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by Brian Butler

The “savings glut” that may be to blame…

2009/02/10 in credit crisis, macro trends

The “savings glut” theory is one of the two main competing theories to explain some of the bigger mysteries of global finance in recent years (including the credit crisis of 2007 ).  The basis of this theory is that there are underlying fundamental “global imbalances” which are causing all of the trouble (and which need to be fixed in order for the crises to stop).  In this blog post, Im going to quickly outline “savings glut” theory…

The other theory (money glut)

The more popular (and easier to understand) theory (which Im not going to cover in this blog) is called the “money glut” theory…which basically says that American Central Bank kept interest rates too low for too long, which led to too much money, too much credit and encouraged too much risk taking by banks and greedy people on wall street.  This is the popular version of the story that most people hear every night from their local news commentator.  This is NOT the theory that Im going to review in this blog posting.

Savings glut (summarized)

The less well known (and more difficult to understand) theory of what-went-wrong…is the  “savings glut theory”….which basically says that the root of the problem lies not within the US, but with the fundamental imbalance of international finance.

While finance is risky (borrow short, lend long), it is even more risky when it crosses borders.  Countries in Asia and Latin America learned the lesson not to accept deficits after punishing recessions in the 1990′s and early 2000′s.  Since then, nearly all emerging nations (and most developed ones, minus USA) have fought hard to keep current account surpluses.   In an effort to keep away from risky deficits, many central banks (especially in emerging Asia) have purposefully chosen to (a) keep their currencies undervalued, and (b) to accumulate foreign exchange reserves to buffer against potential shocks.  Note that the countries with large reserves in 2009 are the ones most likely to survive this latest crisis with their economies in tact.   After seeing the prescriptions given by the IMF after the last round of crises, most emerging countries said “no thanks” to foreign capital, and instead have chosen to run massive surpluses.

The key to understanding the “savings glut” theory is to first understand that the nations “balance of payments“, by definition, must BALANCE.  That means that if a country chooses not to accept foreign capital, and therefore if they choose to run a capital account deficit…then they must by definition also run a current account surplus (the current account is physical goods exports).  That means that in order to export capital, they must also export products (I know, it gets a bit confusing, sorry).  The net result = they must keep the currency undervalued for this to work.  And the currency of choice = the US dollar (as a target peg).

“Ok, so what is the problem?” you might ask…

Well, due to the rules of global accounting…if one country runs a current account surplus, then others must run a current account deficit.  That part is easy to understand….if one country exports, another must import.  Ok, but what is less obvious is that if one country runs a capital account surplus (think China), then another MUST run a capital account surplus (think USA).  This is the root of the “savings glut” theory…

The savings glut theory states that sometime in the late 1990′s to early 2000′s…there was a massive amount of countries that all decided “thats enough”…no more foreign capital can come in.  It was too risky, and led to too many crises.  As Martin Wolf says, they chose to “smoke, but not inhale” from international finance…and so began a massive financial recycling program, whereby money that came in quickly was sent back to sender.  Money no longer flowed from rich countries to poor ones…instead money was borrowed on a massive scale from poor ones to rich ones.

Why did this happen?  The theory is that international finance proved to be too risky, and so developing countries almost unanimously chose to reject international finance and send it back.   (the only emerging markets that did not follow this prescription seems to have been the emerging Eastern European nations, many of which are now facing crisis…on a much deeper scale than emerging Asia).

Enter the “borrower of last resort”

But, with all of these emerging countries sending money back, unfortunately, there was only ONE country on the planet that was willing and able to accept it:  the USA.  (note that economists that subscribe to this theory are extremely critical of Germany / Japan and other developed nations that did not take some of this capital that was flooding the USA).

The US, as the theory goes, was uniquely capable to absorb this flood of “savings” because the US dollar was the global reserve currency, and the US could borrow in its own currency on a massive scale (with no chance of foreign exchange crisis).

economist-image

Who Believes this theory?

Surprisingly, the “savings glut” theory has some pretty impressive followers…

  • the list goes on and on….

Who is to right?  Who is to blame?

The reality is that both “savings glut” theorists and “money glut” practitioners are probably each 1/2 right. I read somewhere…”the Chinese may have supplied the noose, but it was the US that strangled themselves”…Thats probably the most accurate way of reconciling the “savings glut” vs “money glut” theories…

More on the “Savings Glut”

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by Brian Butler

Does borrowing money (to fund a recovery), make the recovery less likely?

