Tuesday, January 25, 2005

Dangerous flows

Here's a very nice figure from today's Times:



Readers of this blog are by now quite familiar with these issues. The US is running unsustainable current account deficits. Asian central bankers are supporting the dollar with massive purchases of Treasury debt (see Brad Setser's blog for detailed analysis), in the interest of protecting their own export-driven economies. (Also see Nouriel Roubini's blog for game theoretic discussion of the world currency regime and "mutual assured destruction" if China and Japan stop buying Treasuries.)

Analysts have often discussed the tremendous paper losses faced by countries like China and Japan if their dollar-denominated FX reserves (approaching the trillion dollar range) were to fall in value. I'm not quite sure how to think about these losses. Take China as an example: dollars repatriated to China by companies are converted back into renminbi, and the PBOC has to issue renminbi-denominated debt to remove the excess currency from the money supply ("sterilization"). This leaves the PBOC with renminbi debt and dollar assets, so dollar devaluation relative to the renminbi makes it hard for the central bank to meet its obligations. Clearly bad for them. As a last resort, though, I suppose dollar reserves can still be used to buy US assets - including technology or natural resources.

In the aftermath of the Plaza Accord of 1985 (see figure) the Yen appreciated by over 100 percent. I would be very interested to know what the consequences were for the BOJ.

21 comments:

Anonymous said...

A very important question. I would love to hear the opinions.

This is way outside my realm of knowledge, but this friendly blog... :)

It seems to me that one difference from the past is that there is now an alternative reserve currency candidate.

As you alluded to in your previous post, technology transfer may be a price the Chinese could be willing to pay for the losses. And the dollar may have less real value, but it can be used to buy US assets, but the US govt. could prevent some of that (Lenovo-IBM?). And can inflation really go that high (would the Fed allow that?) leading to large losses?
My understanding is that it could be very dangerous to use inflation to fight off foreign debt problem, as Soc Sec is indexed to inflation (currently), leading to hyperinflation.

FYI, an interesting site with more details.

U.S. Trade (Imports, Exports and Balance) by Country

http://www.census.gov/foreign-trade/balance/#C

MFA

Anonymous said...

An important question, but I suggest we ask not about the consequences of Yen appreciation for the Bank of Japan but for Japan. Imagine then the dollar were to double in value against the Euro. When there are moments, I will ramble about this question.

Anne

Carson Chow said...

Is the logical conclusion that the US will someday become the low cost exporter to the rest of the world? Has anything like this happened before in history?

Anonymous said...

Imagine then a doubling in value of the dollar against the Euro. European institutions and individuals who anticipated the change in value would buy assets in America to take advantage of the increase in dollar value. This in turn would increase asset prices in America. Americans would also turn to domestic investing and asset accumulation, for the dollar would be worth so much more than the Euro.

Well, there was a flow of investment funds to Japan after the 1985 Plaza Accord and Japanese asset prices rose rapidly, very rapidly. There was no attempt by the Bank of Japan to limit the asset price rise by raising interest rates, for there was no general inflation in Japan. What you had was a high growth, high employment, low inflation economy. All looked well. As the Yen soared in value the currency began to be used to buy what seemed to be cheap assets in America. By buying cheap assets in America, Japanese companies could protect markets by producing directly in America.

What happened, as I understand, was a bubble formed in Japanese asset prices, while the Japanese used valuable Yen to buy American assets at foolish prices. Returns to Japan from American investment would be meager for a while, and in 1990 the Bank of Japan began to raise interest rates. The raising of interest rates immediately broke the Japanese stock market, and sent the Nikkei Index from 38,900 to about 22,000 in an astonishingly short time. Economic growth in Japan began to slow. Exports from Japan were already slowing because of the increase in value of the Yen. Then, in 1992, with the Bank of Japan still in a tightening mode, the price of real property began to fall. Real estate prices fell from there and to varying degrees have never stopped falling. The central bank did not understand the seriousness of the problem till 1994. Too late. Economic growth was anemic from 1992 till now, and only repeated periods of fiscal stimulus drove the economy.

Was the Plaza Accord helpful to Japan? Though I never find discussion of the question, I answer "decidedly not."

Anne

steve said...

Anne,

Thanks for that information on Japan. No argument that their economic performance has been subpar for a decade now.

But was that an *inevitable* consequence of the Yen appreciation? What if they had moved successfully to a consumer driven rather than export driven economy (like, gulp, the US)?

