Stocks sold off in the final hour of trading Friday, turning what had been tidy gains in all the major indexes into losses and almost wiping out all the gains achieved by the markets during the week. The Dow Jones Industrial Average finished the day down 14.81, while the S&P 500 lost 1.33. For the week, the Dow managed to eke out an 8.68-point gain (after having started out Monday gaining 235 points) and the S&P rose 4.12 points (up 26.83 on Monday.
The primary concern among investors was the possible problems the US government was likely to have in funding its debt. Some observers feared a downgrade in the US’ credit rating.
The Dollar touched a new low for 2009 this week (on a trade-weighted basis), dropping three and a half percent against the Euro and four and a half percent vs. the British Pound. Since March 9, when stock markets around the world began their current rally, the Dollar has lost almost 12 percent against the Euro and over 15 percent vs. the British pound.
Background
Since the middle of September, when the US Treasury allowed the bankruptcy of Lehman Brothers and which date serves as the starting point for the current financial crisis, the Dollar has had two significant rallies (from mid-September to mid-November and from the end of December to March 9) and two major sell-offs (November to December and March 9 to the present date).
In attempt to find reasons for these major moves, analysts have resorted to the "safe-haven" theory: In times of uncertainty, investors and traders bought Dollars (and Japanese Yen, as well), despite the United States and Japan having the lowest interest rates among the developed nations, and sold European currencies. When the economic outlook appeared to be gaining some clarity, investors turned around and sold Dollars and Yen, having developed an "appetite for uncertainty", according to the pundits.
Thus, during the period from September to November, when things looked most bleak, the Yen and Dollar both appreciated. From November to late-December, the euphoria over Obama’s election victory and the hopes he carried regarding economic recovery led to strength in the European currencies. Then, just before Christmas, new pessimism set in and back came the Dollar. Finally, in March, when Treasury Secretary Geithner revealed his "bank bail-out package, with stress test details and toxic asset solutions, the Dollar started on its latest (and current) slide.
On Friday, an article in the Financial Times again cited the current aura of economic optimism as the reason the Dollar’s "prognosis is far from good" (implying, of course, that a reversal of this optimism could lead once more to a Dollar rebound). We agree that the Dollar’s prognosis "is far from good", however, we believe there are more deep-seated reasons for the negative outlook for the Dollar other than simply an "increased appetite for uncertainty".
Analysis
During times of "normal" currency trading, investors, taking a long-term view, tend to buy currencies whose countries’ governments are expected to maintain a strong anti-inflationary stance. Inflation is probably the single most important factor that can lead to erosion of the values of one’s assets (or, at least it was until the current financial meltdown). It was this anti-inflationary bias that led the Deutschemark to dominate all other currencies in the period leading up to the establishment of the Euro. The Bundesbank’s main goal, year in and year out, was to keep a lid on inflation.
On a short-term basis, traders tend to buy currencies whose countries offer the highest short-term interest rates. Short-term currency trading involves rapid in-and-out movements. So, in the short run, the currencies offering the highest interest rates tend to be the strongest currencies.
In conjunction with this attraction for higher short-term interest rates, investors also tend move their funds into investments in countries that promise solid economic growth. Higher growth rates usually mean higher interest rates.
Until about 2001, the Dollar benefited from all three of these factors: Historically, dating from the appointment of Paul Volcker as Federal Reserve Chairman in 1979 and continuing with Alan Greenspan, the Fed has produced a solid anti-inflationary record.
In order to retain control over inflation, the Fed, during this period, ensured that real interest rates (nominal interest rates adjusted for inflation) remained positive. Diversified investors prefer high real rates.
Finally, the US economy for most of this period was among the strongest in the world, especially among the developed nations.
There was one other factor that, we believe, contributed to the Dollar’s strength during this period. This was confidence in the US’ political and financial leadership. I remember sitting in a Swiss banker’s office in 1981, shortly after Ronald Reagan’s election as President, and listening while the banker told me how happy he and his colleagues were about Reagan’s leadership. The Dollar began to appreciate shortly after Reagan’s victory. (Margaret Thatcher’s election produced similar results for the British Pound.)
During the nineties, the combination of Fed Chairman Greenspan and Treasury Secretary Robert Rubin elicited similar confidence among investors (although Rubin’s star has since become tarnished in connection with Citigroup’s problems).
Consequently, the Dollar, especially during the 1990s, remained strong.
After 2001, however, the Dollar began to depreciate. There were a number of reasons behind this decline.
First, many economists at the time cited the large US current account deficit. Normally, countries that run large deficits of this nature ultimately have to resort to currency devaluations because they can’t attract the foreign capital necessary to finance the deficit. The US, on the other hand, was in a different sort of boat. We have since come to realize (most of us, that is) that the US needed to run a structural deficit in its current account to counterbalance the current account surpluses run up by export-dependent countries like Japan and, especially, China. Because the US economy was so strong, US consumers were really supporting the rest of the world. The US economy was the only economy big enough to absorb the exports from these countries.
In our opinion, another, and perhaps more important, reason for the Dollar weakness after 2001, was the increasing loss of confidence in the leadership exhibited by the Bush administration after 2001. Midway through this period we also saw a change in the reins of control at the Fed, with Ben Bernanke replacing Greenspan. Although Bernanke may turn out to be an effective chairman (and, in our opinion is doing an extremely creditable job), at the time, his newness sparked concern.
Outlook
We believe the Dollar’s current outlook is related to factors similar to those that led to its decline beginning in 2001.
First, on a short-term basis, because of both the economic and financial crisis, the Fed has been forced to lower short-term interest rates to virtually zero. And because nominal rates cannot go below zero, the Fed has also had to resort to "quantitative easing" - increasing the money supply by buying up all sorts of securities. To do this, the Fed has in effect been creating money. The Fed’s balance sheet has swollen to more than $2,000 billion and could grow larger. Goldman, Sachs has forecast that that the Obama Administration will sell a record $3,250 billion worth of debt in the fiscal year ending September 30.
In normal times, money creation of this magnitude would be extremely inflationary. However, right now, deflation is a more immediate concern. Nevertheless, should the economy turn around, inflation could quickly become the real problem. And many analysts believe the Fed will be hard-pressed to soak up these excess funds. In perhaps an omen of times to come, this week the Fed offered to buy $7.4 billion in bonds and was flooded with $45.7 billion in offers.
This week, Bill Gross, managing director at Pimco warned that the US could be in danger of losing it AAA credit rating. Now, the US has never defaulted on its debt and a downgrade of this nature is probably not an imminent threat. But earlier in the week, Standard and Poor lowered its outlook for the UK’s AAA credit rating to "negative" from "stable", and investors were concerned enough to sell the Pound at the time. The Dollar fell sharply on Gross’s comments.
