In recent weeks I read two important contributions which aim at explaining the financial markets phenomena such as low long term rates, inverted yield curves, very high equity and real estate valuations, record low spreads for emerging markets and for corporate bonds. These are: Caballero (2006) paper or presentation and Rajan (2006) speech, which refer to the concept of scarcity of assets. Intuition behind this concept was provided in an earlier paper by Caballero, Farhi, Gourinchas (2005) .
This theory – correctly in my view – puts low supply of investable assets relative to high demand for these assets at the heart of the global imbalances issue, and draws policy conclusions, which are different from the consensus view on policy measures that should be pursued in order to solve the global imbalances problem. The full list of theories explaining global imbalances you may find in my speech at the recent NBP/CEPR/ESI 10th Annual Conference on Globalisation and Monetary Policy.
Basic points of asset shortages theory are as follows:
- there has been significant increase in global savings relative to investments (you can merge Bernanke global savings glut with IMF global investment drought hypotheses here)
- this excess saving is chasing too few available investable assets, which leads to very high valuations (rising equity indices, low long-term rates, low corporate and EM spreads etc.)
- problem lies in underdevelopment of financial markets in emerging economies, which due to poor governance and property rights do not have enough good quality collateral to back debt obligations
- Anglo-saxon countries which are very good at producing financial assets have already shown enormous imbalances, with US current account deficit and housing market bubbles as the headline examples;
- while financial market development moves ahead (think about large listings in China, improving corporate governance or rapid development of credit derivatives) it is unlikely that excess demand for assets will be eliminated soon, as it seems to have structural backbone, related to demographics (aging), or to higher uncertaity for corporations operating in more competitive global economy in XXI century, which probably explains why profits to GDP ratio is at 40-years high and investments fail to recover to pre-Asia-crisis and pre-dot-com-boom levels
It does matter whether you believe or not in the asset shortage story, as it dramatically alters the likelihood of competing scenarions for 2007. As PIMCO Michael Gomez puts it in September emerging markets note titled Is it safe? :
“EM has historically been vulnerable to deteriorating economic and financial conditions in the United States and other developed countries. Slower growth, tighter liquidity, and heightened risk aversion in mature markets generally mean lower commodity prices, less capital flows, and higher interest rates for EM borrowers – conditions that helped produce some spectacular financial crises in the past dozen years. Not a pretty picture, and one that begs the question of what lies around the corner“.
However, if asset shortages story is correct, then upcoming US slowdown (or brief recession) would likely further increase excess saving (as fading growth prospects will discourage investment projects and encourage more private saving, only partly offset by higher public dissaving amid automatic stabilizers), and lower valuation of US equities will make the world supply of assets even more scarce. In such situation US economy having hard times may not necessarily lead to higher risk premia for emerging markets (as it was the case in the past) rather any increase in risk premia would be used by investors to enhance returns and spread compression will continue, and yield curve inversion may even deepen on major markets, and knock the door in some emerging markets.
PIMCO seems to sunscribe to this possibility, although they do not use asset shortage argument, but they do say:
“Local markets investments may provide the greatest divergence of returns within the EM universe, with those “developing” economies furthest along the road to “developed” market status able to enact traditional policy prescriptions in a slowing global economy and therefore providing enhanced return potential to local fixed-income instruments“.
As a central banker in emerging market well advanced on the road to developed status I ask myself a question which story is correct, because it may have different implications for inflation prospects. Should we expect slowing external demand combined with local currency strength or combined with a local currency weakness. These are important questions (even in the context of falling exchnage rate passthrough) which will be empirically answered next year. Today we can only think in balance of risks terms. Evidence in the last few months, including December BIS report shows, that official institutions may have accelerated their attempts to diversify reserve assets, which may mean more demand for non-core currencies, and in particular for emerging market currencies (recall official Goverment of Singapore Investment Corporation statement that their emerging market weight will be increased from 15 to 20 percent of assets, recall a number of hints given by oil exporting nations). So ceteris paribus this factor will imply balance of risks skewed towards futher risk premia compresion in emerging markets in situation when US growth slows and expected returns in developed markets drop amid poor growth outlook.
The important question is how it will end? Temporary US growth aslowdown is unlikely to solve global imbalances issue, it is unlikely that Arab conutries will accelerate further their investment in real estate, as the pace is already frantic, lack of reforms in the eurozone indicates that potential output in this part of the world is unlikely to speed up. So standard, consensus precricptions will not work. The only feasible channel that might work is accelerating the pace of financial sector development in emerging markets, to produce more financial assets and more collateral. These reforms are easier to implement, because they do not require taking away social benefits and they do not hit any specific groups of interests. So it appears that the discussion should shift away from overvaluation of renminbi, and from pegging gulf currencies to weakening dollar towards ways of speeding up necessary financial markets reforms in saving abundant countries. If these reforms gain speed, we may be able to solve global imbalances problem without much global pain. Time will tell, and 2007 will be interesting indeed. Any educated guesses on what 2007 may look like in emerging markets are more than welcome!