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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

If Mexico falls, dont punish Brazil…

2009/01/16 in BRIC - emerging markets, currency, macro trends

Mexico is facing a severe economic crisis, with falling oil prices, decreased exports to the US, and a falling currency.  Brazil has its own challenges, but they are different (outlined in GloboTrends here), and should be distinguished from Mexico´s for foreign investors.

Many foreign investors simply lump Latin America together, and assume that their economies behave similarly.  They do not.  Even when looking at the two biggest economies in Latin America, Brazil and Mexico, its clear that their economies are responding differently to the global economic crisis.

Judging by the way currency traders have been trading the Real and Peso, however,  it appears as if traders are not properly distinguishing between the two.  When a crisis hits (as one did in September 2008), it seems as if traders sell Latin American together first, then ask questions later.  Take a look at the following currency graph from yahoo finance..

Chart for USD/MXN (MXN=X)

The Challenges for Mexico:

The macro economic challenges confronting the Mexican economy are quite serious.

I recently read an excellent (although slightly negative) analysis of the challenges facing Mexico from the source ´RGE monitor` (here).  In this article, the economist  Walter Molano outlined the following challenges (summarized here):

summary of points:

  • The decline in oil prices will hit Mexico hard. The Mexican government will soon face a gaping hole in the fiscal accounts. Oil represents about a third of government revenues.  Unfortunately, the decline in the valuation of crude coincides with a plunge in oil production.
  • Drop in metal prices will weigh heavily on the mining regions, particularly in the north.
  • dramatic fall in remittances expected as the US slows (especially construction)
  • Slow down in the automobile industry is forcing some Maquiladoras to close factories and furlough workers.
  • The current account gap may exceed $24 billion in 2009.
  • This shortfall will be larger if remittances collapse. (which might fall by 50% due to contraction in the US)
  • the capital account will not provide any solace. Foreign direct investment will also decline, due to the downturn in manufacturing. There is a chance that the portfolio flows will be negative, as investors flee the emerging markets.
  • the peso will have to devalue…the Mexican currency could lose another 20% to 25%, which could put it above 17 to 1 against the USD
  • corporate defaults expected; No Mexican CFO is prepared for such a scenario, which could lead to despair on the corporate front. Hence, we could be in for a wave of unexpected defaults.
  • social situation could become explosive. The lawlessness caused by the burgeoning drug trade undermined local institutions, such as the press, judiciary and law enforcement.
  • author:  Walter Molano | Dec 18, 2008

This may be the extreme view to the negative side, but it does throw up the red-flag, and warn investors about the potential for crisis.  Investors should be careful, however, to recognize that Mexico has some unique characteristics that should be highlighted, so that investors dont reflexivly sell `Latin America` on bad news in Mexico.

Brazil is different:

While Brazil and Mexico do share a bond as commodity-exporting Latin American nations, there are some critical differences that investors should keep in mind.

Nearly 80% of Mexicos exports go to the USA, but only 17% of Brazils exports head for North America (Canada, Mexico, and USA included).  This makes Brazil much less export dependent upon the US manufacturing sector (who´s slowdown is driving the slump in Mexico).

Another big difference is that Mexico´s major commodity export is oil, which has dropped from $130+ per barrel, down to $30.52 last week.  Brazil´s exports of commodities are much more food-based and therfore should have support even if the recession turns to depression and lasts longer than analysts predict (so there is less long-term risk for Brazil, as people will continue needing to eat, even if production of material goods doesnt come back for a while).

Also, remittances play a much smaller role in Brazil´s economy than in Mexico´s.

My point is that even if you agree with his analysis (as many traders do), it would be unwise to lump all of Latin America together, and to not distinguish some of the unique characteristics that its economies have.  My fear is that investors seem to lump bad news in Latin America together, and punish all commodity exporting countries together whenever one of them shows signs of weakness.

On the other hand….(or, how Mexico could surprise Mr. Molano!)

Before completing this article, I believe its important to first challenge some of Mr. Molano´s assertions…

In response to his article, however, I would say that Mr. Molano forgets to mention that the Mexican government has locked-in oil prices at $70 per barrel throughout 2009 (by purchasing $1.5 billion in derivatives contracts).   source: Ft.com

Another factor that Mr. Molano fails to mention is the huge warchest of reserves that Mexico has built up…

`The central bank has accumulated more than $90 billion in foreign currency reserves since Mexico’s own 1995 financial crisis, allowing it to auction off at least $15 billion to prop up the battered peso last year`.  source Ft.com

In the mean time, however, I agree with Mr. Molano´s analysis that Mexico will be challenged by a mixture of reduced demand of oil exports, lower level of orders for its manufactured goods, and a reduced level of remittances from abroad, especially from the USA.  The danger is that oil prices may stay low beyond one year, at which time, Mexican budget could be serverly challenged.

