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You also can find a very interesting story by Benassy-Quere et al. (CEPII paper )about emergence of China as a global player and its role in the dollar oil equation. Authors find (in a cointegration framework) that in the long run 10% increase in the oil price was associated with an APPRECIATION of the dollar real effective exchange rate by 4.3%. Authors develop the model which explains why emergence of China could have reversed the relationship. In short falling dollar makes renminbi very cheap (as a currency pegged/closely linked to the dollar) which boosts China export led growth further accelerated by reserve accumulation and related monetary expansion. Because China uses a lot of energy per unit of output it leads to higher demand for oil and to higher oil prices.

The bottom line is that there are many models and many good stories explaining dollar and oil price changes. I like the China story, as we are finding more and more that China has an impact on dollar oil relationship, on world food prices and on world commodity prices (it uses half of world cement output f.ex.). But I think that market strongly believes in negative dollar/oil relationship, so if many investors decide to take directional view speculation can extend trends well beyond levels justified by fundamentals (do they matter these days anyway, as we are in the crisis of trust when world liqudity is abundant).

Should this be the case we could end in an unwelcome situation. Last thing the world needs today is oil price going to 200 dollars per barrel (although I did put my forecast out six months ago, that oil will go to to 200 first and then it will fall to 2 amid disruptive innovations rapidly reducing demand for oil). And I am not worried about recession, Shumpeterian creative destruction is needed these days, but I am worried about further enormous buildup of global imbalances implied by surging oil prices.

I do not know how it will end. I predict that after going to 1.50-1.60 dollar will reverse and end 2008 stronger that it started against the euro. But I am worried that monetary and fiscal medicine applied today to avoid recession will aggravate global imbalances problem. So if we avoid hard landing this time, and the global plane takes off again, the next safe landing would require enormous skills and wise coordination among global pilots.

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He showed that there was a huge growth of cross border flows, and equity contributed to this trend, with equity share in many funds portfolios rising from 2 to 16-fold in the past 15 years. He also said that US households saving rate should rise amid reduced expectations of further sharp rise of asset prices.

Then Wu Xiaoling, deputy governor of the PBoC took the floor. She definitely spoke English, but she chose to speak in Chinese, and gave the translator hard time. I was also surprised by a poor quality of slides, she used word document with a font size probably below 12, could not see anything. But governor Wu made a number of very interesting statements, here is my subjective perception:

• global imbalances are normal and inevitable phenomenon in a global economy. Interestingly during the discussion Wilem Buiter, former EBRD chief economist now advising Goldman Sachs and teaching at LSE said essentially the same. Relax, be complacent, this is normal in a global economy. Some would fret at this, I would ponder.

• Governor Wu stated that special dollar status as a settlement currency also fuelled global imbalances, I would definitely agree;

• She said that PBoC now has 1247bn dollars of reserves, which implies 45bn increase in April alone, wait a moment and Brad Setser will tell you how much are inflows and how much are valuation changes.

• China plans the following policy measures:

Increase FX regime flexibility, but treats this as an issue of secondary importance. Mrs. Wu said that had China revalued massively it would have shifted trade surpluses to other Asian countries and the overall picture would not change (debatable, isn’t it);

China will try to boost consumption by building social safety net, rising household incomes, changing foreign trade policy to encourage imports, enhance environmental standards, and, I stress, encourage Chinese enterprises with surpluses to invest in other emerging markets. If anything it appears that China has embarked on a decisive captive offshoring path, watch out;

During the panel Mrs. Wu made few comments on China investment strategy. She was very careful with the wording, she said what we already know: China will not become net dollar seller, but with growing euro importance in world financial markets its importance will also be growing in central bank’s coffers.

She also said, and I find it quite important, that it be beneficial for the world to have several global settlement currencies. I bet that in the long term Chinese authorities would see three such currencies: dollar, euro and … asian.