Treasury Secretary Tim Geithner (more on Geithner below) tried to calm investors’ fears by saying the Obama Administration was committed to minimizing the nation’s budget deficit to 3 percent of GDP by 2015 (this year it is expected to reach 12.9 percent of GDP). The Congressional Budget Office believes the Administration will only be able to reduce the deficit to 5 percent of GDP by 2015 and that it will then remain at that level for some time after that.
There are rumblings of trouble among the developing countries. China has already called for expansion of the SDR as a reserve currency and has established swap facilities (where China will swap its currencies for those of other nations) with a number of countries, especially in South America. And this week, China and Brazil announced they will begin denominating trade between their two countries in Chinese renminbi and Brazilian reals. None of these steps will have much of a short-term impact on the Dollar, especially since the value of global trade is such a small percentage of total currency movements. But, they could be harbingers of the future.
Our main concern about the Dollar, however, centers on the question of confidence in the US leadership at this critical juncture. Geithner’s performance to date has certainly been less than reassuring. His initial announcement of the bank bail-out program in February was a disaster for the markets. His subsequent clarification in March was an improvement in that he provided more details in what was to come. But, subsequent performance hasn’t borne out this promise. The stress tests, in the eyes of many observers, were less than stressful. No banks have been either nationalized or allowed to fail. All will apparently muddle through.
Nothing to date has been done about the toxic assets on the books of the banks and many observers question whether his plan can work.
There are a number of observers who believe that Geithner is in over his head. Unfortunately, many of these control the purse strings of the world’s money managers.
The bright spot, among the American leadership to date, has been Barack Obama. His approval ratings remain well above 60 percent. His speeches have been fantastic. Yet so far he has failed to accomplish anything. He has let Congress have its way on most of the projects he has championed, to the detriment of those plans. His honeymoon with international investors may not last much longer (and may already be nearing an end).
This lack of confidence in America’s leaders, on top of the other tangible factors, could be the factor that sends the Dollar plummeting. Unless, of course, Obama starts getting things done.
But where does one invest? The Euro is one likely candidate, but Eurozone GDP fell 2.5 percent in the first quarter, and is expected to show a 4 percent decline for the full year. Germany’s GDP alone is expected to fall 6 percent this year. The aforementioned UK has its own problems. Japan’s GDP fell 4 percent, quarter-to-quarter, in the first three months of the year, after dropping 3.8 percent, the preceding quarter. That foreshadows a double-digit decline in GDP for the entire year.
Dollar weakness will put upward pressure on the Chinese currency and it will be interesting to see whether the Chinese can continue to keep a lid on the renminbi.
Monday, May 25, 2009
Monday, May 18, 2009
Whither the Stock Market
Investors received a dose of reality this week. After weeks of waiting for the results of the bank stress tests and of watching the stock market rise or fall with the fortunes of bank stocks, traders this week had to confront what was happening in the real world: the state of the global economy.
The markets took a roller coaster ride this week, with the down days, unfortunately for the bulls, outweighing the up days.
We will look at current economic conditions and try to determine whether the recent rally in stocks was in fact the leading indicator for an economic recovery or if it was just another bear market rally (of which, we’ve already had three or four during this recession).
Background
Stocks had fallen about fifty percent from their pre-Lehman highs (we equate the Treasury’s failure to bail out Lehman Brothers back in September with the beginning of the most recent crisis in both the market and the economy) until March 9, when they began their most recent rally. Since March 9, going into the this week, both the S&P and the Dow had recovered about one third from those lows.
Most of the rally, in our opinion, had occurred because of optimism regarding the financial system. It started following Treasury Secretary Tim Geithner’s unveiling of his latest bank bailout plan, including specifics regarding stress tests that officials would be conducting at the nation’s top nineteen banks. It continued as leaks regarding the results of those tests appeared to indicate that none of the top nineteen would be found to be insolvent or would have to be nationalized. Last week, when the results were finally announced and confirmed this optimism, the rally suddenly came to a halt (buy on the rumor, sell on the news).
In all fairness, banks’ health wasn’t the only reason for the rally. From time to time, comments from various officials, most notably Fed Chairman Ben Bernanke, regarding "green shoots" of economic recovery also encouraged investors.
None of the green shoots, however, seemed to signal an actual recovery. Rather they only showed the economy wasn’t falling as precipitously as it had been earlier in the year. House prices were still in decline, but the drops each month were smaller than the previous month. The country was still losing massive amounts of jobs, but April’s loss was "only" 539,000, compared to 663,000 the month before - a major improvement (although April’s job loss was the seventh biggest in history). Nevertheless, the unemployment rate still climbed to 8.9 percent, on its way to 10 percent?
What the green shoots were really showing was a decline in the rate of decline. As one commentator put it, people were no longer talking about a repeat of the Great Depression, only about the Great Recession.
The Recovery
About two weeks ago, writers in the Financial Times laid out four conditions that might be signs of a nascent recovery. It might be helpful to revisit those conditions today.
The first condition was an easing in financial conditions. The health of the banks is a necessary part of that condition. The stress tests "showed" that the banks were not seriously undercapitalized. But a number of economists have pointed out that perhaps the stress tests weren’t stressful enough. And, as we pointed out last week, banks have learned to "game" the system. They will do whatever is needed to ensure that they meet capital requirements. But will they do enough to ensure that the flow of credit to businesses resumes?
One indicator of easing credit conditions is the 3-month LIBOR rate, which fell below one percent for the first time this week. But another segment of the financial system that, in the past, has been responsible for lending - loan securitization - has so far failed to even approach pre-crisis levels.
A second condition for economic recovery is a bottoming out in US home sales and signs of life in the construction market. Mortgage rates are at record lows and home prices are down 30 percent from their highs, indicating that opportunities for a recovery in the sector are there. An index of pending home sales rose by 2 points in March. But, again, as we have pointed out before, one number doesn’t constitute a trend. Perhaps in coming weeks we will see confirmation of a housing recovery. But it’s not evident yet.
The third condition the FT pointed to was a recovery in consumer spending. GDP in the US fell a depressing 6.1 percent (annualized) in the first quarter. Yet, the one bright spot in the report was the fact that consumer spending actually rose 2.2 percent. If this were a harbinger of things to come, it would be good news. But this week, the commerce department reported that retail sales declined 0.4 percent in April, when economists had been predicting an increase. And retail stores are still reporting that consumers are only buying essentials, leaving discretionary items on the shelves and on the racks.
We believe consumer spending will play a vital role in the recovery. But three factors will weigh on spending: fear of job loss, confidence in a housing recovery, and further reduction of household debt.
As we pointed out above, employers are still shedding jobs, and the unemployment rate continues to climb. Yesterday, Chrysler announced it was closing almost 800 dealerships. GM is expected to close twice as many in coming weeks. That could mean the loss of another 150,00 jobs. News like this doesn’t help to build consumer confidence.
Confidence in a housing recovery won’t occur until there is hard evidence of a recovery. And we think that this recession has really frightened consumers: the household savings rate is up to 4.2 percent and could reach as high as 6 percent.
