Sunday, July 31, 2005

Fortune on globalization and US competitiveness

Nice article here. For those who don't recognize the cartoon reference, it's from an old comic book ad for the Charles Atlas bodybuilding course, guaranteed to turn skinny weaklings into musclemen!

...Low-cost countries—not just China and India but also Mexico, Malaysia, Brazil, and others—are turning out large numbers of well-educated young people fully qualified to work in an information-based economy. China will produce about 3.3 million college graduates this year, India 3.1 million (all of them English-speaking), the U.S. just 1.3 million. In engineering, China’s graduates will number over 600,000, India’s 350,000, America’s only about 70,000.

...So the offshoring of any jobs will produce job seekers who will tend to push wages down even in industries in which outsourcing isn’t happening. Far more significantly, the mere threat of moving jobs offshore is enough to hold wages down—those growing armies of skilled workers around the world are increasing the labor supply in many occupations, and the immutable law of markets is that when supply goes up, prices come down. It has happened in all kinds of other markets—food, clothing, microchips, appliances. Why not in labor?

Some economists believe they see it happening already. They note that something extremely odd occurred in the U.S. economy last year: Average compensation, including pay and benefits, fell. That is a rare event; the last time it happened was 14 years ago. More important, it usually happens in or around recessions or when productivity is going nowhere. But last year wasn’t like that. Productivity rose. The economy grew. The unemployment rate was low and falling. Every indicator pointed to strong wage increases, but just the opposite happened. Now some of the nation’s most eminent economists, including professor Richard B. Freeman of Harvard and Stephen Roach of Morgan Stanley, believe the supply of overseas workers in newly globalizing labor markets is holding U.S. pay down and will do so for years.

All those university graduates in China and India threaten U.S. living standards in another way. Paradoxically, it’s not because they’ll end up working for U.S. employers, but because some of them won’t, finding jobs instead with domestic companies in their own countries. That’s a problem for America if many of those graduates are top students in science and engineering.

You might wonder why we’re constantly reading about Chinese graduates in engineering and not in law, medicine, literature, or philosophy. Why this veneration of the pocket-protector set? Engineering is fine, but there’s more to life than technology, isn’t there? Obviously there is. The question—and for America and the West it’s a huge question—is whether there can be economic dominance without technology leadership.

...The Task Force on the Future of American Innovation, a group of academic societies, high-tech companies, and industry associations, concludes in a recent report that "the United States still leads the world in research and discovery, but our advantage is rapidly eroding, and our global competitors may soon overtake us." Aggregate R&D spending by six fast-growing economies (China, Ireland, Israel, Singapore, South Korea, Taiwan) is on track to exceed U.S. spending in a few years. Industrial R&D continues to increase, but 71% of that spending is on development, not the kind of basic research that created the transistor and the laser. Federal funding of research in the physical sciences has been declining as a percentage of GDP for 30 years. The Council on Competitiveness, consisting of CEOs, university presidents, and labor leaders, wants federal research spending increased substantially, to 1% of GDP—about $110 billion a year.

Weekend reading

LSE professor John Gray on Thomas Friedman and globalization in NY Review of books.

Globalization has no inherent tendency to promote the free market or liberal democracy. Neither does it augur an end to nationalism or great-power rivalries Describing a long conversation with the CEO of a smal Indian game company in Bangalore, Friedman recount the entrepreneur concluding: "India is going to be superpower and we are going to rule." Friedman replies: "Rule whom?" Friedman's response suggests that the present phase of globalization is tending to make imbalances of power between states irrelevant. In fact what it is doing is creating new great powers, and this is one of the reasons it has been embraced in China and India

Neoliberals interpret globalization as being driven by a search for greater productivity, and view nationalism as a kind of cultural backwardness that acts mainly to slow this process. Yet the economic takeoff in both England and the US occurred against the background of a strong sense of nationality, and nationalist resistance to Western power was a powerful stimulus of economic development in Meiji Japan.

Nationalism fueled the rapid growth of capitalism in the nineteenth and early twentieth centuries,[2] and is doing the same in China and India at the present time. In both countries globalization is being embraced not only because of the prosperity it makes possible, but also for the opportunity it creates to challenge Western hegemony. As China and India become great powers they will demand recognition of their distinctive cultures and values, and international institutions will have to be reshaped to reflect the legitimacy of a variety of economic and political models. At that point the universal claims of the United States and other Western nations will be fundamentally challenged, and the global balance of power will shift.

Interview with BCA Research economist Martin Barnes on our strange and fascinating low-return macro times.

Why do you see inflation staying low? Yeah, we've had the almost perfect conditions for inflation in the last few years. The Fed has run a very stimulative monetary policy. We have run big budget deficits. We have driven the dollar down. To top it off, oil prices are up. We've had the perfect inflationary mix, and yet we haven't really had any inflation despite that.

If you look around the world, there is no evidence of inflation at all. China is perhaps the best place to prove it. Here is a country that has been growing at 9% to 10% and effectively adopted U.S. monetary policy by pegging its currency to the dollar. Yet there is no inflation in China at all. In fact, there is deflation, and that tells you there is something very powerful going on there in terms of a supply-side boom.

In the U.S., there are tough competitive conditions. And the Internet and technology in general is still a very powerful force for disinflation. There are pockets of inflation, but the overall picture isn't all that bad. The Fed's view is there is still a problem. They are worried about labor costs going up. But a lot of the inflation indicators we look at are rolling over. Producer prices are easing.

If the economy was to continue growing really strongly here, at a 4% clip for the next year, of course, there would be pressures on resources and the unemployment rate would fall and wages would go up. But that's not likely. The economy is going to do OK -- but I don't see it growing much above trend over the next year.

Would you expect to see capital expenditures stronger than they have been? The corporate sector is still in a post-bubble world after the information-technology boom. The Enron and WorldCom scandals have also shaken up the corporate world. Corporate executives are worried also about housing bubbles and trade deficits and protectionism. It is not an environment where companies feel that they want to be great heroes and strongly expansionist.

They are investing to become more efficient, but not expanding capacity in a big way. They could have invested more strongly, given how healthy cash flows have been, but they've been focusing more on repairing balance sheets and getting their financial house in order, taking the view that the markets are rewarding them more for stronger finances than they would for being expansionist.

That attitude might change gradually the longer the economy stays OK. Then the problem becomes slowing profit growth. It is hard to make the case for capital-spending growth to accelerate. It is probably going to weaken a bit. You end up with a decent economy, but it is not going to be growing at an inflationary pace, in my view.