2009/02/09 in credit crisis, macro trends

The trouble with borrowing money to pay for stimulus is that interest rates rise, which is exactly the opposite of what the government wanted in the first place (to get credit markets functioning again).  In this blog post, we will look a how there is a limit to the amount of stimulus that will be effective, because after some point…the additional cost of borrowing will push rates back up

Timeline:

  1. Rates elevated (in the credit markets)…see previous GloboTrends posts here, and here…
  2. Government tries to bring rates down by flooding market with money.
  3. But, government must pay for money…so it borrows
  4. Issuing of bonds at attractive prices pushes up borrowing cost
  5. Interest rates go back up.

Spending money to bring the rates down…

The US effort to fight the credit crisis (of ’07-’09) has been truly spectacular.   No expense was too great, no tool was off the table.  The treasury / central bank seemed willing to try anything to get credit moving again.  And, to some respects, their efforts have really started to work.  We see credit markets start to function again.  Interbank lending is flowing.  As the graph below shows, the US LIBOR rate has fallen back inline with pre-crisis levels.  (the spread over Treasuries may be high, but that’s due to “artificially” low Treasury rates, as investors flock to Treasuries for security, and not to increased borrowing costs for banks and AAA-quality companies).

ted-spread-libor-normal

“if you look at any debt instrument versus Treasuries, the spread will still be indicating financial stress. But that’s only because treasury securities are trading at unsustainable levels.  source: seeking alpha

ted-spread-libor-normal

The same trend can be seen for Commercial paper markets, Industrial corporate bonds rated AAA to A…but not for industrial corporate bonds rated BBB or lower.  To explain why BBB rated bonds are still increasing, you dont have to look at the weakness of the credit markets, but instead to investors decisions to shun risk and to favor high quality assets.  This is not an indicator of poorly functioning credit markets, but inversely a sign that investors preferences during a recession are reflected in the financial markets.

while investors are flocking back to high quality credits, they are still shunning lower quality bonds. That would be normal investor behavior in a recession.  source seeking alpha

So, government intervention in the credit markets seemed to be working..

But…then LIBOR rates started going back UP!

3m-us-libor

But, LIBOR is climbing at the same time that other indicators of credit availability are doing the opposite and falling.  The mystery to solve is “why would LIBOR rates be climbing while corporate bond rates fall?”

“…recent increase in Libor contrasts with recent improvements made elsewhere in the credit markets. U.S. corporate bond spreads, which reflect the interest rate investors are demanding to hold this debt, have fallen after hitting record highs in December.  Standard & Poor’s said Wednesday that spreads on investment-grade corporate bonds tightened to 458 basis points prior day, down from 523 at the start of the year. Junk-bond spreads fell to 1,424 basis points from 1,647 basis points”  source:  marketwatch.com

Borrowing costs get factored in…

To explain why interbank lending rates are tightening (LIBOR rates are going back up), while other measures of credit market liquidity are easing, you need to look at the flood of new sovereign borrowing coming onto the market (especially from the USA).

In order to fund this boost in liquidity, the US government has needed to tap the market for funds.  In essence, they needed to borrow money in order to fund the recovery.  This makes sense, but the problem is that the very act of borrowing funds started putting upward pressure on the very same interest rates that the government wanted to bring down.

Why? Well, because of how the bond markets work….in order to borrow money the US government offers bonds, and to get investors to buy those bonds, they offer a better price.   As investors can get a better bang-for-the-buck on US treasuries, it pulls up rates across the board.  More supply for equal demand makes the price go higher.  This movement is reflected by the higher interest rates.

The question is a matter of scale.  If the additional borrowing is minimal, then it wont overpower the stimulus, and rates will continue to fall.  But, if the borrowing increases too much, then the very act of borrowing can push rates back up (where the government intended them to fall).   But, how much extra borrowing are we seeing now (and is it enough to push up rates)?

