio was finally triggered; fills are in the P/L below. This week could prove interesting for equities; US earnings season picks up steam, and the data slate is chock full of important releases, starting with retail sales today. Ultimately, though, the world continues to look like a pretty happy place, especially if you work at PBOC and you’re holding all the cards.



Anonymous said...

Sad to see so few comments on your writings, as many of them are worthy of more discussion.

Macro Man said...

Thanks. The lack of response to this one at least isn't unique.. Brad Setser's blog only has 5 posts on the same topic (he's usually good for 30-40), and the only one since markets opened today is from me!

"Cassandra" said...

Anonymous, Perhaps everyone is simply too busy today trying to dispose of USD holdings by buying assets before the monster holders do . World financial leaders and the sheepish mandarins at the IMF have given the green-light that asset purchases with real or borrowed funds are "safe" for yet another weee interval.

MM - my response to your response to my response to yours at Setser's got "nuked" in transmission and I didn't have the energy to repost. Our disagreement can be parsed in terms of you believing Japanese monetary policy is mostly justified, whereas I am the opinion that it is rather nefariously Macchiavellian, unjustified, and in the scheme of global rebalancing (particularly Brad's point that the Continentals were "doing their part"), wholly on the wrong tack.

Anonymous said...

Before we start pointing the finger at China for making the G7/IMF meetings irrelevant, we should remember that the German finance minister took a pass on the meeting to take a family vacation! As for policy prescriptions from the weekend’s meetings, it’s not clear that the global economy really needs to be fiddled with. Let’s take stock of the global macro environment: 1) generally solid growth picture in the industrialized world with Europe and Japan looking better than the US, even the supposedly doomed US economic picture seems far from recession (expectations of 1.8% real GDP in Q1 and core PCE at ~2.5%); and 2) extremely firm EM fundamentals with the global labor force (and hence the global consumption base) expanding by 25% since 2000 (see Fig. 5.1 in the IMF’s World Economic Outlook, Ch. 5). Haven’t most experts been calling for exactly this sort of growth rebalancing for sometime?

As for the frustration regarding currency values, I think the consensus view goes something like this: 1) Asian currencies are undervalued because of reserve accumulation and mercantilist export-promotion policies; 2) EUR is overvalued because of reserve diversification and something has to bear the brunt of USD weakness; 3) carry crosses (e.g. AUDCHF, NZDJPY, etc…) are all out of whack because yield hungry reserve managers seek out yield at any price.

Again, the consensus that something smells fishy in Denmark seems to be a bit wide of the mark. First, given the commodity intensity of Chinese economic activity, it seems to me that one way of restraining growth with a shaky banking system is to keep local interest rates and currency values low, thus keeping the effective price of commodities high (the Chinese are very careful not to be too tight because of external pressure and internal political concerns since the Communist Party’s hold on power is based on their ability to deliver growth). Second, the view that Asian and Middle Eastern reserve accumulators are going out in the market and blindly buying USD on a daily basis is way off the mark. Sure, they are active in the market and do occasionally wreak havoc, but for the most part their dollars come from US consumers printing currency via a negative savings rate. The real impact of this USD accumulation is that reserve rebalancing means that they have to sell USD for EUR and GBP, part of the reason why these currencies are brushing against all time highs. Now one might ask why these reserve managers don’t just sell USD? I would argue that they don’t sell more USD because they have substantial USD assets and hitting the market with USD137bn (which is what China accumulated in Q1 2007 alone) might have a negative impact on the overall balance sheet. Will this end in tears eventually? Probably but not necessarily, especially if they broaden their holdings (a la GIC/Temasek) and purchase US equities (which are cheap relative to rates/credit markets). The bottom line is that it doesn’t seem like the blame is solely on the Chinese and that a rebalancing of US growth should help things.

Turning to the argument that Asian CBs are pursuing a beggar thy neighbor policy of capping currency gains to support exports, this one also has a few issues. First, if we look at Asian currencies from Dec. 2003 to present, what do we see? We would find that the JPY has underperformed over the period to the tune of 20%-40%. Is this surprising? Not really considering the horrendous shape Japan was in and the fact that they unleashed the helicopters on a scale that would have made Ben Bernanke proud. If we also consider that Japan’s intra-Asia trade volumes have skyrocketed over the past 5 years, I would have expected that if Asian CBs were really interested in export competitiveness, they would have stayed closer to JPY than they have.

Apologies for the rant… Cutting to the chase, it appears that the world is still feeling the effects of a MASSIVE labor supply shock which is likely to be magnified by a labor productivity shock in the next few years. Much as I hate to admit it as an alpha seeker, isn’t this an ideal environment for beta?

Macro Man said...

Cassandra, I think we've cracked it. We're in agreement about what the MOF was up to in 2003-04. I was satisfied when they cut out the intervention gig.

On ZIRP and its progeny, I think the Japanese are pursuing a fairly sensible policy of not screwing up like they did a couple of times in the 90's by tightening too much, too soon. One rationale for maintaining a low OCR is to allow the government to get its fiscal house in order. And in fairness, there HAS been a reasonable tightening of fiscal policy over the last few years. Omi is a tax guy, so I'd expect to see more tightening after the Upper House elections this summer. As long as they're doing that, I have no real beef with the pact to keep BOJ rates lower than where Fukui himself would like.