Join our Forum and our Wiki to discuss…

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by Brian Butler

Brazilian history of hyper-inflation, and the resulting propensity to consume

2009/01/10 in Tumblr blog imports

People who have witnessed hyper-inflation may fear that if crisis hits again, they may loose all of the value of their savings….and so with a hint of potential crisis to come…they spend their money on physical goods because they know that physical goods will remain even if the money in the bank were to loose its value.  The resulting “spend-it-while-you-can” dynamic is harmful to the nations savings rate, increases the current account deficit, and in turn scares away foreign investors…driving down the exchange rate, and pushing the country closer to crisis.

Upon my arrival in Brazil , after having been away since September, and having missed the past 4 months of the global economic crisis, I was curious to see how much might have changed.   I was shocked to see that (on the surface at least), it appeared as if the crisis hasn’t effected Brazil all that much (as of yet).  True, everyone was talking about the `crisis`, but the shopping malls were full.  Packed.  More full than I ever remember seeing them before, either in Brazil or out.    Sure, some of that had to do with a post Christmas bounce, perhaps …but I started to wonder if something else might be going on…

Responding differently…

In the US, when consumers were faced with “crisis”, they stopped spending.  In Brazil, perhaps because “crisis” has been more common in recent memory, the consumers seemed less effected.  Or, perhaps, they just reacted in a different way…

My thought was that a country with a history of hyper-inflation (Brazil) is responding differently than one that recently never experienced crisis (at least, not in my generation in the USA).

While I dont think inflation is a risk in Brazil at the moment (although a weakening currency might make imports more expensive), I think that when the poor in Brazil hear that `crisis` is coming, they usually associate crisis with hyperinflation (as they have often gone together in Brazil).   It appeared to me as if poor / middle class of Brazilians (perhaps subconsciously) believed that inflation monster would bite again, and bank-account wealth will be wiped out (again)…so when talk of looming crisis appeared in the news, they did the opposite of Americans and spent rather than saved.

Policy decisions:

The Brazilian government isn’t helping people shift from consumption to savings.   In fact, they are doing their best to spur consumption now.  In an effort to keep the economy going, the government is doing its best in Brazil to encourage people to spend money on big-ticket items by waiving taxes on cars, and giving people incentives to spend now, rather than wait.  The trouble is not that Brazilians lost any desire to purchase cars, nor that their prices have gone up (with tax cuts, the cars are now cheaper than ever)…the problem is that credit availability for big-ticket purchases has all but vanished.

Having the government encourage consumption may be good for the economy (now), but if the downturn is more permanent globally, it may be more wise for the Brazilian government to encourage savings rather than consumption (follow the Asian model, and not the North American one!).

Looking at the numbers…

So, when you are looking at overall economic activity of a country such as Brazil, you might be inclined to think that they were motoring on well in spite of the global economic crisis.  But, my theory is that much of this economic boost is temporary rather than sustainable.

Comparison with Asia…

This “fear of saving” (due to a history of hyper-inflation) is a clear indicator of why Latin America has historically lower savings rates than in other developing nations (especially in Asia), and is one of the main problems about why Brazil may get sucked right into the financial hurricane that is brewing beyond its shores.

Without the luxury of having inflation expectations firmly rooted, Brazilian consumers have more of an inclination to spend their savings at the hint of a crisis, rather than tuck the money away in a savings account.

But in this global environment, it is exactly savings which would insulate them from the outside financial world),  and not consumption (which drives up the import bill, and leads to current account deficits).

On the other hand….

Maybe its just that Brazilians are extremely optimistic, and dont believe that the crisis will effect them.  Brazil as the land of optimism:  even in 2009, with global economy in slowdown…”According to IBOPE, a pollster, 74% of Brazilians expect this year to be better than last.” says, the Economist

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by Brian Butler

China’s role in (spreading) the global crisis to Latin America

2008/11/24 in Tumblr blog imports

What started as a financial crisis in the USA has turned into an economic crisis that effects the entire globe.  But, not all of the blame of contagion can be blamed on the USA.  In this article, I will outline how China also shares some of the blame for spreading the crisis to emerging markets (especially in Latin America).