The fourth condition the FT signaled as pointing to a global economic recovery was encouraging numbers from China. China spent the equivalent of $586 billion in its own fiscal stimulus package last November and it seems to be paying off. The Chinese government reported that first quarter GDP growth was 6.1 percent (annualized), down from 6.8 percent in the previous quarter, but still healthy growth. Industrial production rose 8.3 percent in March after gaining only 2.8 percent in January-February. But exports fell 30 percent in the first quarter. Loan growth was 25 percent in the quarter, much of it resulting from government strong-arming of the banks to lend. This has resulted in a big increase in investment spending. But some analysts believe the lending/spending is creating severe production overcapacity, and could be setting China up for a setback in the future.
Another factor which could delay recovery is the lack of capital spending. The decline in capital spending accounted for 4.7 percent of the 6.1 percent decline in GDP in the first quarter. Capital spending has fallen 16.8 percent since the third quarter 2008. Until that turns around, any recovery will be difficult.
On the plus side, there are two factors, which, we believe, could be contributing to a nascent recovery. One is the recent run-up in commodity prices. Crude oil this week topped $60 a barrel for the first time in six months. Much of the increases have been attributed to China, on a global buying spree, taking advantage of low prices to stockpile critical commodities. However, it could also be an indication of a wider growing optimism among purchasing managers, in general.
A second factor that could lead to economic recovery is the draw-down in business inventories. Firms slashing production and reducing inventories have resulted in a situation where current inventories are so low that firms will soon have to begin restocking inventories, which could also help economic recovery.
In summary, we see more disappointment ahead for the economic bulls and, correspondingly, for the market bulls. We see more weakness in stocks in the coming weeks.
Outlook for India Stocks and the Rupee
Stocks in India traded in a narrow range this past week, while the Rupee fell against the Dollar. The stock market seemed to be hinging on election results, which will be announced this weekend. We feel a Congress victory will lead to a sell-off next week. The Rupee is trading in the pattern of all emerging market currencies: when traders are uncertain about economic or market conditions, they tend to run to the safe-haven currencies, the US Dollar and the Japanese Yen, and sell all other currencies including the emerging market currencies. That was the case this week. We see this situation continuing next week as well and therefore look for the Rupee to continue to trade lower vs. both the Dollar and the Yen. Gold, which approached $930 an ounce this week, should also trade higher next week.
The markets took a roller coaster ride this week, with the down days, unfortunately for the bulls, outweighing the up days.
We will look at current economic conditions and try to determine whether the recent rally in stocks was in fact the leading indicator for an economic recovery or if it was just another bear market rally (of which, we’ve already had three or four during this recession).
Background
Stocks had fallen about fifty percent from their pre-Lehman highs (we equate the Treasury’s failure to bail out Lehman Brothers back in September with the beginning of the most recent crisis in both the market and the economy) until March 9, when they began their most recent rally. Since March 9, going into the this week, both the S&P and the Dow had recovered about one third from those lows.
Most of the rally, in our opinion, had occurred because of optimism regarding the financial system. It started following Treasury Secretary Tim Geithner’s unveiling of his latest bank bailout plan, including specifics regarding stress tests that officials would be conducting at the nation’s top nineteen banks. It continued as leaks regarding the results of those tests appeared to indicate that none of the top nineteen would be found to be insolvent or would have to be nationalized. Last week, when the results were finally announced and confirmed this optimism, the rally suddenly came to a halt (buy on the rumor, sell on the news).
In all fairness, banks’ health wasn’t the only reason for the rally. From time to time, comments from various officials, most notably Fed Chairman Ben Bernanke, regarding "green shoots" of economic recovery also encouraged investors.
None of the green shoots, however, seemed to signal an actual recovery. Rather they only showed the economy wasn’t falling as precipitously as it had been earlier in the year. House prices were still in decline, but the drops each month were smaller than the previous month. The country was still losing massive amounts of jobs, but April’s loss was "only" 539,000, compared to 663,000 the month before - a major improvement (although April’s job loss was the seventh biggest in history). Nevertheless, the unemployment rate still climbed to 8.9 percent, on its way to 10 percent?
What the green shoots were really showing was a decline in the rate of decline. As one commentator put it, people were no longer talking about a repeat of the Great Depression, only about the Great Recession.
The Recovery
About two weeks ago, writers in the Financial Times laid out four conditions that might be signs of a nascent recovery. It might be helpful to revisit those conditions today.
The first condition was an easing in financial conditions. The health of the banks is a necessary part of that condition. The stress tests "showed" that the banks were not seriously undercapitalized. But a number of economists have pointed out that perhaps the stress tests weren’t stressful enough. And, as we pointed out last week, banks have learned to "game" the system. They will do whatever is needed to ensure that they meet capital requirements. But will they do enough to ensure that the flow of credit to businesses resumes?
One indicator of easing credit conditions is the 3-month LIBOR rate, which fell below one percent for the first time this week. But another segment of the financial system that, in the past, has been responsible for lending - loan securitization - has so far failed to even approach pre-crisis levels.
A second condition for economic recovery is a bottoming out in US home sales and signs of life in the construction market. Mortgage rates are at record lows and home prices are down 30 percent from their highs, indicating that opportunities for a recovery in the sector are there. An index of pending home sales rose by 2 points in March. But, again, as we have pointed out before, one number doesn’t constitute a trend. Perhaps in coming weeks we will see confirmation of a housing recovery. But it’s not evident yet.
The third condition the FT pointed to was a recovery in consumer spending. GDP in the US fell a depressing 6.1 percent (annualized) in the first quarter. Yet, the one bright spot in the report was the fact that consumer spending actually rose 2.2 percent. If this were a harbinger of things to come, it would be good news. But this week, the commerce department reported that retail sales declined 0.4 percent in April, when economists had been predicting an increase. And retail stores are still reporting that consumers are only buying essentials, leaving discretionary items on the shelves and on the racks.
We believe consumer spending will play a vital role in the recovery. But three factors will weigh on spending: fear of job loss, confidence in a housing recovery, and further reduction of household debt.
As we pointed out above, employers are still shedding jobs, and the unemployment rate continues to climb. Yesterday, Chrysler announced it was closing almost 800 dealerships. GM is expected to close twice as many in coming weeks. That could mean the loss of another 150,00 jobs. News like this doesn’t help to build consumer confidence.
Confidence in a housing recovery won’t occur until there is hard evidence of a recovery. And we think that this recession has really frightened consumers: the household savings rate is up to 4.2 percent and could reach as high as 6 percent.
The fourth condition the FT signaled as pointing to a global economic recovery was encouraging numbers from China. China spent the equivalent of $586 billion in its own fiscal stimulus package last November and it seems to be paying off. The Chinese government reported that first quarter GDP growth was 6.1 percent (annualized), down from 6.8 percent in the previous quarter, but still healthy growth. Industrial production rose 8.3 percent in March after gaining only 2.8 percent in January-February. But exports fell 30 percent in the first quarter. Loan growth was 25 percent in the quarter, much of it resulting from government strong-arming of the banks to lend. This has resulted in a big increase in investment spending. But some analysts believe the lending/spending is creating severe production overcapacity, and could be setting China up for a setback in the future.