In just this week alone, we are seeing  …”billions of dollars in new debt are due to be sold this this week.  The Treasury was set to auction off $31 billion of 13-week notes and $30 billion in 26-week notes Monday. On Tuesday, $23 billion of 52-week bills go on the chopping block, along with $32 billion of 3-year notes. On Wednesday, the government auctions $21 billion of the 10-year note and $14 billion worth of 30-year bonds will be sold Thursday.”  source:   CNN money

A limit to the stimulus…

Maybe there is a limit to the amount of impact that governments can have in loosening the credit markets.  It would be terribly ironic if the very act of fighting to push down the interest rates might be pushing them back up again.

Question is…how far will rates rise?   That all depends on how much the government borrows to pay for more stimulus.

Moral of the story:  there is a limit to the amount of stimulus that will be effective, because after some point…the additional cost of borrowing will push rates back up

visit GloboTrends Wiki for more..

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by Brian Butler

Beggar thy neighbor (part 2); this time its Switzerland?!?

2009/01/26 in credit crisis, currency, macro trends

Back in December, I wrote an article about the risks of rising protectionism in which I forecast the potential rise in beggar-thy-neighbor policies as a result of the ongoing economic crisis.  I called that article “part one” in anticipation that further articles may need to be written (hoping that they would not).  But unfortunately, there has been a string of recent news articles that have shocked me into writing a part 2 for this series  (lets hope there wont be a part 3!).   The culprit this time comes from the most unlikely of all places…Switzerland (yes, the home of the “WTO“, the global protector of free trade).

Why worry about Switzerland?  Well, because of a recent quote from Swiss National Bank Vice President Philipp Hildebrand….where he  pledged to sell “unlimited amounts of the currency (Swiss Franc) to curb its  appreciation.”  In other words, the Swiss National Bank would do everything in its power to devalue their currency (compared to market supply /demand).  This means selling their own currency to buy another currency (likely target = the Euro).

On the surface it appears harmless for Switzerland to assume this protectionist stance…what can it hurt if a tiny country decides to defend its currency?  ( With a GDP of around $490 billion, Switzerland is about the size of Belgium or Sweden, two middle-ranking economies in the 27- nation EU.)…And, doesn’t Switzerland need the help? (because their banking-dependent economy has been harmed by the global crisis, with the resulting unemployment and potential deflation which are threatening the Swiss economy)…

The reasons actually make some sense…

  1. Switzerland is facing the risk of deflation….which is terrible….and so, in order to avoid this terrible economic situation of deflation, Switzerland might need to have a weaker currency so that prices of imports will be higher, hopefully leading to some inflation (some rise in prices, which would counter this deflationary pressure)…
  2. Also, Switzerland needs jobs, and since the economy is heavily dependent on exports (to Europe mostly), the currency should be weaker to help drive up exports and keep the Swiss economy moving.  (Swiss exports, make up more than half of Swiss gross domestic product, and account for a  large percentage of Swiss jobs).

Ok, that sounds reasonable…but Switzerland is not just a “tiny European country”…they are a modern, advanced economy at the heart of the global financial system (and hence, smack in the middle of this global crisis).

The trouble with protectionism in Switzerland is that the same excuses (to turn protectionist) could equally apply to both Japan and to the US…who are both fighting slow economic growth, rising unemployment, falling exports and the threat of deflation (which Japan fought for over a decade).

Why focus on the relationship among Switzerland, Japan and the US?

Because all three of these currencies have appreciated during the global crisis.   These are the three major “safe havens” for global capital as it flees risk in other areas.  All three were major carry-trade partners (in the past) in which their local currency was borrowed at low interest rates, and invested abroad at higher interest rates.  But, as the world lost its appetite for risk, and as volatility increased, global investors were forced to unwind (reverse) those investments, and to bring massive amounts of capital home (to all three countries).  This explains why US, Japan and Swiss have seen their currencies appreciate during this crisis.

The trouble is that none of these countries manufacturing base benefits from having currency appreciate.  All three see their exports less competitive internationally as a result of strengthening currencies.  All three are facing job losses and deflation and near-zero percent interest rates.  All three are facing political pressures to create jobs and fight their local recessions.

And up until now, all three have respected the principles of free trade, and have allowed their currencies to float on international markets.  But, this changed when Switzerland broke-ranks with the others, and announced their intention to try and stop this appreciation to help their local economy.

This is extremely dangerous because it sets precedent for the other major trading partners.

