from Follow the Money

Martin Wolf, Korea’s Central Bank, and Collateralized Debt Obligations

April 19, 2005

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Somehow, all three are linked together today in my mind. And at some level, they do all connect.

As Martin Wolf notes, Asia’s current account surplus (savings surplus) shows up in the phenomenal growth in Asian central bank reserves (which are actually increasing more rapidly than Asia’s current account surplus as a result of private capital inflows). Tuesday’s Wall Street Journal observed -- accurately -- that Korea is looking to boost the yield of its reserve portfolio by holding a more diverse set of financial assets (though not a more diverse set of currencies, we are told). One way to get a higher yield than plain vanilla paper is to invest in collateralized debt obligations --a subject discussed in Tuesday’s Financial Times ...

All three articles also raise important points for those concerned about the health of the international financial system. Martin Wolf’s excellent essay takes a lot of themes that we have discussed here, and pulls them together into a coherent picture. In my view (no doubt biased, since he cites Roubini), Wolf gets all nuances right.

The US has outsourced savings to China, and East Asia more generally. East Asia, has, in a sense, outsourced consumption to the US. Each needs the other. But since the US saves way too little (and consumes too much) and East Asia consumes too little (and yes, saves too much), the situation is ultimately unsustainable.

It is vitally important to move over time to more balanced and healthy economic relationship. Yet extricating the US and East Asia from their current unhealthy and unbalanced embrace will require a rather delicate touch -- something the Bush Administration is not noted for. It also will require a willingness on all parties involved to look inward, not just to blame the other guy -- something that so far seems lacking on both sides of the Pacific.

The best evidence that the current situation is unsustainable? The current flow of private capital. To sustain current account deficits of its current magnitude, all of the world’s surplus savings (the global current account surplus) needs to flow to the US. Yet private investors are putting a lot of their money in emerging Asia, not to the US: They would prefer to fund some of Asia’s investment than to fund the lack of savings in the US.

Private investors are inviting Asia to draw on their savings so that Asia can consume more today (i.e. save less) and still invest the same amount. Wolf correctly notes "the private sector has been trying to push emerging market economies into current account deficit." Asian central banks, however, are getting in the way. They are taking the funds flowing into Asia, along with Asia’s own excess savings, and investing them in the US, making it possible for the US to get away with next-to-no household savings and a structural budget deficit.

But this is a dangerous foundation for today’s the world economy.

Why? Look at the Wall Street Journal’s examination of the dilemmas facing Korea’s central bank on Tuesday (p. C1). There are two reasons why Korea is less comfortable adding to its already substantial reserves than China. First, it is a democracy, and, if the central bank is borrowing in won to invest in depreciating dollars, it has to explain itself. Second, Korea has to pay more to "sterilize" its reserve inflows than China, for reasons that I’ll discuss at length in another post. Indeed, on a cash flow basis, the Bank of Korea paid more in interest on its sterilization bonds than it earned on its reserves. To quote the Journal:

The Bank of Korea posted a loss last year of $150.2 billion won ($147.5 million). It was the first central bank deficit since 1994, and was largely the result of issuing so called monetary stabilizatoin bonds in an effort to sterilize, or offset, foreign capital inflows.

Losing money on every dollar of reserves makes you think twice about adding to your reserves. And, more immediately, it is pushing the Koreans to "reach for yield" and invest in a wider range of assets.

Who knows, they might even be buying Collateralized Debt Obligations (CDOs, essentially repackaged corporate debt), or even Synthetic Collateralized Debt Obligations (don’t ask for an explanation, just read the FT). It seems like everyone else is. Presumably, central banks would buy the safer, high-rated tranches of a CDO, not the riskier, higher-yielding tranches. A CDO more or less takes a group of moderately risky loans and transforms the underlying loans into a set of new "loans," typically, a relatively safe loan, a moderately risk loan and a very risky loan. Each of these parcels of the original set of loans -- usually called a tranche -- is backed by cash flow from the moderately risky loans, unless the investment bankers get fancy.

I am not convinced that collateralized debt obligations are reducing systemic risk by spreading risk around toward those most able to bear it. I tend to agree with an unnamed policy maker (central banker?):

We are in uncharted territory ... if a crisis hits, we think the market will absorb shocks smoothly -- but the truth is no one knows.

I don’t necessarily take comfort in the fact that "real money" types are buying the safe parts of the CDOs, while hedge funds and other leveraged types are buying the risky parts. I worry that already leveraged hedge funds are buying instruments that themselves sometimes have a lot of embedded leverage.

It may be that the hedge funds really do know how to hedge their risks, and thus are not as exposed as it would seem. But big risks are sometimes taken by investors looking for high returns to justify high fees in an environment where there is less and less easy money to be made ...

Remember, historical correlations do not always predict future correlations. I’ll give one example. If memory serves, Brazilian and Russian debt were highly correlated before 1998 (both profited from global interest in emerging market debt, and both had fixed exchange rates and active domestic debt markets). They were not so correlated in 2002 (When Brazil almost melted down and Russia did not). And they probably were quite correlated in 2004, as both benefited from China’s insatiable demand for commodities, along with a benign global interest rate environment. My point: hedges based on the assumption that historical correlations will hold in the future can break down.

Then again, I am more inclined to see a half-empty glass than a half-full glass.

Apologies for veering off into financese, which can be worse than economese ...

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