Some Thoughts on Liquidity in the Global Economy
Sometimes here at Alpha.Sources I do a review and preview note on the state of play in the global economy and markets. Over the course of the past year this has amounted to quite a few notes and most of them have contained the same overall strings of topics with the notable qualifier of course that specifically the effect of changing global demographics have tended to be my main focus. In my latest note the following topics were dealt with; Bretton Woods 2 (global imbalances), excess liquidity, an impending credit crunch, de-coupling, and demographics.
Clearly, these topics continue to constitute the topics which matter in the global economy and perhaps even more today than yesterday in the sense that they collectively describe and underpin a series of issues and questions which are still unresolved. One important qualifier to this is of course the issue of the credit crisis and crunch. In my recent note I simply asked the question of whether it was going to happen or not even leaning towards a positive outcome. Obviously, events have surpassed this discussion and at this point in time we are right smack in the middle of it. In this way and while the technical aspects of how inter bank liquidity has been drying out leaving interest rates (the LIBOR) persistently above target are interesting and potentially malicious in themselves we need to consider that this is also going to have a considerable lagged effect on the real economy and especially those economies where the housing market (and in general consumer spending) has been the main driver of growth. The downside to all this is then furthermore that all those economies which have not been de-facto running on consumer spending and a housing boom have conversely been dependent on its more profligate peers through strong trade links; i.e. this is what this whole debacle is about in the sense that global economy is very interlinked. As such, the rubber band which is the global economy is being stretched quite severely at the moment. For a general overview the Economist ran a cover story and subsequent briefing on the global economy in one of the latest issues (new one out tonight) which is much worthwhile as a general primer on the situation. In this post I won't do a re-run of my analysis presented in my very recent note (linked above) which is still valid I think. One thing however which perhaps should be immediately added at this point is that for the next installment trying to take a more comprehensive stock of the global economy the issue of inflation and what to do about it should take a prominent place amongst the other topics.
In this post I want home in a bit on the context the changing tectonics of global liquidity conditions and then subsequently where the liquidity is going and whether this will have a fundamental impact on the global imbalances and thus idea of de-coupling which in this case should be understood more as whether importers will turn into exporters than the more narrow and essentially trivial question of whether the world can de-couple from the US. As a point of departure we might want to start out with one of Stephen Jen's recent notes published over at GEF in which he discusses the impact of the sovereign wealth funds (SWFs) on the EUR and USD. The main argument is the following ...
In this note, we argue that the emergence and full deployment of the SWFs – i.e., rebalancing their investment portfolios toward their long-term desired targets – could translate into large sales of both the USD and the EUR, and large purchases of EM currencies and the JPY. In other words, while official reserves are likely to continue to evolve in a way that is USD-negative and EUR-positive, the emergence and maturing of SWFs will likely help support the non-G7 currencies, and hurt, in particular, both the USD and the EUR: It will not be a tug-of-war between the USD and the EUR anymore. EM currencies and equities’ impressive performance in recent weeks are consistent with this perspective on the SWFs.
In general I have been very impressive with the work presented by Jen and I also tend to agree with the main thrust of the argument above but it comes with two important conditions which makes me wonder whether in fact I agree with Jen or not. Let me explain. First of all and while I won't go into this in detail I don't see how the mobilization of global liquidity proxied (in part) by the emergence of SWFs is going to be JPY positive. If anything, I see Japan as being one of the big net suppliers of liquidity, as a result of its demographics, rather than a net recipient of liquidity until we of course get to the hypothetical situation of dissaving as the Japanese population structure really begins to crack in which case the issues confronting will be of a much more serious kind. The second condition is a bit more ambiguous. In many ways the conceptualization above links in very well with my own perception of the global economy in the sense that in stead of talking about de-coupling we should be talking about re-coupling. As such, I agree with the underlying current in the sense that the global economy is changing in a structural sense (re-coupling) to make the clout of the G3 (which in my book most emphatically includes (obviously) Japan) smaller relative to emergence of key emerging economies such as India, Turkey, Brazil, and of course China although the red dragon's potential for actually being able to turn the supertanker of a surplus into reverse is pretty unclear at this point, even if the Brad Setser's of the world got their way with respect to the Yuan. Speaking of Brad Setser he also makes a very important in his recent post which really goes to the heart of matter concerning the flows of international capital and whether in fact exporters will turn into importers and vice versa, but also in essence what effect to expect from these SWFs.
Jen believes that the shift toward Sovereign Wealth Funds implies a shift in official flows toward Asia and emerging economies – and a shift away from both the US and Europe. I suspect Jen is right. Sovereign wealth funds aren’t restricted to classic reserve assets and Asian equities are a lot more attractive than Asian bonds. Most sovereign wealth funds have signaled that they are looking to increase their exposure to emerging Asia.
That though begs another question. While sovereign wealth funds want to invest in Asia and emerging markets (and particularly in Asian emerging markets), both Asia and the world’s emerging markets run current account surpluses. They don’t need the money. The US by contrast does. If the shift from reserves to sovereign wealth funds means a shift from financing the US to financing emerging Asia, both the US and a host of Asian economies need to adjust. Otherwise, one country’s sovereign wealth fund will just end up adding to another country’s reserves.
Clearly, between me, Jen and Setser there is not much to it in terms of differences. Yet, one thing which is very important to point out I this is that the forces which drive international capital flows and essentially serve to keep the current system of imbalances going are deeply structural in nature and given my belief in how demographics will drive liquidity going forward the structural base of the imbalances, however perverse and seemingly unsustainable, are very strong. This also leads to an important point about those SWFs in the sense that I see their existence and rise as a natural symptom of liquidity and too much capital chasing too little yield. In fact, you can argue that when a country sets up a SWF it is a response to excess liquidity relative to institutional and political constraint to invest in other asset classes than foreign sovereign debt under a traditional reserve management scheme. Of course, if you are pegging to the Dollar this in itself will pull in a lot of reserves but at the end of the day the SWF is a prime example of how surplus governments are waking up the fact that they might end up sitting on a pile of money and no possibility to find return. This is also perhaps where Jen is slightly forgetting his own assertion that SWFs are going to be very big indeed. As such, would it not be reasonable to expect that the SWFs would be able to both support the external deficits of the (few) deficit nations we have and roam the edges of the world for return in all kinds of other asset classes. We need to remember that when it comes to the decision of whether to retreat financing of e.g. the US external deficit it is a proxy for an assumption that you yourself can suck up some of the capital and as such an assumption that returns can be earned in the domestic economy. Essentially, as you see I have moving right smack into the notion of how, as the world steadily ages, more countries will have a propensity to run a surplus and thus a need to invest its savings elsewhere to earn a return in order to finance growth in the domestic economy.