Another factor which could delay recovery is the lack of capital spending. The decline in capital spending accounted for 4.7 percent of the 6.1 percent decline in GDP in the first quarter. Capital spending has fallen 16.8 percent since the third quarter 2008. Until that turns around, any recovery will be difficult.
On the plus side, there are two factors, which, we believe, could be contributing to a nascent recovery. One is the recent run-up in commodity prices. Crude oil this week topped $60 a barrel for the first time in six months. Much of the increases have been attributed to China, on a global buying spree, taking advantage of low prices to stockpile critical commodities. However, it could also be an indication of a wider growing optimism among purchasing managers, in general.
A second factor that could lead to economic recovery is the draw-down in business inventories. Firms slashing production and reducing inventories have resulted in a situation where current inventories are so low that firms will soon have to begin restocking inventories, which could also help economic recovery.
In summary, we see more disappointment ahead for the economic bulls and, correspondingly, for the market bulls. We see more weakness in stocks in the coming weeks.
Outlook for India Stocks and the Rupee
Stocks in India traded in a narrow range this past week, while the Rupee fell against the Dollar. The stock market seemed to be hinging on election results, which will be announced this weekend. We feel a Congress victory will lead to a sell-off next week. The Rupee is trading in the pattern of all emerging market currencies: when traders are uncertain about economic or market conditions, they tend to run to the safe-haven currencies, the US Dollar and the Japanese Yen, and sell all other currencies including the emerging market currencies. That was the case this week. We see this situation continuing next week as well and therefore look for the Rupee to continue to trade lower vs. both the Dollar and the Yen. Gold, which approached $930 an ounce this week, should also trade higher next week.
Wednesday, May 13, 2009
Stress Test
The focus of the markets this week was on the Obama Administration’s stress tests of the nation’s nineteen top banks. Results from the tests had been highly anticipated since early February when Treasury Secretary Tim Geithner first announced they would be included in his bail-out plan for the banks. The markets have risen and fallen in line with changing speculation as to the test results.
Results from the tests were originally due to be released May 4 but were delayed until yesterday so that bank executives would have time to discuss the results (read "lobby") with the government regarding their effect.
This week stock markets opened sharply higher (with both the Dow and the S&P each about three percent higher on Monday) on trader optimism that banks would not have to raise much additional capital. The markets fell back Tuesday with profit-taking, rallied again Wednesday, then slipped back Thursday when the results were finally released ("buy on the rumor, sell on the news") - the financial index fell 8.5 percent - before closing the week on an up note.
For the week, the Dow Jones Industrial Average finished the week with a 362-point gain (up 4.4 percent), while the S&P 500 Index rose 52 points (a gain of almost 6 percent).
The markets’ performance wasn’t entirely due to the stress-test results: the economy lost a less-than-expected 539,000 non-agricultural jobs in April (a loss of 630,000 had been expected). In addition, earlier in the week, numbers regarding pending home sales, construction spending, and the Institute of Supply Management’s non-manufacturing index all came in better-than-expected, reinforcing optimism that the end of the recession was in sight.
Nevertheless, the stress tests dominated trading and in this article we will try to put some perspective on the tests and their results.
Background
The failure of Lehman Brothers back in September was a major blow to the confidence of bank managers and investors alike. Banks were afraid to lend, holding on to their capital in case their assets deteriorated further, and investors, fearing other bank failures, sold bank shares accordingly.
Then-Treasury Secretary Hank Paulson tried to restore confidence through the Troubled Assets Relief Program (TARP), ultimately pumping capital into the banks to get them to resume lending. The banks took the money but they didn’t lend.
When the Obama Administration took office in January, the economy was in a tailspin. One of the Administration’s first priorities was to fix the banking system. In March, when new Treasury Secretary Geithner finally revealed a detailed bank plan, a keystone of that plan was the administration of "stress tests" to the nation’s top banks. The test would determine which banks would need additional capital (and how much) in the event the economy continued to deteriorate.
Geithner’s primary goal, like Paulson before him, was to restore the banks’ confidence and get them lending again. Secondary objectives would be to ensure the public maintained confidence in the banking system, thus avoiding bank runs ( la "It’s a Wonderful Night") and to also help bank shareholders.
The Treasury, with the help of the Federal Reserve, would send a small army of investigators into the banks and review the adequacy of each bank’s capital under a variety of adverse economic scenarios. The goal was to determine which banks required additional capital and how that capital would be attained.
The emphasis of the reviews would be on tangible common equity - basic common stock - as a percentage of total risk-adjusted assets. This was an old-fashioned way of calculating capital requirements: In 1989, the Bank for Institutional Settlements in Basel, Switzerland, had decreed that all banks would be required to maintain "Tier One Capital" equal to four percent of risk-weighted assets. Tier One Capital included common equity, but also included other categories, such as preferred shares (including those that had been issued to the treasury in exchange for TARP funds), goodwill and other intangible assets. Geithner determined that investors preferred the more conservative tangible-common-equity calculation. The stress tests required that tangible common equity would have to be at least four percent of total assets, while tier-one capital would need to be equal to six percent of assets.
In addition, since 1989, banks had learned to "game" the system: Basel determined that different classes of assets were less risky than others and were therefore subject to lower capital requirements (yes, residential and commercial mortgages were included in the less-risky category). Since 1989, banks had become very adept at finding ways to move more and more of their assets into these categories. The stress tests would require a higher percentage of capital for many of these assets.
By reducing the capital required for certain assets, the banks would increase their leverage and likewise increase their return on common equity. Before the economy went into a tailspin, US banks, on average, were leveraged at better than 25 to 1. (European banks generally operated at 40-to-1 leverage and banks in the UK carried leverage at almost 50 to 1.) Leverage magnifies returns when times are good (and asset values are increasing) but when times turn bad a small decrease in the value of assets can wipe out a bank’s capital. Once a bank’s capital is gone, it is insolvent. Requiring a higher percentage of capital (and lowering the leverage ratio) decreases the risk of insolvency.
A second objective of the stress tests was to increase so-called "transparency" at the banks - to give investors and creditors a better picture of what was going on inside the banks.
Anticipation
For the past two months, anticipation before the results was mixed. Bank executives were unfailingly optimistic. Jamie Dimon, Chairman and Chief Executive Officer at JP Morgan Chase, was confident his bank would not need additional capital. So was Lloyd Blankfein, head of Goldman, Sachs. In addition, Blankfein wanted to repay his company’s TARP funds as quickly. Executives at Bank of America and Citigroup, while trying to remain outwardly positive, appeared less confident.
