Tag Archives: Exchange Rate

The Next Emerging Bubble (and crisis?) Is Underway

Both the US weekend print editions of the Financial Times and Wall Street Journal reported on what I consider to be the nextfinancial bubble and potential global financial crisis. Let’s ask ourselves – what would the source of the next financial crisis be?

  •  Japan, with its massive public debt that might, should the market ever give up on Japan, swallow up government spending with unyielding interest payments (should interest rates need to be hiked to defend the loss of confidencet in the economy)?
  • Europe, with its weakened and twisted euro, now bereft of the stability of Britain, at the hands of the profligate consumer south of Europe stretching away from the conservative and producer norther states? It maybe the bailed-out Italian banks fall?
  • US, with its “exorbitant privilege” of reserve currency status but with huge watches of government debt held by China, decides to dump it in order to drive the dollar to he floor as a step to push the yuan to reserve status?

No, none of these three challenges are going to blow-up any time soon though they are clear risks. They are all slow burners.  But what might just snap enough to cause a global financial crisis that can overwhelm the monetary policy and reserves of the world? I think it’s emerging markets. 
You see, there is a finely balanced investment model that is ticking and it slips and slides every day – trillions of dollars – and right now the shift is back toward investing in emerging markets.

This is how it works: Yield is globally very low. This is due to (mainly) low and near- or negative interest rates. As such, the trillions of dollars in the world that represents currency exchange combined with hedge fund investments move around the globe daily in search of yield. When the US Fed suggests that interest rates will rise in the US, it is clearly a vote of confidence in the US economy and so funds are attracted toward the dollar. This then puts pressure on the dollar (since everyone wants dollars) and so the value increases with respect to other currencies. This then leads to increased export prices thus depressing US exports. 

But where does that money come from that would move toward the US? The answer is from everywhere around the world and specifically wherever the money is most liquid. Guess what, that means emerging markets. Right now the US is signaling to the market that interest rates are not going to rise immediately, so yield is slightly more attractive in emerging markets. Thus, as the reports in the two newspapers show, funds are flowing freely towards them. This puts pressure on those economies much as the same funds would do to the US. They stoke currency valuation, inflation and weaker exports (over time).  But short term they hep fund construction and keep the recycling of dollars and funds around the world.

As you probably noted in the last two years, as the Fed sneezes with respect to changes in interest rates, even hints of changes to interest rates, trillions of dollars move back and forth between the US and EM in the search for the greater yield.  US interest rates will raise and when they do, the yield will shift to the US.  And we are talking of razor thin margins hence the nervousness of the market.
From the FT article:

  • Equity funds saw inflows of $5.1bn during week ending August 17, the seventh straight week of inflows, according to data from EPFR
  • Over the same seven weeks, a record $20bn was invested in emerging market bonds, with investors taking money out of US and European bonds in favor of the riskier assets

From the WSJ article:

  • The Bank for International Settlements warned Thursday that a corporate-debt binge for emerging-market countries that starts in 2010 is starting to come due now. Between this year and 2018, repayments will total $340bn, it’s estimates show, which is 40% more than during the past three years

Thus the global system of equity and currency trade and investments are finely balanced. Should the dollar suddenly look more attractive, and funds then flow towards the US, at the exact same time as emerging markets need to recycle their debt, there will be a big problem. Emerging markets will have to jack rates up in an attempt to strengthen their currencies which could choke their own growth, thus reducing the markets confidence in them, and so a spiral takes shape – downward. If EM have to jack up interest rates, the US may have to reciprocate. Either way the balance is finely tuned and the great weight of funds will flip-flop between EM and the world supremely quickly. That will create huge complexity and volatility.

Hang on, everyone!


China Shock: The Untold Story

Front one of the US print edition of the Wall Street Journal last Fridy: Deep, Swift China Shock Drove Trump’s Support. A fascinating article that suggest, despite its title, that the impacts of China as it joined the global trade game led to swift and irreparable damage to America’s workforce and so led to the swell of support for Trump and Saunders. It so happens that I am half way through reading China Shock, by  David Autor, David Dorn, and Gordon Hanson. The story in the paper and the WSJ article is referring to in its title.

There are are several things to note about this so called, “China Shock”. They are not all good news and hindsight helps (where doesn’t it?)

Firstly global trade is taking a bashing. This is unfortunate. It is unfortunate because economically global trade has been shown to balance out and help everyone, even if one nation is better than all others at everything. What the economists models thus far did not show, nor were they meant to, is what happens under extreme changes in the dynamics of global trade. That is the fact: China shock is not a weakness of global trade, it’s a lack of understanding of the dynamics underpinning it.

The WSJ journal and the paper demonstrate with examples where massive displacement of jobs took place, in a very quick period, over and over in related industries. The two factors that made the shock such a shock are:

  • Original employers (US, per WSJ article and including Europe per the paper) national institutions, job training, educational practices and industrial policy were focused on the wrong thing. Instead of being focused on rapid migration and support for global trade dynamics, they were more focused on slow and limited protection for targeted and said to be critical industries
  • Exporting nation (China) was exporting so much cheap Labour and products across a broad and often related swathe of markets and industries that had a multiplier effect I terms of displacement and elimination of ‘landing places’ for those initially displaced.