Friday, July 29, 2005

China macro effects

The Economist summarizes China's impact on the world economy. The effective global labor force doubled in the last decade, but global capital stock did not. Therefore, one would expect reduced returns to labor relative to capital. This is in fact the case, as can be seen from US wage data:

However, the return on capital is also currently quite low, as indicated by interest rates. Again, deflationary forces due to Chinese economic integration have allowed central bankers to keep interest rates low while maintaining price stability. Here the effects are not so clear cut, as increased demand for commodities leads to price increases, while decreased labor costs lead to deflation. Insofar as the latter effects are dominant (and the current trend corresponds to "good deflation"), central bankers would be making a mistake keeping interest rates so low. In effect, they are flooding the world with cheap capital, reducing the return on capital and producing serious misallocation of resources (housing bubbles).

China's impact on the world economy can best be understood as what economists call a “positive supply-side shock”. Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets.

The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits.

In America, Europe and Japan, the pace of growth in real wages has been unusually weak in recent years. Indeed, measured by the growth in income from employment, this is America's weakest recovery for decades. According to Stephen Roach, an economist at Morgan Stanley, American private-sector workers' total compensation (wages plus benefits) has risen by only 11% in real terms since November 2001, the trough of the recession, compared with an average gain of 17% over the equivalent period of the five previous recoveries (see chart 3). In most developed countries, average real wages have lagged well behind productivity gains.

The entry of China's vast army of cheap workers into the international system of production and trade has reduced the bargaining power of workers in developed economies. Although the absolute number of jobs outsourced from developed countries to China remains small, the threat that firms could produce offshore helps to keep a lid on wages. In most developed countries, wages as a proportion of total national income are currently close to their lowest level for decades.

The flip side is that profits are grabbing a bigger slice of the cake (see chart 4). Last year, America's after-tax profits rose to their highest as a proportion of GDP for 75 years; the shares of profit in the euro area and Japan are also close to their highest for at least 25 years. This is exactly what economic theory would predict. China's emergence into the world economy has made labour relatively abundant and capital relatively scarce, and so the relative return to capital has risen. It is ironic that western capitalists can thank the world's biggest communist country for their good fortune.

China's main impact on the world economy is to change relative prices and incomes. Not only are the prices of the goods that China exports falling; the prices of the goods that it imports are rising, notably oil and other raw materials. China is already the world's biggest consumer of many commodities, such as aluminium, steel, copper and coal, and the second-biggest consumer of oil, so changes in Chinese demand have a big impact on world prices.

China has accounted for one-third of the increase in global oil demand since 2000 and so must bear some of the blame for higher oil prices. Likewise, if China's economy stumbles, then so will oil prices. However, with China's oil consumption per person still only one-fifteenth of that in America, it is inevitable that China's energy demands will grow over the years in step with its income.

There is currently only one car for every 70 people in China, against one car for every two Americans. That implies a huge increase in oil demand, which could keep prices high for the foreseeable future, because of scarce global spare capacity. China's consumption per person of raw materials, such as copper and aluminium, is also still low, so rising demand will continue to support commodity prices.

Cheap money
Overall, the upward pressure that Chinese imports of raw materials have put on the prices of oil and other commodities has been more than offset by the downward pressure of Chinese manufactured exports. As a result, another important aspect of the China effect is low inflation.

Central bankers like to take all the credit for the defeat of inflation, but China has given them a big helping hand in recent years. China's ability to produce more cheaply has pushed down the prices of many goods worldwide, as well as restraining wage pressures in developed economies. For instance, the average prices of shoes and clothing in America have fallen by 10% over the past ten years—a drop of 35% in real terms.

A study by Dresdner Kleinwort Wasserstein reckons that China has knocked almost a full percentage-point off America's inflation rate in recent years. The recent 2% revaluation of the yuan will probably be absorbed by Chinese manufacturers trimming their profit margins and so will not be passed on into export prices. But Americans calling for a 25-30% revaluation may come to regret it: the result would almost certainly be faster inflation.

As it is, China's reduction of inflationary pressures has allowed central banks to hold interest rates lower than they otherwise would be. Three and a half years into its recovery, America's real short-term interest rates are only 0.7%, almost two percentage-points below their average at the equivalent stage in previous recoveries since 1960. This is good news for borrowers, but some economists worry that the entry of China and other emerging countries into the global economy may have affected monetary policy in ways that central banks do not fully understand.

In its latest annual report, the Bank for International Settlements (BIS) asks whether it is really desirable to maintain positive inflation rates when China is boosting the world's productive potential so dramatically and thus reducing the prices of so many goods. In other words, are central banks targeting too high a rate of inflation now that China has joined the global market economy?

During the late 19th-century era of rapid globalisation, falling average prices were quite common. This “good deflation”, which was accompanied by robust growth, is very different to the bad deflation experienced in the 1930s depression. Today, we would again have had “good deflation”—but central banks have instead held interest rates low in order to meet their inflation targets. The BIS frets that this has encouraged excessive credit growth.

This echoes a fierce debate in the 1920s. At that time, a similar jump in the world's productive potential (then caused by technology-driven productivity growth) was reducing manufacturing costs. Some economists suggested that, in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.

The Austrian school of economics offers perhaps the best framework to understand what is going on. The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.

Not only has China's disinflationary impact caused low short-term interest rates, but China is also partly responsible for the low level of long-term bond yields. To keep its exchange rate pegged to the dollar, China was the biggest buyer of American Treasury bonds over the past year. In the first six months of 2005, its foreign-exchange reserves increased by more than $100 billion, to $711 billion, of which about three-quarters are in dollars. This has also kept capital costs artificially low.

Wednesday, July 27, 2005

The future of US scientific leadership

NBER working paper by Harvard economist R. Freeman: Does Globalization of the Scientific/Engineering Workforce Threaten US Economic Leadership?

Some basic observations: fewer and fewer Americans want to be scientists and engineers (S&E). US S&E compensation growth has lagged that of doctors, lawyers and other professionals in the last ten years. Other nations, particularly in Asia, are catching up, with Asia now producing more S&E PhDs per year than the US, and China to surpass the US in PhDs per year in 2010. Freeman points out that lack of interest in S&E by native-born US students is rational - their career prospects are diminished by foreign (outsourcing) and foreign-born (immigration) competition.

Note Freeman's Proposition 2: Despite perennial concerns over shortages of scientific and engineering specialists, the job market in most S&E specialties is too weak to attract increasing numbers of US students. Nevertheless, US S&E pay rates are still high enough to attract talented foreigners. This competition further reduces the attractiveness of S&E careers to US students.

For related commentary, see my previous posts Don't become a scientist!, history repeats, brain drain slowdown and Tale of two geeks.

