from Follow the Money

A world turned upside down …

October 5, 2006

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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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I guess it is only natural that in world where capital flows – in unprecedented sums – from the poor to the rich, that the poor countries on the periphery also have lower inflation rates than the US.

Not just China.   Brazil and Mexico too.   Valerie Rota and Adriana Brasileiro of Bloomberg:

Annual inflation rates that reached 6,800 percent in Brazil in 1990 have fallen to 3.7 percent in the 12 months through mid-September. Inflation in Mexico, which surpassed 180 percent in 1988, was 3.5 percent last month. It is the first time both of the countries have recorded lower inflation rates than the United States, where consumer prices rose 3.8 percent in August.

What a difference a decade and a half makes.  

Today Brazil and Mexico are paragons of price stability.   And the US -- not any of the big Latin countries -- is the world’s biggest external debtor   

Iceland and New Zealand have bigger current account deficits -- measured as a percent of their GDP -- than the US.  But both are tiny.  The US isn’t.    Spain, Greece and Portugal all also have large deficits, but they are part of the eurozone.   Whatever you want to say about Bretton Woods two/ the dollar zone, China, the oil exporters in the Gulf and the US are not tied together they way the countries of Europe are.

The other striking thing about the (new) financial world order?   An unbalanced world has been a financially stable world.   At least to date. That has not escaped the notice of Ken Rogoff.  Or Rich Clarida.    More below.

Some things, it should be noted, are still as they always have been.    The US may have higher inflation than Mexico or Brazil, but the US still has lower nominal interest rates than either big Latin economy.  That means the US has much lower real rates. 

It also means that the “carry” on Mexican and Brazilian financing of the US is negative – something that has not escaped the notice of the governor of Mexico’s central bank.    

Chinese rates, by contrast, are lower than US rates.  So China’s central bank gets “paid” to take on the exchange rate risk associated with financing the US.  I suspect that this has something to do with China’s willingness to continue to finance the US on a huge scale.  The cost of financing the US is immediate and visible in Mexico and Brazil, while China gets to push off all the costs into the future.  That is one reason why a country with a capital stock per capita of $4000 (according to Goldman) is happy to finances a country with a capital stock per capital of $150,000.    

How else is our current world upside down? 

Well, at least to date, an unbalanced world –  – has been a financially stable world.    Or least a world with very little volatility.    Rich Clarida argues that the world will (most likely) remain unbalanced and (most likely) remain stable.   

The financial markets seem to agree.    The logic seems to be as follows.

Larger imbalances haven’t led to any increase in volatility.  So why should persistent (but perhaps no longer growing) imbalances lead to any more volatility?    

Moreover, the very folks who have facilitated the increase in the world’s imbalances stand ready to insure against any precipitous change. China, the argument goes, cannot tolerate a more volatile world.    If private investors don’t want to hold dollars, China will.  It has to protect the value of its existing portfolio (even if that means doubling down on the dollar, and adding to the PBoC’s VAR … ).   

If China needs to add $400 or $500b to its reserves to keep the current system going, the market believes it will …

So far, that has been a good bet.   A far better bet than listening to me, or any of the others who have doubted the stability of the new (financial) world order.

If the US has a hard landing in 2006/07, it won’t be because the US exhausted its foreign credit line.   Nouriel and I overestimated that risk. But the argument that since volatility fell as imbalances (large US deficits, large surpluses elsewhere) built up,  imbalances can also shrink without a rise in volatility remains entirely untested. 

We don’t know if the world where imbalances unwind will be as benign as the world where imbalances built up. Because imbalances haven’t started to unwind.    

One source of concern.  The yen/ euro today (hell, even the yen/ dollar – in real terms) looks a lot like the yen/ dollar in 98.    I don’t know to what extent hedge funds have joined real (Japanese) money in the (new) yen carry trade.   But it sure seems like real Japanese money is taking a very large – and increasingly unhedged bet that strong Japanese growth is consistent with a weak yen ….

Hedging was cheap when US interest rates were low.  But now that it is expensive, lots of folks just stopped hedging.  See Joe Prendergast of Credit Suisse.  

That makes me nervous.  If the yen started to move and the BoJ/ MOF stayed out of the market, lot of folks might suddenly want to reduce their exposure to further rises in the yen.    We know what that means. 

At least those of us old enough to remember 1998.

Another example:  Both LTCM and Amaranth were brought down by market moves that were as rare as “100 year” floods.   At least by what their (backward looking) risk models thought were events even rarer than 100 year floods.    Think meteors.

“The Edhec study, based on public reports of the debacle, confirms that the price changes were extremely unlikely based on historical analysis. But it also notes that the size of Amaranth's positions made unusually sharp market moves almost inevitable as it tried to scale them down.

Hilary Till, a research associate at Edhec and a principal of Premia Capital Management in Chicago, said her analysis suggested the market moves that hit Amaranth were statistically even more improbable than those that brought down Long Term Capital Management in 1998.

The probability of those events has been likened to the chance of a meteor hitting the earth. But with positions as large relative to the market as Amaranth's, the attempt to get out of trades can itself dramatically move prices.”

Which suggests to me that meteors strike a bit more often than folks think.  They seem to hit the financial markets once every ten years, if not more frequently.  

That also worries me. 

Especially since many playing the credit markets seem to think spreads only go down, never up …

A tanking housing market?  Hardly a reason not to sell insurance on a CDO composed of a pool of a junior tranches of a mortgage backed securities …  we know Americans never default on the loans that finance their homes. 

In the near future, I want to delve into a world where mortgages are pooled together and then divided into tranches (asset backed securities) and the tranches of different mortgage pools are themselves assembled together into a new security (a CDO) that itself is divided up into risky and not-so-risky tranches.  And then, to top it off, lots of folks feel sufficiently confident in the pricing of the credit risk in the tranches of these CDO that they sell insurance (a credit default swap) against a default on one tranche of a pool of tranches of a pool of mortgages. 

Makes lots of sense, right?   

Remember, Paul Krugman once summed up the US economy as a place where Americans are busy selling homes to each other, with the Chinese financing it all.  

Helped along by a lot of financial engineering.  Which, if nothing else, does create jobs for well-educated Americans ...  

Update: this week's Buttonwood (on the popularity of carry trades in a low volatility world) is quite relevant.

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