The mark also appreciated tremendously after Plaza. I would think that most developing countries following an export development path would (i) hold their currencies down at first and (ii) expect strong appreciation at some later point.

The question is: is it really as bad an outcome as claimed by some analysts?

China can always use its dollar reserves to send Chinese students to study at US universities, or lure researchers and educators from the US to China...

Carson: I doubt the US will ever be a low labor-cost country in our lifetime...

Anonymous said...

http://web.mit.edu/krugman/www/jpage.html

Paul Krugman has pointed out that there has been markedly little study of the Japanese malaise and attempts to recover. So, I am simply loosely thinking. Krugman's articles about Japanese monetary and fiscal policy are noted above.

Since you bring up Germany, it may be worth noting that Germany has grown at less than half the American rate since 1990. Remember as well that England and what are now the Euro countries were subject to currency attacks in 1992 that significantly lowered the values of currencies. While the Yen generally held in value through the 1990s, European currencies generally lost value. I think Japan was harmed by the Plaza Accord, but I think appropriate monetary and fiscal policy could have saved Japan the long long slow growth period.

Imagine, playing at economics :)

Anne

Anonymous said...

Remember, I am thinking along and not arguing. Japan has long puzzled me and my Japanese friends.

Anne

Anonymous said...

When we blithely think all that is needed is to turn Japanese or German consumers to American consumers, I wonder. Wandering about Tokyo, I have not had the sense that the Japanese were reluctant to "buy." Are the Germans? Slow growth, nonetheless, if ever a people appeared to be style and design conscious surely the Japanese are so. Surely the Japanese are a remarkably generous people from family to guests. But, the Japanese save. There is a large government debt, but household saving compensates. The saving propensity of the Japanese even with the government debt assures a trade surplus relative to us. Are the Japanese to strip away household savings, especially when the society is aging? So the Japanese depend on American consumers to supplement domestic consumption even in a design and style loving country.

Anne

Anonymous said...

Hmmm...

http://www.nytimes.com/2005/01/25/science/25eins.html

Brace Yourself! Here Comes Einstein's Year
By DENNIS OVERBYE

What are you up to, you frozen whale, you smoked, dried, canned piece of soul?"

So did Albert Einstein, then a 26-year-old patent clerk in Bern, Switzerland, begin a letter to his pal Conrad Habicht in the spring of 1905.

Whatever Habicht, a math teacher in Schaffhausen, had been up to was not much compared to his irreverent friend, who had been altering the foundations of physics during the few free hours left to a young father, husband and government worker. As he related to Habicht, Einstein had just finished writing three major physics papers.

One showed how the existence of atoms, still a debatable proposition, could be verified by measuring the jigglingof microscopic particles in a glass of water, a process known as Brownian motion; in another, his doctoral dissertation for the University of Zurich, he deduced the size of molecules. In still another, which he described as "very revolutionary," Einstein argued that light behaved as if it were composed of particles, rather than the waves that most physicists thought.

That paper, which won him the 1921 Nobel Prize, helped lay the foundation for quantum theory, a paradoxical statistical description of nature on the smallest subatomic scales that he himself later rejected, saying that God did not play dice with the universe.

Anne

Anonymous said...

Very enjoyable discussion!

I have found Krugman's articles on Japan very intriguing.

The interesting question is how this would play in China. Would the consumers spend their way out of a recession?

I do not know if there is a difference between China and Japan, but based on what I heard from a few people from Hong Kong, the young are expected to take care of their old, EVEN if the old have the money. They set aside a portion of their savings for that. I have seen a few instances. It is similar in India as well. I would be surprised if it is different in Japan.

So why the propensity to save so much among the people in Japan, when the young are expected to supplement it anyway, unlike here?

Interesting comment on importance of style/taste in Japan. This is stupid, but I could sense some of that from "The Iron Chef" series on TV :) I am veg, but I was impressed how their creations were true works of art!

MFA

Anonymous said...

Sorry not to follow up; I will. Apparently Blogger did not like me or you :) for I could not find "Information Processing."

Anne

Anonymous said...

"I do not know if there is a difference between China and Japan, but based on what I heard from a few people from Hong Kong, the young are expected to take care of their old, EVEN if the old have the money. They set aside a portion of their savings for that. I have seen a few instances. It is similar in India as well. I would be surprised if it is different in Japan."