First, let me admit my own previous mistake:  In a previous posting, I argued back in May ’08 that a slowdown in the US would mean less demand for Chinese products, which in turn would result in less demand for Latin American commodities, which would eventually hurt countries such as Brazil.  But, this isnt exactly the way it happened…

While it may be true that orders from China (for Latin American commodities) did fall as we expected them to…it is also true that the fall in orders had less to do with the crisis in the USA, and more to do with internal Chinese market demand (some of which was engineered to fall due to Chinese government policy).

But, investors around the globe punished Latin America anyways.  Without really understanding what was happening…investors assumed that falling commodity prices in Latin America was evidence of contagion from the US-based crisis.

You see…when orders from China started slowing, and commodity prices started falling, investors withdrew massive amounts of capital from Latin America.  Stock markets fell.  Currencies followed suit, and analysts around the globe recited the story that US financial crisis had finally spilled over to the “Latin America”…

But, while this analysis seems good on the surface, it may be lacking in substance.  What is missing from this analysis is the role that Chinese policy has played in engineering the Chinese slowdown.

According to Geoff Dyer of the Financial Times, “For all the talk of international crises, the slowdown (in China) actually started at home”.

Why did China slow?

Why is it important to talk about “what caused a Chinese slowdown”?  Well, because if you assume that the US slowdown was linked to the global economy through China, then its important to know whether the slowdown in China was a result of linkages with the US, or whether it was in fact caused by internal Chinese policy mistakes.

While the global crisis may have played a minor role, it appears as if Chinese slowdown is more a result of choice than of influence.

Earlier this year, China was facing a very difficult level of inflation as food and energy costs were putting intense pressure on domestic political stability.  In response to fears of an overheating economy, China put the breaks on the economy, and attempted to slow down bank lending, the construction industry, and to allow the currency to appreciate.  Just a few months ago, the biggest problem in China appeared to be a massive inflow of foreign currency and a resulting bubble in construction and investments.

With the Olympics quickly arriving, the Chinese temporarily asked companies to stop producing and polluting in and around Beijing.  In order to slow down the overheating economy, the Chinese put pressure on Banks to slow down lending.  In order to ease inflation pressures, the Chinese allowed their currency to appreciate rather drastically vs the Dollar (perhaps in response to US pressure?).

After the Olympics, construction slowed and spending on commodities followed.

Less commodities needed:

With the construction industry temporarily on hold, the financial industry lending less, and with exports challenged due to an appreciated currency, it appeared inevitable that China’s demand for commodities would slow.

Global investors get spooked

The trouble is that China was slowing just at the same moment that the financial crisis was hitting in the USA.  And, as a result, investors were looking very carefully to see if the crisis was going to spill over to other emerging nations.   While there was much talk of “decoupling“, many analysts were skeptical.  History had taught us that “when the US sneezed, Latin America caught a cold”.

Then, in early September we started hearing reports that the Chinese were cutting back purchases of commodities such as steel, and that Brazilian steel producers such as Vale were having trouble passing along price increases.   Commodity exporters around the globe started indicating falling demand from Chinese buyers, and as a result, commodity prices fell like a rock.  Investors had their proof that the world was in fact “coupled”, and that the financial crisis had inded spilled over to become a global economic crisis.  With proof of falling commodity prices on their trading screens, investors around the globe pulled money out of commodity exporting nations (such as Brazil), and currencies tumbled.   With falling currency prices, investors really got spooked as bets-gone-wrong caused massive losses at some of the most respected companies.

Mis-information and bad-assumptions

Investors that only see superficial analyst reports were probably misled to believe that falling commodity prices were a direct result of the financial crisis in the USA spilling over to the factories of China, and onto the mines of Latin America.  They likely mis-read the signs and assumed that falling commodity prices were a sign to start selling emerging markets for fear that slowing US consumer consumption was in fact causing a chain reaction of falling production in China, which was going to hurt global commodity-producing nations.

The reality is that a big cause of slowing Chinese demand for commodities was due to Chinese internal markets and regulatory decisions that had very little to do with the US financial crisis.

While the links between the US consumer and the Chinese producer may be real, they were not the main driver of global economic slowdown, and should not have been the trigger to ignite a global financial crisis.

Perhaps a better understanding of the Chinese economy and a more thorough understanding of the connections between China and the rest of the world could have helped investors to realize that falling commodity prices were not a direct result of the financial troubles on Wall Street, but were more of an indication of economic engineering in Beijing.   With cooler heads and a better understanding of these factors, perhaps we could have avoided the massive sell-off of emerging markets during September and October of 2008.

