from Follow the Money

$1 trillion, $100, $1.50

February 28, 2008

Blog Post

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A lot of milestones have been passed in the last few days. Most aren’t positive for the United States.

Nouriel Roubini is no longer the only economist putting the eventual toll of the financial crisis at close to a trillion dollars.

It takes about $100 to buy a barrel of oil that could have been bought for about $20 a few years back.

It takes $1.50 (a bit more actually) to buy a currency that could have been bought for 80 or 90 cents six years ago.

George W. Bush efforts to push the Gulf to democraticize aren’t going anywhere. In some sense they cannot go far when Ben Bernanke is encouraging US financial institutions to look to non-democratic governments for additional capital.

The US financial system no longer seems like a model for the rest of the world. Apparently SIVS are only one category of potentially troublesome off-balance sheet conduits. Read Dr. Feldstein’s important oped. US banks and broker-dealers rather clearly lacked sufficient capital to sustain the risks they were taking.

The absence of lending by US and European banks has led private equity firms to encourage some of their large investors to lend them money directly. It isn’t, though, clear to me what ADIA gains financially by lending to a firm that it already likely managing ADIA’s money. Any gains on the debt will come out of its equity returns.

There is an overarching logic that ties these developments together. A weak US financial system needs low rates and time. Low rates contribute to a weak dollar. A weak dollar - especially in a still-sort-of-strong global economy - contributes to higher commodity prices, at least in dollar-terms. Or high commodity prices contribute to a weak dollar. No one is quite sure. High oil means the big Gulf funds have more money. It also means American consumers have less money - and either have to consume less or save less. Gulf "liquidity" substitutes for US liquidity. Pressure on the dollar means more exchange rate intervention in Asia. China is once again cracking down on hot money inflows. Rising reserves and faster RMB appreciation create pressure for China to seek higher returns, and either to expand the CIC or let SAFE invest more aggressively.

But rather than launching into (yet) another lengthy post on sovereign wealth funds, let me just highlight two excellent articles on sovereign funds - the William Mellor and Le-Min Lim’s Bloomberg feature on the challenges facing the CIC and Landon Thomas’ New York Times profile of ADIA.

Thomas’ article offers the best analysis of ADIA I have seen. His estimate of ADIA’s size -- "for now bankers, former employees and analysts familiar with the fund estimate its size at $650 billion to $700 billion" -- strikes me as about right. That is big. But is also only a bit more than China is likely to add to its foreign assets this year. $10b in monthly FDI inflows, hot money flows, a large trade surplus even with $100 oil -- it all adds up. The Bloomberg story on the CIC also provides an excuse to highlight Victor Shih’s excellent blog, Elite Chinese Politics. Dr. Shih is one of many experts quoted in the Bloomberg story.

It probably is a good idea for the US to get to know its creditors a bit better.

The formative experience of my professional career came in the late 1990s, when I worked as a staff economist at the US Treasury. I spent a fair amount of time thinking about how the US should use the leverage created by the United States’ ability to act as a lender of last resort to cash strapped emerging economies. Or, more accurately, the ability of the US to lend along with a standing coalition of other creditor countries through a well established international institution to cash short emerging economies. The US didn’t lend to make money; it lent to help avoid systemic trouble - trouble that would rebound back to the US - and to shape, along with other large contributors to the IMF, the policies that emerging economies adopted during their crises. Policy conditionality stems from a need to assure the country’s ability to repay, but in practice that inevitably meant making judgments about the "right" economic policy to assure payment.

The US today is not in the same position emerging economies were then. The expected fall in US output is tiny compared to the falls in emerging economies. Relative to US GDP, the likely financial losses in the subprime crisis are also far smaller than the losses in many emerging economies. The US has benefited enormously from its capacity to borrow in its own currency, and thus to pass the risk of dollar depreciation onto its creditors. Central banks willingness to add to their dollar reserves has helped to provide the financing that allows the US adopt counter-cyclical rather than pro-cyclical macroeconomic policies despite running large deficits. No emerging market had a similar luxury.

Nonetheless, the headlines of the past few days have given me a somewhat better sense of how many in the emerging economies must have felt in the 1990s.

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