Next speaker was OECD chief economist Jean Philippe Cotis. He made many interesting points, but let me share with you three:

• Good national policies that worsen global imbalances problem should not be discouraged (e.g. labor reforms in Europe);

• Do not recommend policies that are good for solving global imbalances, but bad for particular country (e.g. Japan increasing fiscal deficit to reduce excess saving);

• Structural reforms may help global imbalances in the short-run, but will be neutral in the long run.

Cotis spend long time discussing labor market reform in Europe, which is needed for Europe reasons, but if implemented may not help global imbalances, as precautionary saving may rise and may offset higher consumption driven by expected potential output rise (sounds complicated but trained economists will know what I mean). Cotis suggested that services market deregulation will have a much stronger positive implications for global imbalances, as it will boost output without generating jobs insecurity and a possible rise in precautionary saving. I agree, but look what politicians did to services directive proposed by the European Commission, and optimism fades immediately.

Mohammad Al.-Jasser, deputy governor of SAMA (Saudi Arabia Monetary Authority) had a very interesting speech, but let me focus on two statements. First, he defended oil exporters strategy to run counter-cyclical fiscal policy, which means building large reserves when oil prices are high, and running them down when oil prices fall. He than stated that Saudis will continue to invest in US securities because US markets are biggest and most liquid, and the central bank focus should be on stability and liquidity. I challenge this view in my paper on Global Reserves Management.

The second panel was more on economic theory and less on policy issues, but I did like Wilem Buiter presentation titled: “Mundell on his head: Asymmetric shocks are good for you – thanks for EMU in Europe”. To sum up Buiter’s several slides with equations I would say the following. Home bias has fallen, so many households now hold a European portfolio. In finance it is good when returns on particular assets are negatively correlated, because it will help you to diversify risk and achieve better risk return tradeoff. So if asymmetric shocks hit EMU, it means by definition negatively correlated returns on EMU assets portfolio held by households, so the household will be better off, in comparison with scenario where there are no asymmetric shocks. Of course this is in the case of capital income, the story is different with respect to labor income, where mobility is the best hedging strategy.

Let me sum up. The panel confirmed my view, that New Bretton Woods is well and alive. IMF seams relaxed seeing the medium term risk, Europe structural reforms can’t do much good (labor reforms are imbalances-neutral, and services liberalization was killed by politicians), oil exporters will continue to finance US deficits, and they do not require weaker dollar or higher US bond yield to find it attractive. China will move very slowly on all fronts, maybe one trend will accelerate, which is higher Chinese FDI (definitely in Africa, but I would also bet on Chinese plans to buy assets in developed world, see Blackrock as the headline case).

It does appear, that absent unexpected shocks (protectionism, US Senate FX intervention legislation, global viral disease etc.) global markets will continues to be awash with liquidity and global imbalances will persist. This is confirmed by recent forecasts of IMF, OECD and EC, all point to continued global imbalances.

Someone commented at the end that it was a panel of one handed economists. I agree.