Pooling family resources seems quite important in several Asian countries, and cleverly answers the question as to why each generation saves.

Anne

Anonymous said...

http://www.nytimes.com/2005/01/26/business/worldbusiness/26yuan.html

Growth Up and Inflation Down in China
By KEITH BRADSHER and CHRIS BUCKLEY

HONG KONG - Economic growth in China accelerated to 9.5 percent in the fourth quarter, computed from the year-earlier period, while inflation slowed, the National Bureau of Statistics said Tuesday. Chinese officials promised to maintain controls on speculators, but took no new measures to temper economic growth.

But just nine months after the Chinese economy seemed on the verge of an upward spiral of higher wages and prices, Beijing appears to have kept growth at a brisk pace while bringing inflation under control. Still, private-sector and academic economists are deeply divided over whether inflation can remain low, as Chinese leaders have eased some of the controls they imposed last spring.

Growth had declined to 9.1 percent in the third quarter, compared with the year-earlier period, and had been expected to fall further in the fourth.

The growth rate for all of 2004 was also 9.5 percent, despite the government's stated goal of lowering growth from the 9.3 percent pace of 2003 to try to calm inflation.

Anne

Anonymous said...

http://www.nytimes.com/2005/01/26/business/26prop.html?pagewanted=all&position=

Echoes of the 80's: Japanese Return to U.S. Market
By TERRY PRISTIN

Japanese investment in United States real estate soared in the 1980's, as companies and financial institutions poured nearly $300 billion into high-profile properties like Rockefeller Center in New York and the Pebble Beach Golf Club in California. But the value of many of these assets plunged by as much as 50 percent in the early 90's, and for more than a decade, the Japanese have been sellers rather than buyers.

After a 15-year hiatus, however, Japanese capital is re-entering the United States market, but much more quietly and cautiously this time. 'They have begun to test the waters again,' said Bill Collins, who runs the capital markets group at Cassidy & Pinkard, a real estate services firm in Washington.

Anne

Anonymous said...

Jonathan Spence is a wonderful thinker and writer:

http://www.nytimes.com/2005/01/26/opinion/26spence.html?ex=1107752400&en=235668be986000ee&ei=5070

Martyr Complex
By JONATHAN SPENCE

New Haven — WHY has the Chinese government been so intent on showing that the former Communist Party chief Zhao Ziyang was a man of no significance, a man whose life should not be celebrated and whose death should pass unsung? The answer that comes most readily to the historian's mind is that Mr. Zhao played a role that has often made Chinese governments deeply uneasy: that of a bold and visionary reformer who insistently calls for change and openness in a tightly controlled political environment. Saluted for a time as one of the leaders of the country, Mr. Zhao sought to use his power and visibility to grant a hearing to the voices of those excluded from the inner circles where decisions were normally made. And when he persisted in this course in the face of opposition from senior leaders in his party, he had to be discarded.

Many others have played similar roles in China's long history, from as early as the seventh century B.C. Ancient texts suggest a tendency for historians to personalize the idea of reform, to let one or a few individuals give a human face to inchoate and broad-based pleas for change and innovation. Often, those seeking reforms were punished by their own colleagues, so that the concept of reform led to the construction in China of an elaborate and emotionally powerful martyrology.

Anne

Anonymous said...

http://www.nytimes.com/2005/01/26/business/26rahr.html?pagewanted=all&position=

Making a Fortune by Wagering That Drug Prices Tend to Rise
By STEPHANIE SAUL

Stewart Rahr's new $45 million East Hampton estate, the most expensive house ever purchased in New York State, is just across the pond from Steven Spielberg's. Mr. Rahr plays golf with Donald Trump and practices putting on an indoor green in the basement of his warehouse in Queens. He and his wife, Carol, last drew attention in 2003 when they bought four works of art, including a Renoir and a Picasso, in one sitting at Sotheby's.

But as he becomes increasingly visible as one of New York's wealthiest men, Mr. Rahr, a 58-year-old law school dropout, is girding himself for the elimination of the system that helped generate his fortune. His success offers a rare glimpse into a lucrative but little-known corner of the pharmaceutical industry - the once-mundane business of delivering drugs from manufacturers to pharmacies.

Over the last 20 years, the packing and shipping of drugs evolved into a game of arbitrage, called speculative buying, with distributors like Mr. Rahr wagering on drug price increases.

Anne

Anonymous said...