It is the purpose of GloboTrends to help highlight these global-linkages and to discuss their impacts on global economics and finance.  Please join us on our forum for more discussion…

Links from GloboTrends:

  1. Changes are happening in China
  2. China
  3. China and energy markets
  4. China internet industry
  5. China market entry strategy
  6. China trade data
  7. China’s stockmarket
  8. Doing business in China
  9. Private Equity in China
  10. Real estate market in China
  11. Rising importance of China
  12. Venture Capital in China

Further Reading:


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by Brian Butler

Private Equity opportunities in Brazil

2008/06/05 in Tumblr blog imports

Local Challenges (high cost of Capital)

One of the major difficulties of private investing in Brazil is the relatively high cost of capital, and hence the high hurdle rate (see our discussion on WACC) when analyzing investment opportunities.

When looking at a private investment, it is important to also keep one eye on the returns that can be achieved in the stock market.  Equity investors have a choice about where to put their money.  On one hand, they can easily invest in the stock market, and achieve the expected average return (using an ETF, they would get the “market return”, and would assume the “market risk”).  The benefit of investing in the stock market is that it is very liquid, transparent, and efficient.  They can take their money out at any time.  Also, because the companies publish all of their financial data online, it’s easy to check their balance sheets, and compare them vs other companies in the market.  This is not true with private companies.

With private companies, investors should receive a premium over what the market is returning because they are assuming additional risk (less liquidity, less transparency, etc).

But, in Brazil there is a problem in that ordinary investors have come to expect 10-11% returns as normal (average) for assuming very little risk.  With the stock market booming in recent years (it was the top performer in the past 12 months), there is an environment where local investors are facing a very large hurdle when analyzing local private investments.  If more money can be made in the stock market, many local investors are hence wondering what incentives they might have to invest in riskier (and less liquid) assets.

Opportunity for Foreign PE Capital:

In my opinion, this creates an opportunity for foreign investors, who may be more patient, and more willing to finance deals that Brazilians are not.  This reminds me of the situation back in the mid 1990′s when Japanese investors had a much lower cost of capital than US competitors, and were therefore more willing and able to consider investing in projects that paid back in a longer time period.  If the WACC is too high, then local investors are discouraged from looking at long-term investments (because the discount rate compounds and makes it difficult to pay back).  But, competitors (foreigners) with lower WACC are able to look at longer-term investments, and be more patient in their investment analysis.

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by Brian Butler

What is causing the “commodities bubble?”

2008/05/14 in Tumblr blog imports

One interesting theory (hotly debated) is that the US Federal Reserve is causing the commodites bubble by keeping interest rates so low, effectively a negative real interest rate (after you consider inflation). The theory is nicely outlined here. In summary; the negative real interest rates cause mean that its not wise to invest in treasuries because they are a bad “storage” of value, but commodities that can be held till later, are. Jeff Frankel, a Harvard economist, has long argued that negative real interest rates lead to higher commodity price. When real interest rates fall, there is an incentive to keep the commodity in the ground rather than sell it today. This, presumably, leads to lower supply. The uptick in price also leads speculators (and amateurs) to believe that the upward trend is sustainable, and they jump at the chance to make a quick buck…driving the price even higher.

More reasons to blame the fed:

Monetary easing in the US, while it may be necessary to spur growth in the US, is one of the main culprits that is causing worldwide inflation in the commodities markets. The problem is not just a simple matter of commodities being priced in US dollars, because then the relative value of the commodes would not really be going up at all.

In fact, the trouble is a bit deeper than that.

What is happening is that many emerging market countries have currencies that they fight desperately to keep undervalued vs the dollar so as to spur export growth. Even in Latin America, countries such as Argentina have policies in place to keep downward pressure on the value of the currency to stimulate exports. But, due to the fundamentals of the “Mundell trilemma“, we know that in order for a country to keep the currency controlled, they must give up monetary policy control in the local market.

In other words, each time the US cuts interest rates, these other countries must also cut interest rates, or else risk a rise in the value of their local currency. So, because they are cutting rates, it is having the impact of increasing the availability of money. And, loose monetary policy leads to inflation. By this mechanism, every country in the world that has been trying to keep competitive in export markets (as the US dollar has depreciation), have also been forced to cut interest rates along with the US, and that has led to inflation globally. Its not the Fed’s fault, but it is a reality that their actions are largely to blame for the increase in inflation around the globe…driving up commodity prices in the process.

Links for more discussion:

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