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• As documented by actions and by public announcements many central banks have already embarked or are planning to embark on a journey that leads to a more effcient reserves management;
• This will imply slow but sure move towards more diversified portfolios (across currencies and instruments), while at the same time monetary policy goals and financial stability needs will remain binding constraints;
• This trend, which appears to be a commonly shared vision in the vast majority of public sector institutions jointly managing more than 7 trillion dollars, is likely to result in shift of relative demand across asset classes. It will likely be associated with further effects, as public institutions actions tend to coordinate private sector actions around trends;
• These trend would imply gradualy moving away from treasury bonds and away from the dollar-denominated assets (although many central banks ruled out net sales of dollars);
• This shift, ceteris paribus, could lead to a continuation of tight spreads, or even to further spread compression in markets that still offer some yield pick up, and the low emerging markets volatility and tightening spreads are the best illustration;
• This is also consistent with further weakening of the US dollar and steepening of the US yield curve at the same time (whether it is rising long term rates and falling short term rates depends on the US growth and inflation outlook, which is not relevant for my story). On balance it should contribute to reducing the global imbalances problem;
• However, ceteris paribus is not a relevant assumption here. There are some views, that hedge funds launched an unprecedented in human history speculation in commodities markets and that their activity in credit derivatives makes it impossible to understand what the risks are and how they are distributed across institutions and across borders. So one can safely assume that in the future there will be shocks coming from these markets (be it in commodity of in the sub-prime market), Amaranth loss of USD6bn in gas trading is just a small reminder. In my previous post I showed the picture documenting that all hedge funds investment styles are strongly correlated, which implies that there is no diversification and that correlation crisis, as some put it, should not be ruled out;
• Of course if this happens it could be very bad for some markets, commodities (metals, oil) could be badly hit and countries that rely on commodities exports can be badly hit. However, hedge fund industry is very small relative to global financial markets, actually it is hundred times smaller. So in general the outcome will probably be contained (thanks to better risk managament and better risk diversification than in LTCM times). And some commodities exporting countries will likely get another chance to embark on much needed structural reforms, postponed amid commodities bonanza;
• Taking both stories together it implies continued trend towards new equlibrium, where relative pracies of various asset classes will find its XXI century steady state, in which assets prices will have very little in common with their historical XX century averages. I am not sure whether the investment community is fully aware of that; This trend will be interrupted from time to time by bouts of volatility related to collapse fo this or that market, but with global financial markets deepening progressing rapidly, it would not lead to global financial issue, it will be rather seen as buying opportunity;
• One can of course ask a question, what if central banks move too far with yield enhancement strategy, and they invest in markets that appear liquid in a world within two-sigma deviations, and then five-sigma event hits the markets and it will be a global one. Will markets remain liquid, will central banks be able to take timely actions to preserve liquidity? Well, this responsibility obviously lies with the biggest central banks, banks of rich countries which do not have large opportunity costs of poor investment strategies and possibly with PBoC, which faces huge opprtunity costs but also has huge reserves to be utilised for monetary policy and stability purposes. Another question is whether large central banks should act in such event? This is a Greenspan-put question, beyond discussion in this post. So it appears that as long as smaller central banks have trust in ability of large central banks to deal with global shocks, there may afford to improve asset management of their reserves to a certain degree;
• One more trend, slow, but deterministic, is financial deepending in Asia. This is a welcome development, because in the long term highest returns should be expected in regions with highest potential growth rates. This is Asia in the first 50 years on XXI century, and Africa in the following 50 years (I could be wrong plus/minus 10 years).
• In this context I was more than surprised to find the following statement released after multirateral consultation between USA, EU, China, Japan and Saudi Arabia and facilitated by the IMF. Quote: “The Administration is actively engaged, through the U.S. Treasury, in ways to improve U.S. legal, regulatory, and accounting frameworks and thus better ensure that U.S. capital markets remain the strongest and most innovative in the world.”. I thought that multirateral consultation took place to find ways to resolve global imbalances. While US commitment says we will do our utmost to ensure that foreign funding comes to US and that US current account deficit will be even easier to finance. I know that deep, liquid and effcient financial markets are good for US economy, their existence helped US to enjoy the exorbitant privilege (much higher return on foreign assets than on foreign liabilities), but I cannot see how this goal can contribute to solving global imbalances problem.
• I got a bit off the main thinking track, so let me restate my main claim. We are in an unprecedented process of finding new XXI century steady state in terms of relative prices of various asset classes. Actually this equilibrium should have been found already, but the fact that big chunk of financial intermediation takes place via public institutions, who behave in a different manner that private institutions and individuals, has delayed the process. But the common, collective mindset, to improve assest managament in public institutions (who are expected to manage more than 10 trillion USD by 2010) will slowly remove this distortion. Lets hope this will be a smooth adjustment.
• And a footnote. This change is also coming to the main World Bank business. This respected institution still goes around and asks countries “please take a loan from me, I need interest income”. Countries no longer want this type of simple finance, they require a more sophisticated approach. Exactly as in the case of reserve management.