Abstract: This paper develops four propositions that show that changes in the global job market for science and engineering (S&E) workers are eroding US dominance in S&E, which diminishes comparative advantage in high tech production and creates problems for American industry and workers: (1) The U.S. share of the world's science and engineering graduates is declining rapidly as European and Asian universities, particularly from China, have increased S&E degrees while US degree production has stagnated. 2) The job market has worsened for young workers in S&E fields relative to many other high-level occupations, which discourages US students from going on in S&E, but which still has sufficient rewards to attract large immigrant flows, particularly from developing countries. 3) Populous low income countries such as China and India can compete with the US in high tech by having many S&E specialists although those workers are a small proportion of their work forces. This threatens to undo the "North-South" pattern of trade in which advanced countries dominate high tech while developing countries specialize in less skilled manufacturing. 4) Diminished comparative advantage in high-tech will create a long period of adjustment for US workers, of which the off-shoring of IT jobs to India, growth of high-tech production in China, and multinational R&D facilities in developing countries, are harbingers. To ease the adjustment to a less dominant position in science and engineering, the US will have to develop new labor market and R&D policies that build on existing strengths and develop new ways of benefitting from scientific and technological advances in other countries.

From the paper:

Enrollments in college or university per person aged 20-24 and/or the ratio of degrees granted per 24 year old and in several OECD countries (Australia, New Zealand, Netherlands, Norway, Finland, the United Kingdom, and France) exceeded that in the US. 5 In 2001-2002, UNCESCO data show that the US enrolled just 14% of tertiary level students – less than half the US share 30 years earlier. 6 In most countries, moreover, a larger proportion of college students studied science and engineering than in the US, so that the US share of students in those fields was considerably lower than the US share overall. In 2000, 17% of all university bachelor’s degrees in the US were in the natural sciences and engineering compared to a world average of 27% of degrees, and to 52% of degrees in China.

...Overall, the U.S. share of world S&E PhDs will fall to about 15% by 2010. Within the US, moreover, international students have come to earn an increasing proportion of S&E PhDs. In 1966, US-born males accounted for 71% of science and engineering PhDs awarded; 6% were awarded to US-born females; and 23% were awarded to the foreign-born. In 2000, 36% of S&E PhDs went to U.S.-born males, 25% to U.S.-born females and 39% to the foreign-born. 8 Looking among the S&E fields, in 2002, international students received 19.5% of all doctorates awarded in the social and behavioral sciences, 18.0% in the life sciences, 35.4% in the physical sciences, and 58.7% in engineering. 9

...Whichever indicator one examines, the evidence suggests that the job market for most scientists and engineers in the US has fallen short of the job markets in competitive high level occupations. Exhibit 3 records levels of pay and rates of change in pay from the Census of Population. It shows that scientists and engineers earn less than law and medical school graduate, and that rates of increase in earnings for science and engineering in the 1990’s fell short of the rates of increase for doctors and lawyers and for persons with bachelor’s degrees. The Census comparisons of the income between S&E doctorates and persons obtaining medical or law professional degrees understate the lower income associated with the PhD trajectory. Doctoral graduate students typically spend 7-8 years earning their PhD – a quarter of their post-bachelors working life – during which they are paid stipend rates. In some disciplines, notably the life sciences, most spend 3 or so years doing postdoctoral work, again at stipend incomes that fall far below alternative salaries available to bachelors degree holders or those with professional degrees. Since postdocs work many hours, their pay is particularly low on an hourly basis for someone with their years of education. Given their lengthy training and post-doctoral work, many S&E doctorates do not enter the “real job market” until they are in their mid-30s, by which time many of their undergraduate classmates who chose other careers are well-established in their work lives. The comparison with managers with 2 years of post-bachelor’s training does not adequately reflect the payoff to MBAs since the post-bachelor’s education refers to any sort of further education, not to that degree.

...In 1973, roughly 73% of new PhDs obtained faculty jobs within three years of earning their degrees. By 1999, just 37% of new PhDs obtained faculty jobs within three years of earning their degrees.

Tuesday, July 26, 2005

Portrait of a mathematical geneticist

An interesting PLoS interview with Neil Risch (via the blog Gene Expression.)

Neil Risch (Caltech BS in math; PhD in biomathematics from UCLA) is the Lamond Distinguished Professor in Human Genetics and Director of the Center for Human Genetics at the University of California, San Francisco, California, United States. He has held faculty appointments at Columbia, Yale, and Stanford Universities.

I have a strong problem with the way politicians use this information. [Former President] Clinton, for example, when the first draft of the human genome sequence came out, made a statement about how all people in the world, in terms of their genetic makeup, are 99.9% the same. His intent—to reduce conflict among peoples—is noble. People on the left, anthropologists and sociologists, do the same thing. They use the 99.9% figure as an argument for social equality. But the truth is that people do differ by that remaining 0.1% and that people do cluster according to their ancestry. The problem is that others could use that information to create division.

From NYT, March 20, 2003:

A view widespread among many social scientists, endorsed in official statements by the American Sociological Association and the American Anthropological Association, is that race is not a valid biological concept. But biologists, particularly the population geneticists who study genetic variation, have found that there is a structure in the human population. The structure is a family tree showing separate branches for Africans, Caucasians (Europe, the Middle East and the Indian subcontinent), East Asians, Pacific Islanders and American Indians.

Biologists, too, have often been reluctant to use the term "race." But this taboo was broken last year by Dr. Neil Risch, a leading population geneticist at Stanford University. Vexed by an editorial in The New England Journal that declared that race was "biologically meaningless," Dr. Risch argued in the electronic journal Genome Biology that self-identified race was useful in understanding ethnic differences in disease and in the response to drugs.

Race corresponded broadly to continental ancestry and hence to the branches on the human family tree described by geneticists, he said. Expanding this argument today, Dr. Risch and nine co-authors say that ignoring race will ‘retard progress in biomedical research.’ Racial differences have arisen, they say, because after the ancestral human population in Africa spread throughout the world 40,000 years ago, geographical barriers prevented interbreeding. On each continent, under the influence of natural selection and the random change between generations known as genetic drift, people would have diverged away from the common ancestral population, creating the major races. Within each race, religious, cultural and geographical barriers fostered other endogamous, or inbreeding, populations that led to the ethnic groups.

Monday, July 25, 2005

WSJ on leadup to revaluation

WSJ on the leadup to revaluation. Careful preprations began two years ago, but the Senate tariff threat determined the timing. Treasury officials were on the ball.

Behind Yuan Move, Open Debate and Closed Doors
Two-Year Saga Included Secret and Staged Meetings, Weeks of Quiet Diplomacy
By JAMES T. AREDDY in Shanghai, NEIL KING JR. in Washington, MARY KISSEL in Hong Kong and JASON DEAN in Beijing
July 25, 2005; Page A1

Last Thursday morning, several key foreign banks were asked to send a representative to the headquarters of the People's Bank of China, the central bank. The topic wasn't clear.