Note the following passages:

http://www.nytimes.com/2005/01/26/business/26prop.html?pagewanted=all&position=

Echoes of the 80's: Japanese Return to U.S. Market
By TERRY PRISTIN

In October 2003, it became legal in Japan to sell portfolios of shares in real estate investment trusts, allowing special funds to be marketed specifically to Japanese investors. Some of these funds buy shares only in REIT's based in the United States, which largely own property in this country, while other funds own a portfolio of REIT shares from various countries, including the United States.

Since these funds were first sold, investment in them has steadily increased, reaching $4.6 billion last month. Although this sum is just a fraction of the total $300 billion invested in United States REIT's, real estate specialists say it is significant nonetheless. "It's not a huge number, but it's an encouraging number," said Michael R. Grupe, a senior vice president of the National Association of Real Estate Investment Trusts, a trade group. "It's been a fairly even growth path."

Anne

Anonymous said...

http://www.sims.berkeley.edu/~hal/people/hal/NYTimes/2004-12-16.html

Burden Growing on Pension Group
By HAL R. VARIAN - New York Times

As [Zvi] Bodie explains, there is a fundamental fallacy in pension accounting, which assumes that the ups and downs of the stock market will cancel out over time. This is not necessarily true.

Consider a 40-year-old worker who hopes to receive a lump-sum payment of $1,000 when she retires in 20 years. If the interest rate on 20-year bonds is 5 percent, then the company will have to set aside about $377 now, which is the present value of the $1,000 obligation at a 5 percent interest rate.

But instead of those dull bonds, the company could invest the $377 in a stock market index fund, which yields about 10 percent a year on average. After 20 years, the odds are that the company will have more than enough money to pay the $1,000, leaving itself a tidy profit, or so it seems.

The trouble with this logic is that even though the market will probably do better than bonds on average, there is still a significant risk of a shortfall, even in the long run.

To see this, consider how much the company would have to pay now to guarantee that it could cover its $1,000 obligation. The company would need to buy some sort of portfolio insurance that would pay off if the stock market investment fell below $1,000.

To provide such insurance, the company could buy a put option, a contract that gives it the right, but not the obligation, to sell the pension stock portfolio for $1,000 in 20 years. If the value of the stock portfolio ends up above that amount, there is no problem. If it falls below $1,000, the pension plan would exercise the option to make good on its promise.

How much would such an option cost today? Using standard techniques for option valuation, the price is about $125. Thus, the total cost to guarantee the $1,000 future payment turns out to be $377 plus $125, or $502.

So it is not so inexpensive to invest the pension in stocks after all. Either the employee runs some risk of not being paid the entire amount, or someone - the company or the Pension Benefit Guaranty Corporation - has to provide the put option.

Anne

Anonymous said...

The cost of private Social Security accounts may be far higher than many realize:

http://www.nytimes.com/2005/01/27/business/worldbusiness/27pension.html?oref=login&pagewanted=all&position=

Chile's Retirees Find Shortfall in Private Plan
By LARRY ROHTER

SANTIAGO, Chile - Nearly 25 years ago, Chile embarked on a sweeping experiment that has since been emulated, in one way or another, in a score of other countries. Rather than finance pensions through a system to which workers, employers and the government all contributed, millions of people began to pay 10 percent of their salaries to private investment accounts that they controlled.

Anne

Anonymous said...

http://www.nytimes.com/2005/01/27/business/worldbusiness/27pension.html?oref=login&pagewanted=all&position=

A Growing China Becomes Japan's Top Trade Partner
By TODD ZAUN

TOKYO - China surpassed the United States as Japan's top trading partner for the first time last year, highlighting the growing economic ties between Japan and its rapidly expanding neighbor.

China, including Hong Kong, accounted for 20.1 percent of Japan's total foreign trade last year, compared with an 18.6 percent share for the United States, according to figures released Wednesday by Japan's Ministry of Finance. By value, Japan's trade with China and Hong Kong, including exports and imports, rose to a record high 22.20 trillion yen ($215 billion) in 2004, outstripping the 20.48 trillion yen in trade with its longtime top partner, the United States.

The increase in Japan's trade with China has been driven in part by China's surging growth, but even more, economists say, by the expanding use of China as a production base for Japanese cars, computers and electronic gadgets that are then shipped around the world. While the trade figures show Japan's economic well-being is increasingly linked to China, that has not diminished the importance of the United States, economists say.

Anne

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