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Below are interesting articles also worth reading:

• Brad Setser blog on US income deficit now adding to global imbalances problem;
• Bloomberg post on New Century going belly up, a quote:

“New Century plans to sell most of its assets within 45 days, said the Chapter 11 filing in federal court in Wilmington, Delaware. About 3,200 people, more than half the workforce at the Irvine, California-based company, will be fired. New Century said it already agreed to sell its mortgage billing and collections unit to Carrington Capital Management LLC for $139 million.The company rode the U.S. housing boom to become the largest independent mortgage lender to subprime borrowers, only to collapse as interest rates rose and home prices fell. New Century’s market value soared to more than $3.5 billion in December 2004, and last year it made about $60 billion in loans. Like rival firms, the company lowered its lending standards to keep business flowing after demand slumped.”New Century Financial Corp., overwhelmed by rising defaults from borrowers with poor credit records, became the largest subprime mortgage lender ever to fail as it filed for bankruptcy today. [...] The Wall Street firms that backed New Century probably will have limited losses, Miller said, because their loans were secured by the company’s loans and other assets.“The major institutional holders have said they’re over- collateralized,” he said. Stockholders and junior creditors may be wiped out, he said.”

• IMF First Deputy MD John Lipsky speech on reducing risks of global imbalances, quote:

“Looking ahead, there are clearly many risks to the global outlook that bear close watching. Spillovers from ongoing corrections in the U.S. housing market and in financial markets are of course the most prominent of these risks. But the IMF expects that, while risks to the outlook remain tilted to the downside, global growth in 2007 will again be strong—close to 5 percent.”

[...]

“First, in industrialized countries, assets under management of institutional investors—pension funds, insurance companies and mutual funds—have surged, rising from $21 trillion in 1995 to $53 trillion in 2005.

Second, the home bias of the investor base has declined markedly. The globalization of asset allocation has gained traction with declines in informational and other barriers and advances in financial innovation that allow unbundling and reallocation of risk.

Third, emerging market central banks and sovereign wealth funds have become key global players in cross-border asset allocation.”

[...]

“

In short, it is likely that global imbalances will unwind gradually, through a further rebalancing of domestic demand across countries, with supportive market-driven movements in real exchange rates.

At the IMF, we’ve been helping this process along not only through our bilateral discussions with countries but through a new process of multilateral consultations. These first of these consultations have brought together participants from China, the Euro area, Japan, Saudi Arabia and the United States. The discussion has resulted in a better understanding of the policy agenda of each participant. And we hope that this will be reflected in policy choices that are in each country’s interests but also contribute to the reduction of global imbalances.”

• Societe Generale reserach note of risks assesment, quote:

“Despite all the gloom and doom talk, the market is still treating the current episode as
a mid-cycle slowdown. Investors are assuming that the economy will overcome the risks, perhaps with a little assistance from the Federal Reserve. Investors are looking beyond the current soft patch and are still anticipating healthy economic performance outside of a few select sectors. There is always the possibility that the markets may be wrong, but the investor confidence in the economy – manifested in narrow credit spreads – will help support growth by providing relatively cheap capital.”

• President of Iran writes his own blog in three languages.
• Obama raises as much as Clinton in presidential election fundrasing race, big chunk comes from internet, IHT article.
• India outsourcing edge goes beyond cheap jobs, NYT article. Quote:

“Boeing and Airbus now employ hundreds of Indians in challenging tasks like writing software for next-generation cockpits and building systems to prevent airborne collisions. Investment banks like Morgan Stanley are hiring Indians to analyze American stocks, jobs that commonly pay six-figure salaries on Wall Street.

The drug maker Eli Lilly recently handed over a molecule it discovered to an Indian company, which will be paid $500,000 to $1.5 million a year per scientist to ready the drug for commercial use — work that would be significantly more costly if carried out by Americans.