Some observers, like Warren Buffett, whose company. Berkshire Hathaway is a major shareholder in Wells Fargo (Wells Fargo is Berkshire Hathaway’s second largest holding, behind Coca Cola), dismissed the tests, saying he believed one instead had to focus on a bank’s "dynamism" and its ability to attract depositors. He didn’t believe Wells Fargo needed any additional capital (it turned out it did).
The International Monetary Fund took a more pessimistic view of the world’s economy. It believed the global economy was in worse shape than that considered under the worst-case scenario in the stress test. The IMF forecast that, world-wide, banks would eventually have to write down a total of $4,400 billion. US banks would need an additional $275 billion worth of capital to bring leverage ratios down to 25 to 1. The IMF also stated it felt the chances of raising this type of capital in the private marketplace was essentially zero.
Some observers, like Nouriel Roubini, a professor at New York University also believed the scenarios considered by the stress tests were not stringent enough. He especially believes that unemployment will surpass the Treasury’s worst-case estimate.
Results
Results of the stress tests were much better than most observers feared. Geithner had earlier said that the results would be a "reassuring" picture for investors. In the end, ten of the nineteen banks tested were determined to need additional capital totaling $74.6 billion. Bank of America would require the most -- $33.9 billion. Wells Fargo was second on the list, needing $13.7 billion, followed by GMAC, at $11.5 billion. Citigroup would require an additional $5.5 billion in capital.
By Friday, several of the banks had already taken steps to raise the additional capital they needed. Wells Fargo, on Friday, sold $7.5 billion worth of shares, 25 percent more than they had originally planned. Morgan Stanley, which was told it needed $1.8 billion in additional capital, also sold $7.5 billion worth of stocks and bonds. Bank of America plans to sell 1.25 billion shares of stock in a shelf registration as well as an undetermined amount of debt. Citigroup will exchange preferred shares for common stock.
None of the banks want any additional capital from the government, although several of the regional banks that had smaller capital requirements (PNC Financial Services, Regions Financial, SunTrust, Fifth Third Bancorp, and Keycorp) could find it difficult to raise outside equity and may be forced to resort to government funds.
Legacy
Despite all the hoopla surrounding the stress tests, in the end, tier-one capital at the banks will only increase by $9.5 billion. Total equity will increase by $74.6 billion but most of this could be accomplished by converting other tier-one securities into common equity.
Policymakers believe the market is focused on common equity and they feel the shift into common shares should reduce bank funding costs.
Treasury Secretary Geither said, in releasing the results, "These tests will help ensure that banks will have a sufficient capital cushion to continue lending in a more adverse economic scenario."
In setting up the stress test, the Treasury’s priority was to calm panicked markets. They seem to have done that. Geithner wants to ensure that credit begins flowing smoothly. The tests may produce that result.
The banks will now turn to managing their balance sheets at whatever capital level, arbitrary though that it may be, the government desires. Their main goal will be to keep the government off their backs.
Shareholders will probably be convinced that the banks are healthy again. So far, they seem to be convinced.
On a long-term basis, there is still the prospect of $3,000 billion worth of toxic assets that may have to be written off. That problem seems to have been pushed to the back burner. Also, the stress test and pumping in additional capital doesn’t address the problems in the securitization market, which is going no where (see last week’s article).
There will be other benefits: capital will be concentrated in common equity, which the market seems to want; and the public is provided with considerably more information on the banks.
The treasury also appears to believe that the banks can remain profitable at the operating level, unlike Japanese banks following the 1997-1998 crisis, which many observers feel might provide a pattern for this crisis.
There are still many who believe that banks are considerably less healthy than the stress tests purport to show. Nouriel Roubini and Matthew Richardson, another NYU professor, in an article in Thursday’s Financial Times, argue that there are banks that should be allowed to fail. They cite economist Joseph Schumpeter, who said that "the essence of capitalism is creative destruction, that new economic structures are born from the rubble of old ones." If technically-insolvent banks are allowed to continue, it only sows the seeds of a new and larger crisis in the future.
Results from the tests were originally due to be released May 4 but were delayed until yesterday so that bank executives would have time to discuss the results (read "lobby") with the government regarding their effect.
This week stock markets opened sharply higher (with both the Dow and the S&P each about three percent higher on Monday) on trader optimism that banks would not have to raise much additional capital. The markets fell back Tuesday with profit-taking, rallied again Wednesday, then slipped back Thursday when the results were finally released ("buy on the rumor, sell on the news") - the financial index fell 8.5 percent - before closing the week on an up note.
For the week, the Dow Jones Industrial Average finished the week with a 362-point gain (up 4.4 percent), while the S&P 500 Index rose 52 points (a gain of almost 6 percent).
The markets’ performance wasn’t entirely due to the stress-test results: the economy lost a less-than-expected 539,000 non-agricultural jobs in April (a loss of 630,000 had been expected). In addition, earlier in the week, numbers regarding pending home sales, construction spending, and the Institute of Supply Management’s non-manufacturing index all came in better-than-expected, reinforcing optimism that the end of the recession was in sight.
Nevertheless, the stress tests dominated trading and in this article we will try to put some perspective on the tests and their results.
Background
The failure of Lehman Brothers back in September was a major blow to the confidence of bank managers and investors alike. Banks were afraid to lend, holding on to their capital in case their assets deteriorated further, and investors, fearing other bank failures, sold bank shares accordingly.
Then-Treasury Secretary Hank Paulson tried to restore confidence through the Troubled Assets Relief Program (TARP), ultimately pumping capital into the banks to get them to resume lending. The banks took the money but they didn’t lend.
When the Obama Administration took office in January, the economy was in a tailspin. One of the Administration’s first priorities was to fix the banking system. In March, when new Treasury Secretary Geithner finally revealed a detailed bank plan, a keystone of that plan was the administration of "stress tests" to the nation’s top banks. The test would determine which banks would need additional capital (and how much) in the event the economy continued to deteriorate.
Geithner’s primary goal, like Paulson before him, was to restore the banks’ confidence and get them lending again. Secondary objectives would be to ensure the public maintained confidence in the banking system, thus avoiding bank runs ( la "It’s a Wonderful Night") and to also help bank shareholders.
The Treasury, with the help of the Federal Reserve, would send a small army of investigators into the banks and review the adequacy of each bank’s capital under a variety of adverse economic scenarios. The goal was to determine which banks required additional capital and how that capital would be attained.
The emphasis of the reviews would be on tangible common equity - basic common stock - as a percentage of total risk-adjusted assets. This was an old-fashioned way of calculating capital requirements: In 1989, the Bank for Institutional Settlements in Basel, Switzerland, had decreed that all banks would be required to maintain "Tier One Capital" equal to four percent of risk-weighted assets. Tier One Capital included common equity, but also included other categories, such as preferred shares (including those that had been issued to the treasury in exchange for TARP funds), goodwill and other intangible assets. Geithner determined that investors preferred the more conservative tangible-common-equity calculation. The stress tests required that tangible common equity would have to be at least four percent of total assets, while tier-one capital would need to be equal to six percent of assets.
