Global coordinated action and the consequences
I spent last few days in Washington walking across 19th street, talking to economists at both the IMF and the World Bank, listening to speeches and presentations. I also discussed trends in reserve management with senior central bankers and senior managers of Sovereign Wealth Funds. Several important themes emerged so I will try to put them together to get the broad picture. All trends disussed below relate to years rather than quarters ahead:
- 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.