Large players in large markets, part two

Brad DeLong is rather skilled at squeezing the fat off a post, and then creating something that is sharper, more succinct and often far better than the initial post.

I know. He does it to me every now and again.

One of his recent posts keyed off something I wrote, before heading off into an extended discussion of how the presence of "very large actors ... not in the business of maximizing their profits" (i.e. central banks)influences world markets. Central bank buying has a direct impact of course, but it also has an indirect impact: it can help shape the expectations of the people placing private bets.

James Surowiecki of the New Yorker explores similar themes, in wonderfully clear and accessible language:

More than any other nation in history, the United States depends, economically, on the kindness of strangers. Right now, Asian investors appear very kind.

Markets are hardly known for their tenderness. Usually, you can assume that everyone in a market is trying to make as much money as possible, with as little risk, but the currency market isn’t like most others. In the market for the dollar, many of the players have other things on their mind. China needs to go on selling Americans hundreds of billions in exports in order to keep its economy humming. A weaker dollar makes that harder. Asian central banks also already own trillions of dollars in American assets. As the dollar falls, so does the value of those assets. There are plenty of other traders in the currency markets—who have the luxury of being single-minded regarding profit—but the Asian banks are powerful enough to be, in effect, the lenders of last resort. As long as it’s in their self-interest to keep America afloat, the dollar will not crash.

I won’t try to match Surowiecki’s prose style, or attempt to do an abridged version of Brad Delong’s post. Instead, I want to make two, related (wonky) points:

1) The statistical appendix to the IMF’s WEO gives us the raw data that underlies talk of a "global savings glut" -- which really means lots of demand for fixed income assets in the US and Europe, and thus low real interest rates. Reserve accumulation of emerging economies and developing countries has gone from $87 billion in 2001 to $151 billion in 2002 to $297 billion in 2003 to an incredible $436 billion in 2004.

Just for the sake of comparison, remember that back in 1997, before the emerging market bubble burst, net private capital inflows to these countries totaled $212 billion. It was the withdrawal of those private inflow led to crises in Asia, Russia, Brazil and elsewhere (Net private flows fell to $107 billion in 98, $59 billion in 99 and $46 billion in 00).

The world certainly felt the impact of a $150 billion net fall in private sector financing of emerging economies. And right now central banks in emerging economies are injecting twice as much into the markets of the US and Europe in 2004 as private investors injected into the emerging markets before the 97 crash.

The IMF data on emerging economies excludes the Asian NICs, so the total inflow from Japan, Asia and the rest of the developing world into the US and European markets is even larger. Korea, Taiwan, Singapore and Hong Kong added $96 billion to their reserves; Japan added $177 billion to its reserves. Add it all together, and you get total reserve accumulation in Asia (including Japan) and the developing world of $709 billion (including valuation gains).

Suppose the world’s central banks bought $400 billion in long-term dollar denominated securities with that money and added $100 billion to their dollar bank accounts (which the banks in turn may have lent to a hedge fund seeking to gear up its own bets on the US fixed income market). $400 billion is not trivial in relation to the $1150 billion in (net) US long-term bond issuance in 2004. And as far as I can tell, right now, total reserve accumulation by emerging economies (including the Asian NICs) is on track to be in the $600 billion range this year (roughly $125 billion a quarter from the big countries in emerging Asia, Mexico, Brazil and Russia produces $500 billion, and the IMF forecasts $80 billion in the reserve accumulation by countries in the middle east).

That is a lot of kindness from (poor) strangers. I still think the big question in the global economy is when will the bubble in emerging economy reserve accumulation burst: it is not necessarily a good thing if your largest customer can only afford to buy your products on your credit.

2) As both DeLong and Surowiecki note, central bank intervention, if successful, also shapes private-sector decision-making. Anyone shorting the Treasury market has to consider a range of risks. A soft patch in the US is certainly one of them. But massive intervention by foreign central banks that leads to huge influx of dollars into the Treasury market in the face of renewed dollar weakness is another. The markets often have short memories, but I suspect many remember well the impact of Japan’s 2004 intervention.

If hedge funds are indeed replacing dollar funded carry trades with yen funded carry trades (effectively, a bet that the interest rate differential between long-term dollar denominated debt and short-term yen denominated debt is large enough to offset the risk of dollar depreciation against the yen), then the hedge funds are doing exactly what the Japanese Ministry of Finance (the MOF) wants them to do: they, not the MOF, are taking the risk of future dollar depreciation. Private flows replace official flows, but those private flows are premised on an expectation that official intervention will limit the downside risk of certain private bets. After all, making a leveraged bet on the currency of a country with a 6.5% of GDP current account deficit is not the easiest way in the world to earn a living ...

Back when I first started blogging, I tried to use the conceptual framework laid out in one of Nouriel’s more theoretical papers to explore some of these issues. The crux of the argument is simple. IMF bailouts (or rescues) can work even if the amount of money the IMF puts on the table is small relative to gross private claims on a crisis country if the IMF’s financing changes market expectations. I suspect that foreign central bank intervention on the current scale is also large enough to shape the expectations of the banks, hedge funds, pension funds, insurance companies and private individuals that make up the broader market. That’s one reason why it is hard to estimate the overall impact of central bank actions.