In addition, since 1989, banks had learned to "game" the system: Basel determined that different classes of assets were less risky than others and were therefore subject to lower capital requirements (yes, residential and commercial mortgages were included in the less-risky category). Since 1989, banks had become very adept at finding ways to move more and more of their assets into these categories. The stress tests would require a higher percentage of capital for many of these assets.
By reducing the capital required for certain assets, the banks would increase their leverage and likewise increase their return on common equity. Before the economy went into a tailspin, US banks, on average, were leveraged at better than 25 to 1. (European banks generally operated at 40-to-1 leverage and banks in the UK carried leverage at almost 50 to 1.) Leverage magnifies returns when times are good (and asset values are increasing) but when times turn bad a small decrease in the value of assets can wipe out a bank’s capital. Once a bank’s capital is gone, it is insolvent. Requiring a higher percentage of capital (and lowering the leverage ratio) decreases the risk of insolvency.
A second objective of the stress tests was to increase so-called "transparency" at the banks - to give investors and creditors a better picture of what was going on inside the banks.
Anticipation
For the past two months, anticipation before the results was mixed. Bank executives were unfailingly optimistic. Jamie Dimon, Chairman and Chief Executive Officer at JP Morgan Chase, was confident his bank would not need additional capital. So was Lloyd Blankfein, head of Goldman, Sachs. In addition, Blankfein wanted to repay his company’s TARP funds as quickly. Executives at Bank of America and Citigroup, while trying to remain outwardly positive, appeared less confident.
Some observers, like Warren Buffett, whose company. Berkshire Hathaway is a major shareholder in Wells Fargo (Wells Fargo is Berkshire Hathaway’s second largest holding, behind Coca Cola), dismissed the tests, saying he believed one instead had to focus on a bank’s "dynamism" and its ability to attract depositors. He didn’t believe Wells Fargo needed any additional capital (it turned out it did).
The International Monetary Fund took a more pessimistic view of the world’s economy. It believed the global economy was in worse shape than that considered under the worst-case scenario in the stress test. The IMF forecast that, world-wide, banks would eventually have to write down a total of $4,400 billion. US banks would need an additional $275 billion worth of capital to bring leverage ratios down to 25 to 1. The IMF also stated it felt the chances of raising this type of capital in the private marketplace was essentially zero.
Some observers, like Nouriel Roubini, a professor at New York University also believed the scenarios considered by the stress tests were not stringent enough. He especially believes that unemployment will surpass the Treasury’s worst-case estimate.
Results
Results of the stress tests were much better than most observers feared. Geithner had earlier said that the results would be a "reassuring" picture for investors. In the end, ten of the nineteen banks tested were determined to need additional capital totaling $74.6 billion. Bank of America would require the most -- $33.9 billion. Wells Fargo was second on the list, needing $13.7 billion, followed by GMAC, at $11.5 billion. Citigroup would require an additional $5.5 billion in capital.
By Friday, several of the banks had already taken steps to raise the additional capital they needed. Wells Fargo, on Friday, sold $7.5 billion worth of shares, 25 percent more than they had originally planned. Morgan Stanley, which was told it needed $1.8 billion in additional capital, also sold $7.5 billion worth of stocks and bonds. Bank of America plans to sell 1.25 billion shares of stock in a shelf registration as well as an undetermined amount of debt. Citigroup will exchange preferred shares for common stock.
None of the banks want any additional capital from the government, although several of the regional banks that had smaller capital requirements (PNC Financial Services, Regions Financial, SunTrust, Fifth Third Bancorp, and Keycorp) could find it difficult to raise outside equity and may be forced to resort to government funds.
Legacy
Despite all the hoopla surrounding the stress tests, in the end, tier-one capital at the banks will only increase by $9.5 billion. Total equity will increase by $74.6 billion but most of this could be accomplished by converting other tier-one securities into common equity.
Policymakers believe the market is focused on common equity and they feel the shift into common shares should reduce bank funding costs.
Treasury Secretary Geither said, in releasing the results, "These tests will help ensure that banks will have a sufficient capital cushion to continue lending in a more adverse economic scenario."
In setting up the stress test, the Treasury’s priority was to calm panicked markets. They seem to have done that. Geithner wants to ensure that credit begins flowing smoothly. The tests may produce that result.
The banks will now turn to managing their balance sheets at whatever capital level, arbitrary though that it may be, the government desires. Their main goal will be to keep the government off their backs.
Shareholders will probably be convinced that the banks are healthy again. So far, they seem to be convinced.
On a long-term basis, there is still the prospect of $3,000 billion worth of toxic assets that may have to be written off. That problem seems to have been pushed to the back burner. Also, the stress test and pumping in additional capital doesn’t address the problems in the securitization market, which is going no where (see last week’s article).
There will be other benefits: capital will be concentrated in common equity, which the market seems to want; and the public is provided with considerably more information on the banks.
The treasury also appears to believe that the banks can remain profitable at the operating level, unlike Japanese banks following the 1997-1998 crisis, which many observers feel might provide a pattern for this crisis.
There are still many who believe that banks are considerably less healthy than the stress tests purport to show. Nouriel Roubini and Matthew Richardson, another NYU professor, in an article in Thursday’s Financial Times, argue that there are banks that should be allowed to fail. They cite economist Joseph Schumpeter, who said that "the essence of capitalism is creative destruction, that new economic structures are born from the rubble of old ones." If technically-insolvent banks are allowed to continue, it only sows the seeds of a new and larger crisis in the future.
Monday, May 4, 2009
China and the Use of Special Drawing Rights
World stock markets continued their recovery this week, although in a somewhat subdued manner. Glimmers of an economic recovery along with better-than-expected (for the most part) earnings reports were the key factors driving prices higher. The S&P 500 Index gained over 9 percent in April, its strongest performance in over a year, and is now 29 percent above its March 9 low (but still well below the level it stood at last September just prior to the Lehman collapse).
In the foreign exchange markets, the US Dollar lost ground to most major currencies, except against the Japanese Yen, which lost 2 percent to the Dollar. Trading in all the currencies has seen a lack of volatility over the past month, with most currencies trading within one percent of their March 31 closes. Only the British Pound, which gained about 4 percent against the greenback in the past month, and the Canadian dollar, which is up about 6 percent, have evoked any interest.
The major factor driving currency trading during March and April has been "appetite for risk" (the favorite phrase of currency traders nowadays), with traditional economic fundamentals taking a back seat. Any time there are signs of improving economic conditions, traders demonstrate an "appetite for risk" and buy Euro, Swiss Francs and British Pounds. Whenever the global economy appears to be backsliding, traders move into safe-haven currencies: the US Dollar and the Japanese Yen. As a result, no definitive trading patterns have developed and the major currencies have generally moved sideways. This will probably continue over the near term.