With multinationals employing tens of thousands of Indians, some are beginning to treat the country like a second headquarters, sending senior executives with global responsibilities to work there. For example, Cisco Systems, the leading maker of communications equipment, has decided that 20 percent of its top talent should be in India within five years; it recently moved one of its highest-ranking executives, Wim Elfrink, to Bangalore, the center of the Indian industry, as chief globalization officer.

Accenture, the global consulting giant, has its worldwide head of business-process outsourcing in Bangalore; by December it expects to have more employees in India than in the United States.”

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• And by the way, Fitch estimated that China external assets were 1.55tr dollars, see chart below.

• Stock markets around the globe fell off the cliff, and then recovered nicely, leaving many investros pondering whether it was a long overdue correction or something more serious.
• Yen carry trade was analyzed by dozens investment banks and hedge funds, some say it will last, some predict big unravelling and recall one day 15% yen appreciation few years back
• European Union at fifty tries to revive itself, with German Presidency pushing hard to get the constitution process going on again. Some investment banks predict rosy 2007-2008 period, some economists notice that German growth model based on capital intensive production and exports has its drawbacks.
• China announces its plans to take over world automotive industry, and soon after aircraft industry. Few people seem scared today, saying it is long term and if someone should be worried it should be our kids, or maybe even their kids. Next few years will prove that in XXI century the death of time and death of distance has a very practical meaning.
• We focus on bad African countries, those with hyperinflation, with tribes chopping off heads of those from other tribes. But there are very good things going on in Africa, and this is happening with large presence of Chinese diplomacy and funding, and with little or no European presence.
• US housing market heads south and most people expect that this trip will continue for some time, see recent PIMCO analysis, but investors are divided whether it will lead to broader wekaness or will be contained in construction sector. Recent RBS reserves management survey shows that polled central banks are more pessimistic than consensus, and while they were worried about rising US rates a year ago, now the key worry is slowdown or even a possible recession.
• Global imbalances have not been forgotten, US international investment position is getting more red with every month passing

All that is happening while the global economy still enjoys robust growth, after five years of continued strong global growth. Has globalization changed the world so much that business cycles became rare species. Or, possibly the average length of the cycle will be longer, if this is the case, will it apply to all phases?

I have probably written about 5 percent of issues that I have been thinking lately. These are immense changes, often unprecedented. So we do not know what lies ahead, those with XX-century crystal balls and black cats are helpless as well. The only sensible apporach is to prepare for change, with big C, and resort to change management when things begin to happen. And they are happening already, to see this you need to put your XXI century glasses on. I do not know what scenario will materialize in the next few years. I know that it will happen much faster then we predict and the scale will be much bigger, and I mean the shift of power from US/Europe to Asia. I also think economists who do only macro work get the story wrong. Global optimization of business processes and emergence of global labor and knowledge pool made global economy much more resilient than before. So even when things begin to get nasty, we have very strong and efficient shock absorbers, which will help to avoid black scenarios.

And by the way. If US remains in a protectionist mood, I keep wondering in what parts of the world China will make its shopping with reported US300bn allocated to equity investment – listed stocks, private equity, hedge funds mandates etc. (if one takes into account from whom China is learning to invest). Or maybe people who note that central bank money cannot be traced as it gets lost in London, will have an even bigger puzzle to solve in the coming quarters and years. Finally, in the long run real returns in various parts of the globe should be correlated with potential output rates. If you agree then you should also agree that potential output in Asia will grow much faster than elsewhere in the coming years. Interesting …

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“SUMMARY

The system of multilateral rules and institutions that is currently responsible for global economic governance is in a sorry state. In the coming months, Europe will be faced with important decisions about the
future of this system. The EU should not wait before proposing and initiating reforms. Europe has a large stake in the multilateral system and has considerable experience in designing effective institutions, making it well placed to lead a reform agenda. Moreover, the legitimacy of the EU in the eyes of its citizens depends on its ability to tackle the big issues that really matter for the future of the global economy.