I could of course be wrong, and the government is trying to use monetary policy instead of intervention. But the fact that fiscal policy has tightened gives me some crumb of comfort. And bear in mind, there is something of a precedent: it's taken the SNB 3 years to hike rates from 0.25% to 2.25%- and der Schwiez didn't have the baggage that Japan has. Hell, Roth moans about CHF weakness on a weekly basis, but still won't do more than 25 bps a quarter.

Anonymous, interesting take. I don't think out viewpoints are that far off. I would concur that a more balanced global growth, with the US contributing less than its GDP weight, is probably close to an ideal scenario. I am also a big buyer of the globalized labour force view.

I think that one could construct a pretty decent argument that the reason US labour growth and capex have disappointed is that firms are hiring and spending just as much as they always have- they're just doing a lot more of it than they used to in (low cost) overseas locations. While the string of double digit earnings growth quarters has come to an end, that period lasted as long as it did because US firms were pretty aggressive in capitalizing on the globalization of labour markets, with a concomitant boost to profit margins.

Where we differ is on China's behaviour in the currency market and the conduct of domestic monetary policy.

Given the massive surge in the trade surplus in recent years, the Chinese industrial economy has very clearly hit critical mass. Part of this surge is a result of China's going from an importer to exporter of things like steel, aluminum, and certain chemicals. This represents a massive positive productivity shock (to simplify, agrarian output has turned to industrial output) that should produce a stronger equilibrium exchange rate.

And yes, China has allowed the RMB to strengthen. However, even with special factors, the pace of reserve accumulation has accelerated as the same time as the trade surplus. Thus, it seems clear (to me at least) that China is actively and aggressively distorting the price of its currency to achieve some policy goal. This goal is presumably the continuation of strong trade surpluses and the maximization of employment opportunities for rural workers migrating to the cities.

This might be fine if PBOC had to pay a reasonable cost for sterilizing its intervention. But it doesn't. Banks are prevented by diktat from lending out a large percentage of their deposit base to firms and individuals. They are also prevented from seeking higher returns in foreign assets, just as foreigners are prevented from accessing onshore deposit rates for RMB. So PBOC has a captive audience to buy its sterilization bills, as banks can still earn a decent margin by paying two and a bit percent to depositors and earning three and a bit percent from PBOC.

So the upshot is that PBOC breaks out the printing press, prints RMB to buy dollars, and then uses its regulatory powers to ensure that RMB is snaffled up by domestic banks. PBOC/SAFE/ the new investment authority then has billions and trillions of dollars with which to buy stuff, taking advantage of the convertible currencies and open asset markets of the US, Euroland, UK, Oz, etc.

To me, it's the free-riding that's the wind up. PBOC enforces a closed system within China but enjoys the benefits of the open system outside of China. And because China is so big, they have an impact.

In my view, China and other FX reserve managers have significantly lowered the supply curve of credit in the West. Unsurprisingly, borrowers take out more loans than they would if the price of credit were set by the private sector. Yes, the US would still have a (large) current account deficit if the RMB were a floating currency. But I remain convinced that it would not be nearly as large as it is today. I don't think it's a coincidence that broad money growth in most places that report it is running at double digit annual gains- this is the impact of an artificially low credit supply curve!

As for G10 FX...if they were a relatively passive participant, executing their business as quietly as possible, i could live with that. It's the day trading that grates on me and many others...they buy at the figure and sell sixty points higher. It's not like they can make enough to be anything but a rounding error on SAFE's AUM doing that, and is it really the sort of behaviour that public sector entities and regulators should be engaged in?

By this point, the private sector has to a degree become used to this. Curves are structurally flatter than they used to be and carry trades go on for longer and higher than they used to. Fine. However, I cannot help but think that the compression of volatility and risk premia that results from PBOC/SAMA/CBR etc will ultimately have a sting in the tail. Nominal position sizes must get bigger and bigger and bigger to achieve a given risk budget. That's fine as long as the system holds. If something does happen, could get pretty nasty. I have no idea if anything bad will happen or not. But if it does, I think it will be partially a result of the distortions and perverse incentives created by public sector institutions.

In the meantime...I think you're right. Buy and hold strategies in risk assets beats market timing and beta trumps alpha. That's one of the reasons I have the beta section of my portfolio, but as Charles Butler among others have suggested, I need to do more to braoden my universe.

"Cassandra" said...

To paraphrase more parsimoniously:

Risk-adjusted return only matters there is risk....

In the current environment, this means "arbitrage" becomes, relatively speaking, irrelevant, since at low levels of leverage, it returns cannot compete with outright asset-price inflation.

Macro Man said...

Yes, thanks for summarizing. I look at the pain caused by the GM downgrade in 2005 and the liquidity squeeze in May of last year and wonder what would happen if things actually ever went wrong for real.

While I do think the world is generally still a smiley, happy place, I do get a bit worried when caution gets thrown utterly to the wind...

Sally said...

As for "few comments", don't extrapolate that to few reasders. There may be many like me who read and learn yet have not so much to contribute.

James said...

Thanks for your insights macro man. I'm getting pretty tired of the US bond market being run by governments. They will never be able to allocate resources efficiently.