On a longer-term basis, one of the issues that may turn out to affect trading is the role of the US Dollar as the world’s leading reserve currency and the prospects for its continuance in that role. In March, People’s Bank of China Governor Zhou Xiaochuan shook up the markets when he called for a new "super-sovereign currency", possibly the IMF’s Special Drawing Rights, to replace the world’s reliance on the Dollar,. Zhou’s goal is to create a currency "that is disconnected from individual nations and is able to remain stable in the long run". His remarks raised concern because of China’s massive foreign-exchange reserve position, most of which is in Dollar-denominated assets. A major shift, by China, out of those assets and into another currency (or currencies) could send the Dollar tumbling.
Initial reaction to Zhou’s remarks held that such a shift by China was unlikely because of China’s dependence on the US to buy up China’s exports, and because a shift, if it did occur, would depreciate the value of China’s Dollar holdings. US Treasury Secretary Tim Geithner appeared to dismiss concerns when he declared that he believed the Dollar should remain as the dominant reserve currency and that any shift, were it to occur, should be "evolutionary" (however, he did manage to send the Dollar plunging when, in his usual talk-first think-second manner, he first said he thought such a shift could be considered).
Since Zhou first issued his call for a new reserve currency, the market seems to have shrugged off any near-term possibility of a change and slipped back into a business-as-usual mode.
In this article, we will examine what we believe are the realistic possibilities of using a new reserve currency (in this case, Special Drawing Rights).
Background
At the end of March, China’s foreign-exchange reserves totaled either $1.95 trillion or $2.3 trillion, depending on whether you take China’s official numbers, or whether you include so-called "hidden reserves", the assets of China Investment Corporation (CIC), China’s sovereign wealth fund, as well as "other foreign assets" held by the People’s Bank of China. About three-quarters of these foreign-exchange reserves are in Dollars - about $1.5 trillion worth.
China has generally built up its reserves through massive exports to the West and by its efforts to hold down the value of the renminbi: as firms and other institutions try to buy the Chinese currency (in expectations of a currency appreciation), the Chinese central bank sells all the renminbi they want in exchange for foreign currencies, mostly Dollars.
These Dollars, acquired by the PBOC, have to be invested in Dollar-denominated assets and the PBOC has usually bought US Treasury securities (although CIC, in the past year, has been buying up US stocks and other more risky assets - and taken a bath in the process).
There are some signs that China’s appetite for American assets may be shrinking. In the first quarter, China’s official reserves only increased by $8 billion (and actually fell in January and February), compared to an increase of $154 billion in the first quarter a year ago. (Again, the actual increase may have been somewhat greater, depending on which amounts are included as reserves). In addition, China’s purchases of US Treasuries lately have mainly been concentrated in short-term Treasury bills.
China is worried about a possible decline in the Dollar and the effect that would have on the value of Chinese holdings, especially as the US attempts to spend its way out of the current economic crisis. But China has conflicting objectives regarding its reserves, which make a simple switch out of Dollar assets difficult. First, China would like to reduce its Dollar exposure but a massive move out of Dollars would cause the Dollar to plummet. And, second, China wants to continue to hold down the renminbi (or at least continue to manage its rise), which means accumulating even more Dollars.
The United States obviously doesn’t want China to either move its current reserves out of Dollars or to stop buying US Treasuries because the US needs China to finance its growing debt burden, and will especially need China when the economy turns, inflation becomes a renewed concern, and the Federal Reserve needs to dump all the securities it bought during its quantitative-easing period.
There is another reason to be concerned about China’s continued ability to buy US Treasuries. Many analysts and policymakers assume that when the global economy recovers it will be a return to the status quo, with the US and other developed nations resuming their roles as deficit nations with domestic demand again supporting the exports of the surplus nations.
Some economists have argued, however, that global rebalancing is needed - deficit nations need to increase their savings rates and reduce domestic demand accordingly, while surplus nations should take steps to develop domestic markets and reduce dependence on exports. We are starting to see this in the US as consumers de-leverage and reduce household debt.
According to economists at Goldman, Sachs, China has already announced three policy initiatives in an effort to rebalance its own economy. First, in November, China unveiled a massive stimulus package that would concentrate on infrastructure. Second, the Chinese plan to develop a full medical insurance policy for its rural community, which could spell an end to the country’s high savings rate. Third, they have begun to reverse the tightening of the credit conditions that existed before the crisis. Interest rates in the past few months have come down more than 500 basis points. The initiatives are setting the stage for what could be an acceleration of domestic demand. Goldman projects that China’s GDP will grow by 8.3 percent in 2009 and 10.9 percent in 2010, compared to previous forecasts of 6 and 9 percent, respectively. In short, China may not need to buy Dollar-denominated assets.
Special Drawing Rights
The Special Drawing Right (SDR) is a synthetic currency that was created in 1969 because of concerns that there was insufficient liquidity to support global economic activity at the time. It is not a currency per se, but rather a unit of account that is primarily used by the IMF to settle transactions between the IMF and its members. The value of the SDR is determined as a weighted average of the Dollar, Euro, Japanese Yen and British Pound. SDRs are allocated to IMF members based on their contributions to the fund.
The total amount of SDRs currently outstanding is equivalent to $32 billion, equal to only two percent of China’s foreign-exchange reserves. By comparison, there are $11 trillion worth of US Treasury securities in existence.
The recent G20 conference, held April 2, gave new importance to the IMF, tripling its resources from $250 billion to $750 billion, including a promise to create $250 billion in new SDRs.
Diversification into SDRs
Noble-prize-winning economist Paul Krugman has interpreted Zhou’s speech as an admission that China had driven itself into a Dollar trap. Because China is an export-led economy, when trade declines, as it has done in spectacular fashion, China has really been importing unemployment. By undervaluing the renminbi, China has been forced into accumulating foreign-exchange reserves. Krugman believes that China cannot diversify from the Dollar, because any attempt to diversify, or sell Dollars, would result in a Dollar collapse.
Fred Bergsten of the Petersen Institute of International Economics, and a former Carter advisor, on the other hand, thinks that swapping Dollar balances at the IMF would be of mutual benefit to the US and to any owners of substantial Dollar reserves. Dollar holders would achieve instant diversification because SDRs are based on a basket of currencies (Dollars, Euros, Yen and Pounds) while the US would avoid the risk of unwanted Dollars being dumped on the market. It may be worth considering.
At any rate, the US should certainly be considering contingency plans for the day when countries like China and Japan finally decide they don’t want all those Dollar assets.
In the foreign exchange markets, the US Dollar lost ground to most major currencies, except against the Japanese Yen, which lost 2 percent to the Dollar. Trading in all the currencies has seen a lack of volatility over the past month, with most currencies trading within one percent of their March 31 closes. Only the British Pound, which gained about 4 percent against the greenback in the past month, and the Canadian dollar, which is up about 6 percent, have evoked any interest.