POLICY CHALLENGE

Global economic governance matters. Since the US at present appears less ready to move it forward, European policymakers must take responsibility for advancing the reform agenda. Reforms are especially needed in areas such as trade, finance and the environment. Specifically, the EU should act now to unlock the stalled global trade negotiations, push for badly needed governance reforms at the IMF and the World Bank, and take the lead in addressing the problem of global warming. However, the EU is unlikely to be successful unless it first gets its own house in order and makes changes both to its internal governance and to the way that Europe is represented in international forums. “

• Here is the link to Menzie Chinn post about international economics related sessions during the Chicago ASSA meeting past week. It reviews several important contributions. Menzie Chinn also recommends that every economist should read recent George Akerlof paper, so did I in my previous post .
• European Commission services prepared a paper summarizing 101 proposals to modify the Stability and Growth Pact (SGP). Paper summary is below:

“The failure of key EU Member States to respect the requirements of the Stability and Growth Pact (SGP) a few years after its inception triggered a heated debate on how to reform the framework of fiscal policy coordination in the Economic and Monetary Union (EMU). This paper systematically analyzes 101 reform proposals presented by professional academic and non-academic economists prior to March 2005, when the Council of the European Union adopted a revised version of the SGP. Each proposal is characterized by a set of variables reflecting features such as the degree of modification of the SGP, the background of its
author(s), the main aim attached to fiscal policy coordination in the EMU, the timing of the proposal and the type of proposal made. Using multivariate statistical analysis, roughly four different schools of thought concerning the reform of the SGP are identified. In line with the main findings of the political economy literature, all four schools of thought share the view that in the absence of specific rules fiscal policy would lead to excessive deficits and hence affect the conduct of the common monetary policy. However, beyond this common denominator, there is no consensus on how best to co-ordinate fiscal policy. We present several explanations for the multitude of proposals, the most important being the present lack of a consensus in the economics profession concerning the role of fiscal policy. Economists hold diverging views on the goals, instruments, efficiency and institutions for fiscal policy-making. This state of affairs is in sharp contrast to the case of monetary policy. In addition, the institutional framework for the SGP was completely new. The euro area is the first case where monetary policy-making is centralized while fiscal policy-making is decentralized to national governments. As long as we lack consensus on the proper role of fiscal policy, the SGP will be the subject of different economic assessments.”

• Morgan Stanley’s comment on world reserve accumulation, summary is below:

“We document the latest figures on the world’s official reserves. The total stock of official reserves continues to grow rapidly. Despite the recent trend to the contrary (the last month or so), we continue to hold the view that in 2007 we will witness waning interventions by the Asian central banks, with the sole exception of the PBoC/SAFE. The returns on the underlying investments will account for an increasing share of the incremental changes in the official currency reserve position. Regarding reserve diversification, we also maintain the view that, in 2007, we will see central banks taking a decisive step toward investing their ‘excess’ reserves like ‘sovereign wealth funds’ by diverting from the traditional investment patterns. This prospective move will mark a watershed in central bank reserve management and for the financial markets in general. “

• The Economist article comparing BoE and ECB. There is still a lively and ongoing debate on whether central bank should surprise the markets, or not. Many papers have been written on the subject, many will be.
• IMF has published new Working Paper , which concludes that New Member States are enjoying lower risk premia than their peers, thanks to EU accession via higher policy credibiloity channel. Summary of the paper is below, the full text is not available yet.

“References to policy credibility, particularly with regard to fiscal policy, are ubiquitous in both economic literature and financial markets, even though it is not directly observable. The case of the EU new member states (NMS)-emerging markets joining a supranational entity that is generally considered to have higher policy credibility-provides a unique experiment to assess the effects of credibility on sovereign credit. This paper examines the impact of EU accession on three key variables that can reflect in varying degrees policy credibility: sovereign ratings, foreign currency spreads, and local currency yields. The results suggest that the NMS appear to have enjoyed higher credibility compared to their peers.”

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