The meeting began around the time China's foreign-exchange market was closing for the day at 3:30 p.m. As a central-bank official began to talk, the doors were shut and locked.

"They started talking about something that wasn't very useful and then started to collect mobile phones and BlackBerrys," said a banker who was briefed later. The Chinese then distributed a four-point statement: Beijing was unlinking the yuan from the U.S. dollar effective immediately.

Then another surprise: The bankers were told they would have to cool their heels until an official statement was read nearly three hours later on China's government-controlled 7 p.m. news program.

That last-minute combination of surprise and secrecy was in keeping with the long-running drama over the yuan. It is a saga whose twists and turns included secret trips to Beijing by a U.S. envoy, debates among Chinese ministries about how much to revalue, and a seaside conference in China that featured American economists debating before an audience of high-level Chinese officials whether or not revaluation made sense.

According to U.S. and Chinese officials, China began thinking about allowing the yuan to rise in value against the U.S. dollar in 2003 with the accession to power of a younger, reform-minded generation of Chinese leaders led by President Hu Jintao and Prime Minister Wen Jiabao. Leading the push for change was the newly appointed head of the central bank, the scholarly, English-speaking Zhou Xiaochuan.

Foreign bankers consider Mr. Zhou one of the best of a new breed of senior Chinese officials familiar with the intricacies of global economics and market economies. Before running the central bank, Mr. Zhou spent 20 months as China's top stock-market regulator, but his credibility stemmed from top central-banking positions through the 1990s.

Proponents of a change in the yuan argued that more countries were moving toward flexible exchange-rate systems and that blindly tying the yuan to the value of the dollar kept China's financial system dangerously closed, hobbling the development of needed overhauls like market interest rates.

Opponents feared the impact a change would have on China's booming exports. A stronger yuan would tend to make China's exports more expensive relative to other countries' exports. And some were chafing at what was already becoming a drumbeat of American criticism of China's currency policy.

People were saying, " 'Why should we have to listen to what America says,' " said a Chinese official familiar with the yuan debate. Yet, similar debates about the currency policy were taking place among Chinese leaders, their views emerging through ministry-linked think tanks and reported prominently in the nation's financial media.

In the spring of 2003, the People's Bank stepped up its study of China's peg to the dollar and whether the government should make a change. It held staff seminars on exchange-rate and macroeconomic management, and invited leading U.S. economists to Beijing to present their views. The central bank also sent officials to the Hong Kong Monetary Authority, the city's central bank, and the U.S. Federal Reserve for training.

Aware of the research taking place inside the central bank, economists at investment banks in Hong Kong and China began confidently predicting that China would scrap its peg to the dollar. That accelerated a guessing game in the financial markets about the yuan that would last for the better part of two years.

Meanwhile, in Washington, criticism of China swelled as the U.S. trade deficit with China widened. In 1998, U.S. officials had praised China for sticking with its fixed peg to the dollar during the 1997 Asian financial crisis. But now the U.S. and many European countries charged that the yuan was grossly undervalued and gave China an unfair advantage selling its products overseas.

Hoping to deflate the issue, U.S. Treasury Secretary John Snow flew to Beijing in early September 2003 to meet with Mr. Zhou and Chinese Finance Minister Jin Renjing. The Chinese adopted what became a very familiar line: They might one day move to a more-flexible exchange rate, but never under U.S. pressure.

Three times in 2004 Mr. Snow met with his Chinese counterparts to seek some sign of progress on the currency issue, each time coming away with little to show to increasingly vocal critics back home. China, in the meantime, was quietly stepping up its meetings with officials at the Monetary Authority of Singapore, the city-state's central bank.

Singapore was one of the most successful adherents to a managed floating exchange-rate system, presiding over an expanding economy and keeping inflation in check for several decades. China's central bankers sent midlevel staff for extended visits to Singapore's central bank to learn how it managed its exchange-rate regime.

In May 2004, China hosted a two-day conference in the seaside town of Dalian. Beijing-based officials, including Mr. Zhou and his deputy, listened to presentations on exchange-rate management from top American economists. Stanford University's Ronald McKinnon and Columbia University's Nobel Prize-winning Robert Mundell didn't support a change to China's peg to the dollar. Harvard University's Jeffrey Frankel and Morris Goldstein of the Institute for International Economics in Washington did. One big risk they saw to adjusting the exchange rate was that too small a change could prompt speculators to demand more, a situation China may now face.

At the end of the conference, a senior Chinese bank official stood up and said China planned to follow Mr. Mundell's advice in the short term and Mr. Goldstein's advice in the long term, "only we're not going to tell you how long the short term will be."

In Washington, congressional anger over the yuan came to a boil this spring. On April 6, Sen. Charles Schumer, a New York Democrat, and Sen. Lindsay Graham, a South Carolina Republican, pushed an amendment to the annual State Department spending bill that would impose 27.5% duties on all Chinese imports if Beijing didn't agree to revalue its currency. A vote to reject the amendment was defeated, 67-33. It was an overwhelming vote of support for the anti-China legislation -- especially coming from a chamber not known for its protectionist passions -- and it surprised the Bush administration.

Within the Treasury Department, the tone shifted markedly. "There was a sense of exhaustion over defending the Chinese," said a Treasury official. "There was a general sense of being tired."

On May 19, Mr. Snow appointed a special envoy to China on the currency issue, Olin Wethington, a longtime Treasury official who had just brokered a huge settlement for much of Iraq's international debt. Mr. Wethington left the next day on the first of what became three unpublicized, weeklong trips to Beijing during the next three months. "We made a judgment that...there was ample room for a quiet discreet effort out of the limelight," said another Treasury official. "But we realized we needed to broaden the dialogue within the regime and to reach into other parts of the government and to raise the issue much higher in the hierarchy."

During the next seven weeks, Mr. Wethington and his team met with political and business leaders in China, including officials in the Foreign Ministry, the president's office, the central bank and the upper ranks of the Communist Party. Mr. Wethington told the Chinese that if they didn't give significant flexibility to their exchange rate, there could be adverse consequences on the U.S. side.

By May, according to officials with the International Monetary Fund, it was becoming clear the Chinese were preparing to value the yuan against a basket of currencies and were spending a great deal of time with monetary authorities in Singapore to see how their system worked. The IMF had been pushing Beijing for several years to adopt the basket-of-currencies approach.

Inside China, people who deal with the central bank say, the bank was pushing for an initial 5% revaluation of the yuan against the dollar. But under pressure from other ministries that feared the impact on China's exports, China's State Council, or cabinet, decided instead on 2.1%.