The major factor driving currency trading during March and April has been "appetite for risk" (the favorite phrase of currency traders nowadays), with traditional economic fundamentals taking a back seat. Any time there are signs of improving economic conditions, traders demonstrate an "appetite for risk" and buy Euro, Swiss Francs and British Pounds. Whenever the global economy appears to be backsliding, traders move into safe-haven currencies: the US Dollar and the Japanese Yen. As a result, no definitive trading patterns have developed and the major currencies have generally moved sideways. This will probably continue over the near term.
On a longer-term basis, one of the issues that may turn out to affect trading is the role of the US Dollar as the world’s leading reserve currency and the prospects for its continuance in that role. In March, People’s Bank of China Governor Zhou Xiaochuan shook up the markets when he called for a new "super-sovereign currency", possibly the IMF’s Special Drawing Rights, to replace the world’s reliance on the Dollar,. Zhou’s goal is to create a currency "that is disconnected from individual nations and is able to remain stable in the long run". His remarks raised concern because of China’s massive foreign-exchange reserve position, most of which is in Dollar-denominated assets. A major shift, by China, out of those assets and into another currency (or currencies) could send the Dollar tumbling.
Initial reaction to Zhou’s remarks held that such a shift by China was unlikely because of China’s dependence on the US to buy up China’s exports, and because a shift, if it did occur, would depreciate the value of China’s Dollar holdings. US Treasury Secretary Tim Geithner appeared to dismiss concerns when he declared that he believed the Dollar should remain as the dominant reserve currency and that any shift, were it to occur, should be "evolutionary" (however, he did manage to send the Dollar plunging when, in his usual talk-first think-second manner, he first said he thought such a shift could be considered).
Since Zhou first issued his call for a new reserve currency, the market seems to have shrugged off any near-term possibility of a change and slipped back into a business-as-usual mode.
In this article, we will examine what we believe are the realistic possibilities of using a new reserve currency (in this case, Special Drawing Rights).
Background
At the end of March, China’s foreign-exchange reserves totaled either $1.95 trillion or $2.3 trillion, depending on whether you take China’s official numbers, or whether you include so-called "hidden reserves", the assets of China Investment Corporation (CIC), China’s sovereign wealth fund, as well as "other foreign assets" held by the People’s Bank of China. About three-quarters of these foreign-exchange reserves are in Dollars - about $1.5 trillion worth.
China has generally built up its reserves through massive exports to the West and by its efforts to hold down the value of the renminbi: as firms and other institutions try to buy the Chinese currency (in expectations of a currency appreciation), the Chinese central bank sells all the renminbi they want in exchange for foreign currencies, mostly Dollars.
These Dollars, acquired by the PBOC, have to be invested in Dollar-denominated assets and the PBOC has usually bought US Treasury securities (although CIC, in the past year, has been buying up US stocks and other more risky assets - and taken a bath in the process).
There are some signs that China’s appetite for American assets may be shrinking. In the first quarter, China’s official reserves only increased by $8 billion (and actually fell in January and February), compared to an increase of $154 billion in the first quarter a year ago. (Again, the actual increase may have been somewhat greater, depending on which amounts are included as reserves). In addition, China’s purchases of US Treasuries lately have mainly been concentrated in short-term Treasury bills.
China is worried about a possible decline in the Dollar and the effect that would have on the value of Chinese holdings, especially as the US attempts to spend its way out of the current economic crisis. But China has conflicting objectives regarding its reserves, which make a simple switch out of Dollar assets difficult. First, China would like to reduce its Dollar exposure but a massive move out of Dollars would cause the Dollar to plummet. And, second, China wants to continue to hold down the renminbi (or at least continue to manage its rise), which means accumulating even more Dollars.
The United States obviously doesn’t want China to either move its current reserves out of Dollars or to stop buying US Treasuries because the US needs China to finance its growing debt burden, and will especially need China when the economy turns, inflation becomes a renewed concern, and the Federal Reserve needs to dump all the securities it bought during its quantitative-easing period.
There is another reason to be concerned about China’s continued ability to buy US Treasuries. Many analysts and policymakers assume that when the global economy recovers it will be a return to the status quo, with the US and other developed nations resuming their roles as deficit nations with domestic demand again supporting the exports of the surplus nations.
Some economists have argued, however, that global rebalancing is needed - deficit nations need to increase their savings rates and reduce domestic demand accordingly, while surplus nations should take steps to develop domestic markets and reduce dependence on exports. We are starting to see this in the US as consumers de-leverage and reduce household debt.
According to economists at Goldman, Sachs, China has already announced three policy initiatives in an effort to rebalance its own economy. First, in November, China unveiled a massive stimulus package that would concentrate on infrastructure. Second, the Chinese plan to develop a full medical insurance policy for its rural community, which could spell an end to the country’s high savings rate. Third, they have begun to reverse the tightening of the credit conditions that existed before the crisis. Interest rates in the past few months have come down more than 500 basis points. The initiatives are setting the stage for what could be an acceleration of domestic demand. Goldman projects that China’s GDP will grow by 8.3 percent in 2009 and 10.9 percent in 2010, compared to previous forecasts of 6 and 9 percent, respectively. In short, China may not need to buy Dollar-denominated assets.
Special Drawing Rights
The Special Drawing Right (SDR) is a synthetic currency that was created in 1969 because of concerns that there was insufficient liquidity to support global economic activity at the time. It is not a currency per se, but rather a unit of account that is primarily used by the IMF to settle transactions between the IMF and its members. The value of the SDR is determined as a weighted average of the Dollar, Euro, Japanese Yen and British Pound. SDRs are allocated to IMF members based on their contributions to the fund.
The total amount of SDRs currently outstanding is equivalent to $32 billion, equal to only two percent of China’s foreign-exchange reserves. By comparison, there are $11 trillion worth of US Treasury securities in existence.
The recent G20 conference, held April 2, gave new importance to the IMF, tripling its resources from $250 billion to $750 billion, including a promise to create $250 billion in new SDRs.
Diversification into SDRs
Noble-prize-winning economist Paul Krugman has interpreted Zhou’s speech as an admission that China had driven itself into a Dollar trap. Because China is an export-led economy, when trade declines, as it has done in spectacular fashion, China has really been importing unemployment. By undervaluing the renminbi, China has been forced into accumulating foreign-exchange reserves. Krugman believes that China cannot diversify from the Dollar, because any attempt to diversify, or sell Dollars, would result in a Dollar collapse.
Fred Bergsten of the Petersen Institute of International Economics, and a former Carter advisor, on the other hand, thinks that swapping Dollar balances at the IMF would be of mutual benefit to the US and to any owners of substantial Dollar reserves. Dollar holders would achieve instant diversification because SDRs are based on a basket of currencies (Dollars, Euros, Yen and Pounds) while the US would avoid the risk of unwanted Dollars being dumped on the market. It may be worth considering.
At any rate, the US should certainly be considering contingency plans for the day when countries like China and Japan finally decide they don’t want all those Dollar assets.
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