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Monday, July 07, 2008


the eventual end of vendor financing

brad setser rightly notes that the biggest story of our times continues to be foreign central bank purchasing of united states treasury and agency debt.

This matters. The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons - ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down - at least in nominal terms.

So far that hasn’t been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries — including some big countries — trouble.

skyrocketing reserve growth in asia is what the united states counts on now as much as ever before. private demand for american securities is dead, and so a few central banks are making american economic life possible on anything like current terms. the end of that regime -- what the BCA terms the end of the debt supercycle -- hasn't yet come in force. but it will, with the yuan revaluation already underway diminishing the need of china to support the dollar with vendor financing and reducing third world inflation. indeed, michael pettis notes that officially-regulated newsflow in china is introducing the yuan free-float into the official public debate. and it will thusly remain on radar screens everywhere for some time longer.

setser, yves smith, and tim duy are all concerned -- nouriel roubini is forecasting the end of bretton-woods 2, the regime of emerging market and petrodollar currency pegs.

It is true that BW2 is still alive as the massive ongoing reserve accumulation by BRICs, GCC and other emerging markets suggests. But the rise in inflation that these exchange rate policies are causing may soon lead to its demise: abandoning pegs and/or letting currencies appreciate at a faster rate will be the necessary step to control inflation in such emerging market economies.

roubini notes that economic weakness has stayed the hand of BW2 participants, as the measures needed to quell inflation in those economies are stringent. instead, inflation appears to be the chosen path of these countries which will force the relative macro adjustments that appreciating currencies would be, in a free-float system, forcing.

... [F]ormally BW2 is still alive and well as the reserve accumulation is as aggressive as ever or even more aggressive than in 2006-2007 among many – but not all – members of the BW2 club. But continuing with BW2 is leading now – with certainty – to inflation becoming so unhinged in the BW2 club that the basis of undervalued currencies and export-led growth will be destroyed by the real appreciation that a rise in inflation induces. So the delusion – exposed by the proponents of BW2 – that this regime would last for 20 years or more is rapidly being challenged. Either way, we are now much closer to the end game of BW2.

roubini elicited more commentary from yves smith.

Roubini believes they will let inflation run, and even allow it to become embedded. In the long run, this will achieve similar results to a revaluation (as local goods prices rise in nominal terms, it winds up increasing the price of exports, much as currency appreciation would. However, it would happen more gradually and (implicit in Roubini's argument) it would be hard to point fingers (while a change in the currency regime would clearly be tied to specific authorities).

While Roubini may well be correct, that many countries will follow the path of least resistance, the consequences of this development would be profound. Highly inflationary economies are terrible for financial investment (I recall that the 24 stocks traded on Mexico's Bolsa in 1984 had P/Es of either 2 or 4), indeed, investment of any kind.

Similarly, in the stone ages of my youth, currencies that offered investments with high interest rates were shunned. The assumption was that they were fundamentally unsound and prone to devaluation. The bad image of high inflation economies carried over to moderate inflation ones, the reverse of the yield-chasing carry trade logic of today. Although one robin does not make a spring, India is now apparently having to defend its currency from a fall, the converse of what one would have expected a year ago.

the wild card here is the potential effect of an economic crash in china. few can model the consequences but, as yves points out, with the chinese speculative bubble ending it seems to me that virtually all estimates of chinese growth in 2008 and 2009 are too optimistic. what happens if china's adjustment to high oil prices proves to be, as morgan stanley's stephen jen euphemizes, "non-linear"?

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