On his final trip to China, late last month, Mr. Wethington picked up strong signals that the Chinese were ready to move on the yuan. But they also made clear that they would do nothing under direct pressure from the Bush administration or Congress. So on June 30, in a highly visible move, Fed Chairman Alan Greenspan and Mr. Snow went up to Capitol Hill for a highly staged closed-door session with Sens. Schumer and Graham.

The Chinese were ready to budge, the senators were told, but only if the Senate put aside its tariff threat. The senators emerged from the meeting and announced that they were delaying any vote on the amendment until after the August recess.

Late Wednesday, hours before the rest of the world heard of China's decision, the Bush administration received official word from Beijing that China was ready to alter its exchange rate and adopt what the central bank calls a managed floating-exchange rate that includes reference to a basket of unnamed currencies. Hong Kong was also told in advance, said a person with knowledge of the situation.

The next day, shortly before 7 p.m., Chinese officials delivered the government's official statement to the chief editor of China's main evening news program with directions that it be read at the top of the news. The statement was also placed on the Web sites of China's central bank and the official Xinhua news agency, both of which crashed under an avalanche of Internet hits.

Sunday, July 24, 2005

Revaluation and reactions

Below are two enlightening comments which appeared on Brad Setser's blog, discussing the revaluation and related macro topics.

CSFB has the right perspective, think of it as transferring two percentage points of purchasing power from a country (USA!) with a low personal savings rate to a country with a high PSR :D

then, keep in mind that ~2/3 of the PRC's pop. still resides in the 'countryside'/local villages whose average wage is 45 cents/hr...

then note the revaluation of capital that globalisation has wrought relative to labor...

"Harvard economist, Richard Freeman, has calculated that the global workforce has doubled since the fall of the Iron and Bamboo Curtains as a result of the effective addition of workers from China, India and the former Soviet Union. According to Freeman, the capital/labor ratio has been lowered to 55%-60% of what it would be otherwise, thereby reducing the return to labor and increasing the return to capital. As Freeman said, "A decline in the global capital/labor ratio shifts the balance of power in markets toward capital as more workers compete for working with that capital." Based on Freeman's calculations, thirty years will need to elapse before the global economy returns to the capital ratio that existed when the Iron Curtain fell. If true, this implies an extended period of low inflation."


...lex goes on to note that this arrangement will continue to invite speculation and bubbles, but i would just note that this unstable equilibrium continues to be in the best interest of both parties, at least over the near-term, and as long as 'measured' steps -- so as not to destabilise the unstable equilibrium -- are being take to reduce imbalances in the long-run, then the longer this arrangement can last and eventually (hopefully) morph into something more stable :D


...There is an enormous flow of capital and money out of the industrialized world. Some of it does return in terms of profits and salaries, but a good percentage of those profits never find their way into public coffers. The rich get very rich. There is no way longer any way of really getting a slice of those profits to pay the national bills. In addition, downward pressure on average wages continues.

Cheap labor has been substituted for investment. Credit is cheap. With profits and cheap labor at these quantities, who needs credit? I do not see this as a conundrum. The pump has been primed from every conceivable direction: tax incentives and cheap labor abroad, tax cuts at home.

Ten million Chinese work for a foreign enterprise. The size of that cheap labor force is staggering. And it is only a tip of the Chinese iceberg. And we have yet to touch India. We are living through a boom economy, except the boom is not really heard here. We are paying for it. The dimensions of that boom cause Chinese entrepreneurs to open fake off-shore businesses, pose as foreign investors, and then be eligible for all the goodies--roundtrip investors, they are called. With credit like this, is there any wonder that capital returns cannot be measured by real interest rates? Hell, I should start such a business. Bet doing so is dirt cheap. No loans required. And, you do not needed real investment in automation or equipment when labor is dirt cheap. Look at what the Egyptians did with the pyramids, or the Chinese with the Great Wall.

Normal Keynsian economics was not prepared for anything like globalization of this magnitude or style. There is a glut of capital and credit and labor. And it is coming at the American taxpayer's expense. The average American consumer is going deeper and deeper into debt. Average credit card debt in the U.S. is over $9000. And the interest rates are hefty there! And then place that number against the median wage: credit card debt then becomes one-fourth of the median wage. Some are living on a knife's edge here.

When the bubble does burst, who will pay the bills, personal and national?

The knot that has been tied is Gordian, as Volcker says. There is no easy way out of this one. We cannot wait until China becomes a "consumer society"-- a ten or fifteen year pipe dream. After China, there is India. After India, who knows.

Thursday, July 21, 2005

Revaluation really was imminent

Wow, the yuan-dollar peg is now a moving yuan-basket peg. Only a 2% move for now, but stay tuned for further developments. The 10 yr yield is up to 4.28 today, so 10y treasuries lost about 2.5% in value in a single day. For some historical perspective, see here for a graph of dollar-yen in the wake of the Plaza Accord -- the dollar dropped by more than a factor of 2-3 against the yen in the following decade.

BEIJING, July 21 - Following months of political pressure, China today revalued the yuan to 8.11 for every dollar, scrapping a decade-long peg to the currency in favor of a more flexible band using a "basket of currencies."

China's announcement, which has been anticipated and debated by economists and government leaders for months, is the first time in a decade that China has raised the value of its currency, also known as the renminbi, effectively making the yuan and exports more expensive against the United States dollar.

The move represents China's first step toward the more flexible exchange rate that the United States, Europe and many other countries have called for in recently. Until the announcement, the yuan sold for 8.27 for every dollar, a rate that has remain unchanged since 1998.

The change falls far short of the 10 percent to 15 percent revaluation demanded by many in Washington, where the Bush Administration and Congressional leaders have been calling for a higher yuan, in part to alleviate America's growing trade deficit with China.

Risk aversion, brain damage and gambling

WSJ: Brain damage which impairs emotional response might actually make you a better investor or gambler! Note that in this study the odds are specified with mathematical precision. In real markets gauging the psychology and emotions of others is very important. What is needed is an emotionless automaton with insight into the human condition :-)

Lessons From The Brain-Damaged Investor Unusual Study Explores Links
Between Emotion and Results; 'Neuroeconomics' on Wall Street

People with certain kinds of brain damage may make better investment decisions. That is the conclusion of a new study offering some compelling evidence that mixing emotion with investing can lead to bad outcomes.

By linking brain science to investment behavior, researchers concluded that people with an impaired ability to experience emotions could actually make better financial decisions than other people under certain circumstances. The research is part of a fast-growing interdisciplinary field called "neuroeconomics" that explores the role biology plays in economic decision making, by combining insights from cognitive neuroscience, psychology and economics. The study was published last month in the journal Psychological Science, and was conducted by a team of researchers from Carnegie Mellon University, the Stanford Graduate School of Business and the University of Iowa.


