from Follow the Money

Looking back at 08; thinking about 09

January 6, 2009

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Like Macro Man, I went back and looked at the things I was planning to watch in 2008. My list wasn’t exactly prescient. I didn’t warn of a risk that housing losses might bring about the end of the privately owned, highly leveraged US financial sector. But it also wasn’t totally embarrassing.

The Gulf opted for inflation (and negative real interest rates) rather than a revaluation -- and now the pressure is off. So nothing much happened there. But Eastern Europe is proving to be Europe’s analogue to the US subprime crisis – though the initial trigger for the reversal in capital flows to Europe’s periphery was financial trouble in the US, not credit problems among Eastern Europe’s big borrowers.

Global reserve growth did peak. Some countries’ reserves are even now heading down, though not for the reason I would have expected. Global reserve didn’t fall because emerging economies decided to allow their currencies to appreciate. Rather it fell because private capital flows (and oil prices) went into reverse. As a result, the fall in reserve growth was tied to a fall in most emerging market currencies.

Losses on central bank reserves (and sovereign funds) did emerge as an issue. But the losses that became an issue weren’t losses from currency moves. Rather the losses sovereign funds took on their investments in the global financial sector emerged as a political issue – and those losses scared the world’s central banks. They incidentally had reason to be scared, as they were quietly taking on a bit of risk (kind of like the Reserve Primary Fund) both to eke out higher yields and to show that there wasn’t a need to take large sums away from central banks and hand them to new sovereign funds. Who would have guessed that the CIC’s investment in Blackstone would lead, indirectly, to SAFE’s decision to stop adding to its Agency portfolio? Talk about a bank shot. At the beginning of 2007 China was desperate to get a higher yield than Treasuries offered; at the end of 2008 China wasn’t buying much other than short-term T-bills that literally yielded nothing.

I certainly didn’t foresee that losses in the US and European financial sector would end up topping the (likely) total assets of the world’s sovereign funds. The losses in the financial sector were under-estimated by all (even Roubini, initially; his estimate of the size of the ultimate loss rose over time) while the size of the world’s sovereign funds (at least those with a mandate to take risks; the total size of sovereign funds can be inflated by counting stabilization funds managed by central banks) was almost certainly overestimated even before the recent market slide. And then the correlated slump in oil and global equities dramatically reduced their current and expected future size. The result: that the losses in the financial sector were so large that they effectively had to be backstopped by the taxpayers of the US and the major European countries. No one else – not even China – had a big enough balance sheet.

Nor did I contemplate the possibility that a banking crisis in the US might be good – at least in the short-run – for the dollar. And I don’t know many who predicted that oil would top $140 and fall below $40 over the course a calendar year.

What of 2009?

All leading indicators point to a sharp, synchronized global downturn in the first part of the year. But no doubt the year will also be marked by new surprises. My list of things to watch would include:

-- The depth of the slowdown in the emerging world. China has slowed far far more rapidly than most expected. The major source of its downturn has been a slump in domestic construction. But falling exports are now starting to play a role. I wouldn’t rule out the possibility that its economy may contract for a quarter or two. Russia is in deep trouble even if oil bounces back to around $50. Its economy will contract if nothing changes. Some other oil exporters are in a similar situation. The Gulf (apart from Dubai) is in better shape, but even if is being squeezed a bit. Oil and gas importers in Eastern Europe aren’t faring much better. Ukraine looks set to fall off a Icelandic cliff. Some other Eastern European economies with large current account deficits may follow …

There isn’t yet consensus on the likely growth trajectory of the emerging world though. Jim O’Neill of Goldman remains rather optimistic. That is why, I suspect, that there is a greater chance that the emerging economies will surprise on either the downside or the upside.

-- What happens to East Asia’s current account surplus? China’s trade surplus has increased in the last part of 2008, as imports have fallen more than exports. Korea’s current account should once again post a surplus. Chalk that up to a big fall in imports. Japan’s trade surplus by contrast seems to be shrinking -- and the strong yen augers further trouble. East Asia is on one hand benefiting from a big improvement in its terms of trade. It imports a lot of commodities. Domestic demand in China is also falling due to a slump in construction – which impacts import volumes. And on the other hand it is being hurt by a sharp fall in its exports. The balance between those two forces is still a bit unclear. At this stage I would bet that Asia’s surplus rises -- in large part because I am not convinced that China will do enough to stimulate its economy to offset what could be a sharp fall in investment. I hope I am wrong.

-- What happens to the United States non-oil trade deficit? It was improving quite rapidly for most of the past two years, though a rising oil import bill kept the overall deficit up. But forward looking indicators suggest US exports are poised to fall. Imports are falling too – but a successful stimulus might eventually break their slide. At this point I am expecting the non-oil deficit to get worse not better in 09 as the US does more to stimulate its economy than the rest of the world … the overall deficit will still fall though thanks to the a big reduction ($250b?) in the United States oil import bill …

-- How are the world’s remaining current account deficits financed? Cross-border flows have collapsed. The oil exporters can finance deficits by selling off the assets they accumulated in 2007 and 2008. That though isn’t an option for most of Eastern Europe. The Balts, Romania and Bulgaria all have large current account deficits and most also seem determined to maintain their currency boards (Romania is an important exception; it never had a currency board). Bringing their external accounts into balance consequently requires a huge contraction; avoiding that contraction requires a huge amount of financing. It is also a live question for the US, as the improvement in the United States non-oil balance may stop. If China continues to run a large current account surplus it almost has to be the main source of financing for the US. If the Eurozone is taken as a whole, there may well just be one big deficit and one big surplus in the global economy. But that financing could come either from hot money outflows or from continued Chinese reserve growth …

-- What happens to Treasury yields. Short-term bill rates are effectively zero. The ten year yield is now a bit above 2%. It was close to 4% not so long ago. The Fed wants to keep it down. Low long-term rates would help support home valuations, and thus potentially reduce the scale of the mortgage restructuring that the US needs to bring household debt in line with home prices. Some increase in yields wouldn’t be a bad thing. It would indicate that the flight to safety has abated, and investors aren’t buying Treasuries simply because they aren’t convinced anyone else will give them their principal back. It could signal that investors are willing to keep money in the banks – and there is enough demand for bank lending that the banks want the funds. All that wouldn’t be bad. A big increase in yields though would be a problem … as it would suggest that the United States external deficit limits its ability to run a stimulative macro-economic policy. Bad as things are in the US, they would be worse if the US current account deficit had to swing into surplus quickly to finance (net) capital outflows.

-- Whether or not the banks have all come clean and are valuing all their assets at realistic levels, or whether there is still more trouble to come … and whether or not a second round of bank recapitalization/ purchase of troubled assets will be needed.

What have I missed? Dani Rodrik -- who is always worth reading -- puts more emphasis on the nature of the policy response in the advanced economies, and I would guess that Paul Krugman would as well.

And what might emerge as an issue in a way that surprises many?

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