Here is my list of the top five stories of 2007 - and some things that I’ll be watching in 2008. What did I miss?
1. The "subprime" crisis. The credibility of Wall Street’s financial engineering -- and a business model based on transactions so that clever originators could avoid holding any exposure to the products they created -- took almost as much of a battering as Citi’s balance sheet. The United States comparative advantage at churning out complex financial products (something the IMF argued would assure the financing of the US deficit -- see p. 14) turned out not to be much of advantage after all. And it turns out the US hadn’t actually sold all the toxic stuff to foreigners seduced by a triple AAA rating - an awful lot seems to have been held by US banks (and their offshore SIVs and conduits), broker-dealers and other financial institutions. Anything that turns t-bills into .coms (if only for a few days), makes banks afraid to lend to each other, leads an entire market (ABCP) to come close to disappearing and turns Morgan Stanley’s Bernstein almost as bearish as Merrill’s Rosenberg is big news.With the benefit of hindsight, the notion that the worst tranches of residential mortgage-backed securities, themselves assembled from the loans to the riskiest borrowers, could be combined and repackaged into triple AAA securities does seem rather far-fetched. Take a look at Portfolio’s cascade.
That is just a simple mortgage backed security. Then imagine taking the bottom tier of the cascade - combining it with the bottom tier of other cascades - and feeding it into a new cascade. Then imagine selling insurance (no doubt ultimately to Goldman) against the risk that a bond based on the cash flow from the next to bottom tier of cascade will default ("For Norma, N.I.R. assembled $1.5 billion in investments. Most were not actual securities, but derivatives linked to triple-B-rated mortgage securities ... Norma, acting as the insurer, would receive a regular premium payment, which it would pass on to its investors). Then imagine repackaging the cash flow from the insurance premiums into a CDO with its own cascade of payments. Then imagine convincing the world that the top tier of that new cascade are as good as Treasuries, but yield a bit more (see the Journal’s graphics).
The result, according to Gillian Tett:
... faith in 21st century financial innovation has ... evaporated. The events of last year showed with brutal clarity that risk dispersal does not always prevent financial shocks, but may fuel contagion instead. "Not since the high-quality batch of railroad and utility bonds of the late 1920s faltered during the Great Depression have so many high-quality ratings been unable to stand the test of time," says Jack Malvey, senior analyst at Lehman Brothers.
2. Oil’s rise from $50 (at least briefly) to above $90. If sustained for a full year, the difference between $100 a barrel oil and $50 a barrel oil puts something like $800 billion into the hands of a fairly small number of big oil-exporting economies. It also puts over $250 billion into the hands of four or five politically powerful Gulf families (and their investment managers.) No wonder all of London and a good part of New York decamped to Dubai in December ...
3. Europe, the new engine of demand for Asian manufactured goods. In real terms, US exports have been growing faster than US imports since early 2006. The US deficit - excluding oil - is heading down. US imports from Asia are basically flat this year. Chinese exports to the US are still up - but they are growing at a much slower pace than before. But Asia, rather remarkably, hasn’t been forced to wean itself from exports. It just replaced exports to the US with exports to Europe. The IMF expects Europe - whose population is basically flat and thus should grow about 1% a year more slowly than the US - to grow faster than the US in 2007. Europe certainly grew faster than the US in 2006. The EU’s trade deficit with China was euro 128b in 2006 -- and, on current trends, looks set to top euro 160b in 07. European demand for Asian goods in turn helped sustain China’s resource intensive boom, and the resulting boom in most commodity exporters ...
4. The new trillionaires. Emerging market central banks are on track to add over $1 trillion to their reserves in 2007. China will add - counting reserves shifted to the state banks and the China Investment Corporation (CIC) - about $500b to its coffers. China’s total assets are now closer to $2 trillion than $1 trillion. Russia will add about $150b (after adjusting for valuation gains). Brazil, India and the GCC central banks (counting the non-reserve assets of the Saudi monetary agency) will all add about $100b. Talk of how the market had overpowered the state now seems remarkably premature ....
The intensification of Bretton Woods 2 in turn has generated an intensification of the pressures on Bretton Woods 2 - whether economic (difficulties sterilizing rapid reserve growth and a surge in inflation) or political (Europe isn’t terribly fond of China’s weak RMB policy).
5. Wall Street embraces state capitalism. Privatization: Over. The really big money is now to be made from cross-border nationalization. Transparency, at least from governments with rapidly growing assets: over-rated. Funds that don’t have to disclose their total assets, let alone report to pesky, risk-adverse parliaments are far more fun -- and certainly far more willing to snap up big stakes in distressed banks.
The story of 2007 though isn’t the scale of the increase in the size of sovereign wealth funds.