A new study shows people with brain damage that impaired their ability to experience emotions such as fear outperformed other people in an investment game.
• The brain-damaged participants were more willing to take risks that yielded high payoffs.

• They were less likely to react emotionally to losses.

• They finished the game with 13% more money than other players.

The 15 brain-damaged participants that were the focus of the study had normal IQs, and the areas of their brains responsible for logic and cognitive reasoning were intact. But they had lesions in the region of the brain that controls emotions, which inhibited their ability to experience basic feelings such as fear or anxiety. The lesions were due to a range of causes, including stroke and disease, but they impaired the participants' emotional functioning in a similar manner.

The study suggests the participants' lack of emotional responsiveness actually gave them an advantage when they played a simple investment game. The emotionally impaired players were more willing to take gambles that had high payoffs because they lacked fear. Players with undamaged brain wiring, however, were more cautious and reactive during the game, and wound up with less money at the end.

Some neuroscientists believe good investors may be exceptionally skilled at suppressing emotional reactions. "It's possible that people who are high-risk takers or good investors may have what you call a functional psychopathy," says Antoine Bechara, an associate professor of neurology at the University of Iowa, and a co-author of the study. "They don't react emotionally to things. Good investors can learn to control their emotions in certain ways to become like those people."

...In the late 1990s, when the links between psychology and neurobiology were firmly established, behavioral economists began turning to neuroscientists, in addition to psychologists, for help explaining human behavior. The idea was that if brain chemistry could explain phenomena such as depression or attention deficit disorder, it might also help explain more mundane psychological functions, such as how people reach financial decisions.

Behavioral economists, like Princeton's Daniel Kahneman, who won the Nobel Prize for Economics in 2002, began teaming up with neuroscientists, like Peter Shizgal at Concordia University in Montreal. In one study, the pair used gambling games and neuroimaging techniques to look what part of the brain is triggered when people anticipate winning money. They found that monetary rewards trigger the same brain activity as good tastes, pleasant music or addictive drugs.

The 41 participants in the new study included people with and without brain damage, including a control group of participants with brain damage that didn't affect their emotional processing. Players were given $20 and asked to play a simple gambling game that involved 20 rounds of coin tosses. If they won a coin toss, they earned $2.50. If they lost the toss, they had to give up a dollar. They could choose not to play in any given round, in which case they kept their dollar.

Logic indicates that the best strategy was to take the gamble in every round of the game, since the return on a win was much higher than the potential loss, and the risk in each round was 50-50. The players with emotion-related brain damage took a more logical strategy, investing in 84% of rounds, while the nonbrain-damaged players invested in just 58% of the rounds. Emotionally impaired participants outperformed the nonbrain-damaged participants, winding up with an average of $25.70 versus $22.80 at the end of the game.

The researchers believe fear had a lot to do with the poor performance of nonbrain-damaged participants. "If you just observe these people, they know the right thing to do is invest in every single round," says Baba Shiv, an associate professor of marketing at the Stanford business school and a co-author of the study. "But when they actually get into the game, they start reacting to the outcomes of the previous rounds."

Yet emotions may play a useful role in financial decision making. While the brain-damaged players did well in the specific game in the study, they didn't generally perform well when it came to making financial decisions in the real world. Three of four of the brain-damaged players had experienced personal bankruptcy. Their inability to experience fear led to risk-seeking behavior, and their lack of emotional judgment sometimes led them to get tangled up with people who took advantage of them. Their life experience suggests emotions can play an important role in protecting our interests, even if they sometimes interfere with rational decision making.

Humans developed this fear response as a survival mechanism to protect against predators. But in a world where predators aren't lurking around every corner, this fear system can be over-sensitive, reacting to dangers that don't actually exist and pushing us toward illogical choices.

"There was no such thing as stock in the Pleistocene era," says George Loewenstein, a professor of economics at Carnegie Mellon University, and a co-author of the study. "But human beings are pathologically risk averse. A lot of the mechanisms that drive our emotions aren't really that well adapted to modern life."

Tuesday, July 19, 2005

Instant companies

This excellent article (PDF) from Business2.0 discusses the drastically reduced barriers to entry for designing, manufacturing, marketing and distributing new products. The combination of Web collaboration platforms, outsourced design and outsourced manufacturing (typically in China) are changing the landscape dramatically.

A related phenomena is the "long tail" -- as you might expect, the distribution of market sizes in a product category is a power law, with a few big niches and lots of smaller ones. Now, with efficient search and distribution using the Web, small virtual companies can profitably attack the smaller niches. The winner, of course, is the consumer, who has greater and greater access to inexpensive and innovative goods.

The first question for anyone who wants to build the next superstar widget is this: What's it going to look like? Arriving at an answer was traditionally an arduous task, an age-old struggle between designers and manufacturing engineers to balance what's desirable and what's possible. But the new army of hit makers is getting it done faster and cheaper than ever before. Take Kidrobot founder Paul Budnitz, who describes himself as a "decent artist and database programmer." Just three years after Budnitz began selling collectible dolls on the Web, sales of the figurines -- inspired by hip-hop culture and Japanese anime -- are on track to hit $5.5 million in 2005. There are bustling Kidrobot stores in Los Angeles, New York, and San Francisco and a TV cartoon deal in the works. Aside from salespeople in the stores, Kidrobot has only 11 employees.

To create new characters, Kidrobot's designers first sketch them using Adobe Illustrator, the off-the-shelf drawing program that goes for $500 a copy. They produce six views of each toy, plus blowups of detailed areas like eyelashes. Then they move to Basecamp. Released less than a year ago by software maker 37signals, Basecamp is a Web-based application that links everyone who works on Kidrobot's toys -- from its New York City design team to manufacturers in China. Established toy companies spend tens of thousands of dollars shuttling designers around the world to iron out product details. Kidrobot pays about $100 per month for Basecamp.

Once Budnitz is satisfied with the initial designs, his team uses Basecamp to share Illustrator files with engineers in China who transform them into clay or wax models. One week later the models arrive in New York. With Basecamp acting as the messenger, the two sides repeat the back-and-forth until the toys meet Budnitz's approval. The final design -- along with specs for paint and form-fitting packaging - is then uploaded to Basecamp, and 30 days later finished toys march off production lines in China. "I can have as many as 40 toys in various stages of production at one time, and we can still manage all of these projects with just a few people," Budnitz says. "It's stupid simple."

...Outsourced manufacturing has long been available to the big guys. But thanks to folks like Yu, it's now an option for anybody. Born and raised in the United States, Yu is as comfortable in North America as she is flitting between her office in Taiwan, her shipping center in Hong Kong, and the Union Electric factory in southern China. In addition to Color Kinetics, Yu's clients include Brookstone, Discovery Channel Stores, and RadioShack (RSH). She has shepherded the manufacture of singing cake cutters, golf pedometers, and scads of digital recording devices. Through her, companies tap into some of the deepest manufacturing expertise on the planet -- at a third of what similar work would cost in the United States. "In the States they have such great ideas, but they don't know how to put those ideas into production and they don't have the infrastructure to do it," Yu says. "We do."