These two factors explain how it was that worker after worker listed in the article lost a job, gained a job, then lost it again. Then finally were not able to get a job.

Our economists did misunderstand some of the dynamics of global trade given the entrance of such a large supplier as China. But governments should have spent more time focused on policies related to growth and industrial migration, rather than pandering to selfish efforts protecting themselves.  

Now that China Shock has shocked, what do we do about it? Well, media and press are now gunning for global trade. This hype will damage global growth and crimp efforts to get past current anemic conditions. Capitalism is again under attack not due to a failure of the system but a failure of our own misunderstanding of the dynamics of the world around us.

Governments need to focus on building a resilient trade and industrial policy that responds to changing global dynamics. Industry and government need to work more closely together so that as global trade pressures alter the competing advantage of nations and firms, action can be taken to provide alternative safety nets.

Another article in the Business and Technology section of the WSJ demonstrates this: Coding Camps Attract Tech Firms. A small private educator runs 12 week courses for $15,000 that leads to no degree. But almost every attendee gets a job within 6 weeks of graduating with an average salary of over $74K. What is impressive is that the curriculum changes within weeks of any new demands from industry. Try doing this at more established educational establishments.

Governments also need to work on exchange rate policy and collaborative monetary policy. One aspect, not explored in detail here, relates to how currency value can have a big impact on comparative advantage. As such this policy effort needs to be reconciled to industrial policy.

If global trade gets bashed, and government policy targets protection of industries that are no longer competitive, we will just avoid paying the piper at the right time. The piper will be back but his tune will be louder and more deafening.

Chinese Authorities Buck the Market to save the Yuan – but for how long?

Friday last week and Monday this week saw turmoil in global markets, primarily off the back of negative economic data from China.  With the recent changes in how the exchange rate of the yuan is managed, the yuan’s value crashed.  In Hong Kong last week its value dropped by as much as 2.7%, much more than the guided 1.1% the PBOC managed onshore.  To help assuage the difference and reduce the fall, the PBOC intervened in the markets and acquired yuan, as reported in today’s US print edition of the Wall Street Journal’s article, Beijing Steps In to Prop Up the Yuan.  In so doing the PBOC has probably spent another small fortune from its exchange reserves.  

Those reserves have already been reduced in the last year as China does its best to manage its currency’s fall more carefully than would otherwise happen in a free and open currency market.  It was recently reported that it’s reserves fell by $93m.  It is thought that the total reserve is now closer to $3.5tn, and that this has fallen from about $4tn.  However, with each and every intervention this reserve continues to decline.  This is good practice for sure and very common in the currency markets.  But how long can this go on?  Central banks will forecast long term trends and will try to determine when and if such intervention should slow down.  Too many politicians have fallen on their own currency sword when they try to ‘buck the market’.  Such behavior only works well for a while.  If the fall of the yuan is going to persist, intervention can only help so far.

Yuan – Another step toward to reserve currency status

A smallish article was hidden on page 3 of the US print edition of the Financial Times today.  It was called, “China eases limits on oversease funding as forex reserves fall.  This innocuous article actually describes a policy change by the Chinese authorities that, if it is sustained, provides yet another move toward the necessary global freedom the reminbi, or yaun, requires if it is to be adopted by the IMF as a reserve currency.

In August I blogged about what China was doing to prepare the way for its currency to become a reserve currency (see The Coming Yuan and the Falling Dollar).  This new policy allows Chinese firms tonow raise   funds overseas, and only have to register with the authorities the transaction.  Previously firms had to obtain permission.  This will make it easier for Chinese firms to issue offshore bonds.  It may take time for this policy to become known and widely used, but its a good sign.  It will also increase the flow of capital into China, and increase the amount of Chinese debt held overseas.  

The IMF published a press release August 19th (see IMF Executive Board Approves Extension of Current SDR Currency Basket Until September 30, 2016) confirming that they would not be changing the basket of currencies comprising the reserve currency SDR.  The Special Drawing Rights (SDR) is the IMF currency in which all members deposit funds (exchanged with their local currency) with the IMF in order to use for later emergencies, should the need arrise.  Chine is keen to see the renminbi accepted as one of the currencies in the basket.  This would be a pre-condition for it to eventually replace the dollar as the worlds reserve currency.

Out of interest, the SDR has an interesting past.  Up until the famous Bretton Woods agreement, John Maynard Keynes had been a keen proponent of a new currency to act as the global reserve currency (since gold was finally off the table).  Keynes had come up with all manner of names for this exchange-based currency; he knew American would not accept sterling and Keynes wanted to avoid the dollar being the standard.  The Americans, in the body of Harry White (at Bretton Woods), would have none of this.  The dollar it was going to be.  Keynes of course lost the debate, but eventually won the moral victory.  The dollar did replace sterling as the world’s reserve currency, but the newly minted IMF needed an independent, neutral currency in order to manage the various exchanges between currencies.  So Keynes ideas was eventually adopted by the IMF, long after his death.  It was never quite implemented in the way he envisaged, but implemented it was.   See my book reviews of The Summit: Bretton Woods, 1944,  by ED Conway, Pegasus Books, 2014 and The Battle of Bretton Woods, by Benn Steil, Princeton, 2013.