What would happen if Japan were to announce their intention to also try to devalue their currency?  It clearly is in Japans interests to do so as it would help their important export sector…but, would that set off competitive devaluations across SE Asia?  Would China follow?  If both the Swiss and the Japanese (the only two other appreciating currencies along with the US dollar) were to actively devalue their currencies, would the US be far behind?  Can all currencies devalue?  Clearly not…but if all try to …its the basis of a competitive trade war.

Note:  the Japanese Yen has appreciated much more strongly during this global crisis than the Swiss Franc, but they have been surprisingly quiet and restrained in their non-defense of the currency.  In the chart below…you can see that the Swiss franc was steadily strengthening vs the Yen for about 4 years…but then the crisis hit, and the Yen has strengthened much more in comparison to the Swiss franc (inverted scale…so a downward sloping line = Yen strengthening, Swiss franc weakening).

chfjpy

In summary…it is important to remember that not ALL countries can follow this strategy of devaluing their currency, because one currency must appreciate if another depreciates…the trouble is that if all countries try to follow this strategy, we would have a trade war!

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A closer look at the Swiss Franc – a 5-year perspective…

What is Switzerland really worried about?

Has their currency really appreciated that much?   As we saw in the previous chart, the Swiss Franc has actually depreciated a lot compared to the Japanese Yen (or, not appreciated as much vs other currencies as has the Japanese yen).

How about comparing the Swiss Franc vs the Euro (which is the major trading partner of Switzerland)?  Well, in this case, you do see that the Swiss Franc has appreciated during this crisis.  Where it used to take 1.65 Francs to buy a Euro, but now might cost 1.50 (meaning that the Swiss Franc is stronger as it costs less to buy a Euro). But this movement is less dramatic if you take longer-term horizon and look back over the past 5 years….

eurchf

If you see the chart above…leading up till the beginning of 2008, the Euro was strengthening vs. the Swiss Franc…making Swiss exports more competitive in their critical export market.  But, as the crisis began, the Swiss Franc began strengthening vs the Euro, making Swiss exports slightly less competitive (the basis for protectionist policies as was recently announced by the Swiss central bank).

But, this move in currency appreciation has hardly been dramatic when viewed from a historical perspective.  Over the past 5 years, the Swiss Franc has typically traded between 1.5 and 1.6 to the Euro, with a brief period during the 2007 year in which Switzerland benefited from a slightly weaker currency.   Then, in the end of 2008, the Franc strengthened a little beyond that 1.50 barrier, but is that enough to warrant triggering a protective stance in one of the world major developed economies?  Is that movement significant enough to risk triggering a world wide competitive devaluation competition?

How about vs the dollar?

usdchf

Here again, the chart doesnt show much more than a return back to historical levels.  This really doesnt look like the kind of distortion that would normally lead to a quote like this:

  • quote from Swiss National Bank Vice President Philipp Hildebrand….where he  pledged to sell “unlimited amounts of the currency (Swiss Franc) to curb its  appreciation.”

Boy oh boy, I really hoped cooler heads would prevail in one of the worlds most developed economies!   (especially considering that the WTO, the very institution that is supposed to stop trade wars, is LOCATED in Switzerland!)

Join our Forum and add your comments:  here

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Could there be good-side to all of this?

Effects on Eastern Europe:

Interestingly, the Swiss depreciation might actually help countries such as Hungary, which are facing a very serious economic challenge in 2009.   Many Eastern European nations borrowed heavily in Swiss Francs in the past in order to fund development back home.  But, as the Swiss Franc appreciated, their debts suddenly grew, and default risks rose.  So, perhaps the “beggar thy neighbor” of Swiss….may end up actually saving their (eastern Europe) neighbors…if allows them to be able to pay back swiss frank loans…

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by Brian Butler

credit crisis…a symptom, not the cause of global imbalances

2009/01/17 in BRIC - emerging markets, credit crisis, currency, macro trends

What is often considered to be an American-led banking crisis should really be considered just a symptom of global imbalances (and not the cause of them).   Rather than seeing this credit crisis (turned banking crisis, turned global economic crisis) as the result of US financial greed, innovation or stupidity…its more accurate to look at this recent crisis as just one of a string of bubbles that burst as a RESULT of global imbalances in international finance.

The global imbalance that I’m talking about is the role that the US has been forced to assume as the absorber of surpluses from many exporting countries (especially emerging economies of China, east Asian nations, and oil exporters).