...Start with Google: Type in "China," "manufacturer," and your product and you'll get a list of factories. Or look on eBay for something similar to your gizmo and research who made it.

Sunday, July 17, 2005

Hard times in Japan

From Time magazine. Increased inequality and competition... is this our future, or are we already there?

A decade ago, 90% of Japanese considered themselves "middle-class." In an Asia-wide survey conducted by U.T. last year, however, 60% of Japanese now rate their economic status as "below middle-class." The public's increasing awareness of kakusa shakai is reflected in the Japanese media's obsession with who is up and who is down. Whether in magazines, on TV chat shows or on bookstore shelves, the domestic debate is dominated by the idea of kachigumi and makegumi ("the winning team" and the "losing team"). Fashion magazines are filled with beauty tips to marry early and avoid being a poor, single woman.

Yet, while the poor get poorer, the rich are getting richer. Last month, the national tax agency released its annual list of the country's top 100 taxpayers. Tatsuro Kiyohara, a 46-year-old fund manager at Tower Investment Management, ranked No. 1, with a tax bill that suggested a personal income of approximately $100 million. This marked the first time a wage earner had captured the top spot, an occasion that many writers and talk-show hosts alternately hailed and lamented as a signature moment in the new, more Darwinian society—for Kiyohara's pay is almost entirely performance-based.

Will American workers displaced from jobs in manufacturing, textiles and other industries really be able to "move up the value chain"? Younger Japanese are already facing these issues as their economy "hollows out" in the face of competition from China - Japan's number one trading partner.

Naoki Ijiri... jobless gloom. The 25-year-old polytechnic college graduate had come to the job-placement office this spring after searching fruitlessly for work for six months—long enough to convince himself that he would never find a career to match his training as an environmental-systems engineer.

"People like me who aren't particularly talented at anything are happier with the old system of lifetime employment and seniority-based salaries," he says. "The supposed 'chances and opportunities' that a competitive economy offers is for those who are already steps ahead." Ijiri later found work as a security guard, hardly the future he once envisioned for himself.

...Akiko Miyamoto, manager of the unemployment office that Sasamoto frequents, says she sees the same story again and again: a sense of entitlement and unrealistic expectations followed by depression and paralysis once the going gets tough. "People come in wanting to be designers or photographers or editors," she says, "but there are very few jobs in those fields posted here."

Saturday, July 16, 2005

Missile gap

The Times recently reported a Chinese general's remarks that war over Taiwan could lead to the destruction of hundreds of US cities. China (unlike the US) has an official "no first use" policy for nuclear weapons - previously, it has stated it will only use them in retaliation against nuclear attack. However, Zhu Chenghu's hawkish remarks may constitute some signalling to the US military that the Chinese position is changing. Zhu said he had previously made similar remarks to Adm. Blair, the former commander in chief of the United States Pacific Command. We'll have to see how far Beijing distances itself from Zhu's remarks.

Estimates of the size of China's ICBM arsenal have not changed in 20 years. Reports usually state that they have only 10-20 liquid-fueled missiles capable of reaching the US (albeit now MIRVed with miniaturized warheads similar to the W88 - how similar is a controversial question). However, China's capacity for production of ICBMs and warheads (one can extrapolate from their satellite launch and nuclear programs) suggests that the old estimates are drastically low. Even Israel is estimated to have hundreds of warheads in its arsenal.

The General's comments may have been carefully calculated by the Chinese military in order to force US planners to consider the possibility of a nuclear strike on a US carrier group in the area (or even a strike on US bases in Okinawa or Guam) in the event of a conflict over Taiwan. Zhu sounds bloodthirsty, until we recall that MacArthur wanted to use nuclear weapons against China during the Korean war (this nuclear "blackmail" was an important impetus to Mao to push for a Chinese atomic bomb, although he never admitted it publicly) and that the French wanted the US to save their garrison at Dien Bien Phu (Vietnam) with nuclear bombs. During the cold war, NATO reserved the right to use nuclear weapons in the face of superior Soviet conventional forces.

"If the Americans draw their missiles and position-guided ammunition on to the target zone on China's territory, I think we will have to respond with nuclear weapons," the official, Maj. Gen. Zhu Chenghu, said at an official briefing.

General Zhu, considered a hawk, stressed that his comments reflected his personal views and not official policy. Beijing has long insisted that it will not initiate the use of nuclear weapons in any conflict.

...China has had atomic bombs since 1964 and currently has a small arsenal of land- and sea-based nuclear-tipped missiles that can reach the United States, according to most Western intelligence estimates. Some Pentagon officials have argued that China has been expanding the size and sophistication of its nuclear bombs and delivery systems, while others argue that Beijing has done little more than maintain a minimal but credible deterrent against a nuclear attack.

"If the Americans are determined to interfere, then we will be determined to respond," he said. "We Chinese will prepare ourselves for the destruction of all the cities east of Xian. Of course the Americans will have to be prepared that hundreds of cities will be destroyed by the Chinese."

Friday, July 15, 2005

Revaluation imminent?

Has push come to shove?

From today's Financial Times:

US expects Chinese currency revaluation
By Demetri Sevastopulo and Andrew Balls in Washington, and Richard McGregor in Beijing
Published: July 15 2005 02:08 | Last updated: July 15 2005 04:16

The Bush administration has told key senators that it expects China to revalue its currency in August ahead of a planned visit to Washington by President Hu Jintao in September, according to people familiar with the matter.

Senators Charles Schumer and Lindsey Graham, co-sponsors of a bill that would impose a 27.5 per cent tariff on Chinese imports, agreed to delay a vote on their bill after receiving what they regarded as an assurance that China will move on its currency next month.

In a June meeting attended by Alan Greenspan, Federal Reserve chairman, John Snow, Treasury secretary, told the senators that he believed China would allow the value of the renminbi to increase against the dollar in August, the people familiar with the discussion said.

“Senator Graham and I believe that the administration is convinced that China will begin a revaluation process this summer, forced by our bill's success in the Senate,” Mr Schumer told the FT.

Thursday, July 14, 2005

China property bubble, carry trade and all that

Interesting comments from the GaveKal research group (see here and here for more). They're forecasting a strengthening dollar, no renminbi revaluation and a weakening euro. Looks like an interesting multi-lingual group of analysts with a lot of HK experience.