Sovereign wealth funds did probably add about $250b to their assets in 2007, but that total is somewhat deceptive. It seems likely that China shifted a bit over $100b from the PBoC’s account at SAFE to the CIC’s account at SAFE in late December. Without that influx, sovereign wealth funds wouldn’t be growing all that much faster in 2007 than in 2006 or 2005. Moreover, about $100b of the overall increase comes from funds that are still managed fairly conservatively: Norway is the most obvious example, but Kuwait has also stayed out of the headlines -- at least so far. Some recent press reports suggest that the KIA now has deal-envy. Almost all the excitement came from the roughly the more aggressive management of the roughly $50b going into the funds of Qatar, Abu Dhabi and Dubai (money that is often leveraged), the redeployment of some of the accumulated profits of Singapore’s GIC and Temasek and a couple of small deals from the CIC and two Chinese state banks ...
Rather the story is how quickly the Street and the City jumped on the sovereign wealth fund bandwagon -- without the agonizing of say Tyler Cowen, let alone Larry Summers. The world’s biggest deal-makers are now convinced that the governments of emerging market economies - along with cash-rich state-owned enterprises -- are the natural owners of a host of US and European financial assets, whether US banks, global securities firms, European toll roads or Australian mining companies.
Remember, Morgan Stanley, Blackstone, Barclays and Standard Bank together account for only about 3% of the total increase in the foreign assets of China’s government. The redeployment of China’s financial firepower outside the bond market has hardly started.
So what is next?
The data from the first few days of 2008 certainly seem to suggest that the probability of a US recession has gone up significantly. Nouriel argues that the real question now is what kind of recession -- short and quick or long and protracted. Stephen Jen’s theory that a US slowdown is worse for the dollar than an outright recession may get put to the test. But I don’t claim any particular expertise in the US economy.
My personal watch list is a bit more esoteric:
1. Will the Gulf revalue?
$100 oil. A growing desire to spend the oil revenue at home rather than just stash it all away in Switzerland, London and New York. A weakening dollar. Rising inflation. The UAE central bank governor’s denial of the link between the dollar’s weakness and the rise in inflation lacks credibility. The Gulf isn’t willing to run the kind of restrictive fiscal policies needed to damp down inflation in the face of ongoing dollar weakness. The economics are clear. The Saudis seem to have ruled out a shift away from the dollar, but not a repeg.
I would bet, though, that the revaluation, if it comes, will not be large enough to make much of an impact on inflation -- or large enough to end speculation about the next revaluation.
2. Will Europe’s own -- and hopefully more modest -- version of the subprime crisis begin to unfold in Eastern Europe?
European banks have, in some global sense, transformed the huge capital inflows associated with the global surge in demand for euro reserves into a surge in lending to Eastern Europe. That lending has financed large current account deficits and rapid growth in Eastern Europe. This is a good thing: inside Europe’s institutional structure, capital flows downhill, from the rich to the poor. But I am starting too worry that there has been a bit too much of this good thing. External deficits are now quite large in many Eastern European countries. An excellent recent IMF paper on Southeastern Europe illustrates that there deficits have been accompanied by growing balance sheet vulnerabilities -- notably the buildup of foreign exchange risk in the private sector.
3. Will losses on foreign currency reserves emerge as a major political issue?
A number of countries with substantial dollar holdings let their currencies appreciate against the dollar (at least by more than in the past), some countries with substantial holdings of euros as well as dollars saw their currency rise against both the dollar and the euro. These central banks’ annual reports for 2007 will likely show significant (paper) losses. Some countries now intervening heavily -- India and Brazil come to mind -- also have domestic interest rates well above US and European rates as well.
4. Will global central bank reserve growth "peak" in 2007?
Private capital may be a bit less willing to flow toward those emerging economies with large deficits. That would slow aggregate emerging market reserve growth in 2008 even if the rising oil surplus and China’s still growing surplus keep the emerging world’s current account surplus quite large.
But that isn’t the real basis for my forecast.
Rather it seems likely at a few countries that until now have largely kept their surplus petrodollars and petroeuros on deposit at the central bank -- Libya and Saudi Arabia most notably -- will set up investment funds. Russia is also setting up an investment fund, but its contribution may be more modest.
Another set of countries, countries where the central bank has until now been doing all the country’s intervention, seem set to let the Finance Ministry intervene a bit more in the foreign exchange market. Brazil is one example. China is another -- though the PBoC cannot be pleased that it has been the one that has had to buy the Finance Ministry’s bonds, which implies that it still is doing all the sterilization but not longer managing all the money. Still, the CIC likely got a ton of cash late in 2007 -- and could easily get round 2 sometime in 2008.
And then a number of countries are simply disguising the extent of their intervention. China is forcing its banks to hold dollars to meet the recent rise in their reserve requirement, a policy change that could have led to the purchase of $70-80b of dollars by the banks in q4. Bank regulators used to worry about mismatched balance sheets, not they are forcing the banks to run mismatches. Other central banks -- Thailand most obviously, but also Malaysia, the Philippines and no doubt others -- are building up (and rolling over) large forward positions.
Government intervention in the foreign exchange market may not go down. But the intervention that takes place likely will be substantially less visible.
5. Will more Americans conclude that globalization is not the same as Americanization?
And what impact would such a realization have on public support for the current form of globalization?
I would not, though, rule out the possibility that Europe has its version of CNOOC or Dubai Ports World and rejects a major cross-border deal involving a state firm or investment fund before the US does.