Remember, if one country (or a bloc of nations) runs a current account surplus, then some other country by definition, must be running a deficit.  But when countries such as China, Japan, South Korea, Taiwan, etc make it their policy to control their exchange rates vs. the US dollar, and to drive their economies with export-driven growth, then by definition, there must be some other country running a surplus.

The lessons of the 80´s – 90´s taught most emerging nations the dangers of running current account deficits.  They learned mostly through experience the brutal dangers of accepting capital from foreigners (Mexico in 94, SE Asia in 97-98, Russia in 98, Brazil in 99, Argentina 2001-02).   So, as a result of learning these lessons the hard way, almost every emerging economy chose to build up `reserves´ of US dollars, and to run surpluses rather than deficits.

reserves

China and others purposely decided to ´smoke but not inhale` from global finance.  They would do everything in their power to recycle the incoming dollars, and send them back outside of the country.  This process of dollar recycling guaranteed that the money earned from exports would be sent back out of the country as US treasury purchases.

The more China exported, the more they were forced to purchase US treasuries to keep their undervalued currency undervalued, so that the machine could continue.  But, the more they exported capital, the more that global finance became flooded with cheap credit and easy money.  This should have fueled inflation, but cheap Chinese products and labor kept a lid consumer products and drove down labor costs around the globe.  In this new world, the central bankers in the US and Europe were able to keep interest  rates at all time lows without running the risk of inflation.

The only problem was the (string of) asset bubbles that followed…

A series of bubbles…

In response to a flood of cheap credit on tap from Asia, China, and oil exporters…we saw a series of bubbles build up in assets starting in the late 1990´s.  First was the internet bubble,then Telecom bubble, then real estate bubble, then commodities bubble…all the while there was a credit-bubble building and building and then finally popped.

Each of these asset bubbles built up as a direct result of cheap credit on tap from countries that were unwilling (or unable) to absorb incoming capital from global finance, and instead chose to force that capital back on the only country willing and able to absorb excess savings abroad: the USA.

The key question now that the credit bubble burst is:  what´s next?  If you assume that the credit bubble was just the result of American´s choosing to spend more than their income (and poor regulation in the USA), then you might be inclined to believe that this would be over once the credit crisis were over.  But, if you believe (like I do), that this credit crisis was just a symptom rather than the root cause of the recent pain…then you would have to wonder like I do: what´s next?

Note: Morgan Stanley highlights the fact that there will likely be another bubble in their recent article A New Global Liquidity Cycle, where they say `It’s time to get ready for the new global liquidity cycle.`

The only way that this series of crises will end is for the underlying imbalances in global finance to be corrected.  In order for this to happen, then countries like China (Japan, S Korea, Taiwan,etc) will need to stop targeting undervalued exchange rates by selling local currency and buying US dollars.  The only way out is for global finance to be restructured in a way that emerging markets would not be afraid of accepting capital from developed economies, and would be willing to run deficits without the fear of punishing deficit and currency crises.

In an ideal world (or one that makes sense), capital would flow from the rich developed nations to the rapidly developing ones (where opportunities to invest that capital was greater).

For now, we live in a strange world in which money flows on a massive scale from the worlds poor developing nations to the developed rich ones.  And, as a result of this perverse capial flow, we will continue witnessing bubbles that will continue bursting until we fix the underlying causes of these problems.

Please add your comments to our forum here:

Related blog posts:

  1. What is causing the commodities bubble?
  2. Series of bubbles
  3. USA credit crisis – what caused it to happen?

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by Brian Butler

Crisis, bailout, stocks, the US dollar…and “whats wrong with Europe”?

2008/10/02 in Tumblr blog imports

On Monday the House of Representatives (US Congress) voted “no” on the “bailout”, and the stock market tumbled, commodity markets fell, but the US dollar barely changed in value vs its major trading partners.  How can that be?  How come the US dollar didn’t depreciate in value vs the Euro?

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by Brian Butler

Money recycling: Central bank “lender of last resort”

2008/09/30 in Tumblr blog imports

When private banks no longer are willing to lend money to each other, the Central Banks should act as “lender of last resort”.  When private investors are only willing to lend money to the government, then the government has a responsibility to invest that money back into the private sector.

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