...all of our work has constantly drawn up the same conclusion: in the past couple of years, Asian central bank reserves have grown much more rapidly than domestic current account surpluses and foreign direct investments; in recent years, Asian countries have managed to save more than they have earned. Last year, in China, the difference was some US$80bn... or nearly 6% of Chinese GDP.

This, of course, begs the question of where this money came from? The answer, we believe, is simple enough: the excess US$ that have showed up in central bank reserves represent borrowed US$; not earned US$. A quick example: in 2003, most of the simpletons who sit in the GaveKal HK office became convinced that the RMB was set to revalue. To cash in on this one time bonanza, a "get-rich quick" scheme was put together: the first step involved purchasing real estate on the Mainland (one of the few RMB denominated assets easy for foreigners to purchase). The second step involved securing mortgages on the property denominated in US$. The end result was clear: a US$ liability attached to a RMB asset. Elementary my dear Watson...

So elementary in fact that, as the rumors of a RMB revaluation accelerated, everyone and their dog got in on the trade. And before we knew it, we faced a) a massive construction boom in every Chinese city (hereby depressing rental yields) and b) a growth in the PBoC's US$ reserves that had nothing to do with either trade or direct investment flows and everything to do with speculative leverage.

With an economic slowdown unfolding in China, a revaluation becoming increasingly unlikely, a rising US$, rising US interest rates, and Chinese companies lining up to get money out of China, a number of participants (from Taiwan, HK, Singapore, Indonesia....) in the above real-estate/RMB trade might start to re-think whether the above trade is as one-sided as it appeared two years ago. If they conclude that it isn't, some will sell, turn their RMB to the PBoC and ask for the US$ back to re-pay the bank. Now obviously, the PBoC is swimming in a sea of US$. So it will have no problems meeting that demands for reimbursement. But as it reimburses, the Chinese money supply will shrink. Unless, of course, the PBoC allows the RMB to fall, which, given current political circumstances is unlikely.

The extent by which the Chinese money supply will shrink could well end up being dictated by the extent to which the PBoC has engaged in "reserve diversification". Indeed, if the PBoC has used the "borrowed US$" to buy Euros, AU$ or Yen, then as speculators come forth and ask for their US$ back, the PBoC will be in a bind. It will need to cash in the speculators demand, and sell Euros or Yen at the same time to make sure it maintains enough US$ to defend the RMB peg.

Needless to say, the operation of the PBoC are very opaque, and we have no idea the extent to which they have engaged in reserve diversification. But we know more or less what the Hong Kong Monetary Authority has been up to; our friend David Scott writes: "the HKMA might have cut its US$ holdings to around 70% of total reserves. This is very bullish for the US$. The HKMA has a 100% Dollar target for its currency. So now it faces a) rising US interest rates relative to other currencies - so relative yields on its investment portfolio will be suffering. b) Rising HK rates relative to Euro rates ie the cost of its liabilities will be rising relative to the yield on its assets. c) a partial currency mismatch. We believe the unwinding of the US$ carry trade will affect Asia disproportionately; especially countries with pegged currencies (HK, Malaysia, China) which will be unable to cope with the unwinding of the US carry-trade by allowing their currencies to weaken (something Japan and Thailand are already doing).

Wednesday, July 13, 2005

Iraq, oil and realpolitik: the view from China

This Washington Post article describes the view from China concerning oil, the US invasion of Iraq and future geopolitical conflict.

One issue I have not seen discussed by oil analysts is that China is only now building a strategic reserve capacity (previously, they have not had any strategic reserve). Could their one-time purchases to stock the reserve be driving up current oil prices? Perhaps $60 per barrel is not indicative of future prices.

...Through cultivation of Saddam Hussein's government, China sought to develop some of Iraq's more promising reserves. Beijing advocated lifting the United Nations sanctions that prevented investment in Iraq's oil patch and limited sales of its production.

Then the United States went to war in Iraq in 2003, wiping out China's stakes. The war and its aftermath have reshaped China's basic conception of the geopolitics of oil and added urgency to its mission to lessen dependence on Middle East supplies. It has reinforced China's fears that it is locked in a zero-sum contest for energy with the world's lone superpower, prompting Beijing to intensify its search for new sources, international relations and energy experts say.

..."Iraq changed the government's thinking," said Pan Rui, an international relations expert at Fudan University in Shanghai. "The Middle East is China's largest source of oil. America is now pursuing a grand strategy, the pursuit of American hegemony in the Middle East. Saudi Arabia is the number one oil producer, and Iraq is number two [in terms of reserves]. Now, the United States has direct influence in both countries."

...Many other factors help explain China's motives in dispatching its energy companies abroad for new stocks. Oil demand is exploding in China as people embrace automobiles and as factories, apartment towers and office buildings proliferate. For the third summer in a row, China is rationing energy, limiting production in industrial areas.

...Concern is mounting about future prospects for China's domestic oil production, which supplies about two-thirds of the country's crude oil needs. China's government estimates that it will need 600 million tons of crude oil a year by 2020, more than triple its expected output. Worldwide, the best oil fields are already claimed.

..."Many people argue that oil interests are the driving force behind the Iraq war," said Zhu Feng, a security expert at Beijing University. "For China, it has been a reminder and a warning about how geopolitical changes can affect its own energy interests. So China has decided to focus much more intently to address its security."

...This year, China began work on a strategic oil reserve in coastal Zhejiang province that would allow the country to operate without imports for as long as three months. But the biggest emphasis has been on securing new stocks abroad, particularly in neighboring countries such as Kazakhstan and Russia, to limit dependence on shipping lanes.

Tuesday, July 12, 2005

China roundup

A must-read post by economist Brad Setser, entitled Has a slowing Chinese economy eliminated domestic pressure for a renminbi revaluation? Brad makes the point that a slowdown in the Chinese economy makes it much easier to sterilize dollar inflows:

China is not currently finding it difficult to sell domestic central bank bonds to prevent rising reserves from leading to an increase in the money supply. Sterilization has been pretty easy so far this year -- contrary to what Nouriel and I expected. On one hand, rising rates in the US mean that China is earning more on its shorter-term investments in US dollar assets. China, of course, doesn't just invest in short-term Treasuries though, so it is not obvious that rising short-term rates are having a huge impact on the overall return on China's portfolio. On the other hand, restrictions on lending growth have left China's banks with lots of spare cash -- cash that they are investing in the sterilization bills sold by the central bank. The interest rate on those bills remains well below the interest rate China earns on its reserves. On a cash flow basis, China is not losing money selling sterilization bonds to offset rising reserves. While the central banks currency risk keeps on growing, at the margin, it is not losing money selling sterilization bonds.

Some of the comments on this post are quite insightful:

"I don't think that China's card is particularly strong. They just assemble and make some stuff. Almost any nation's people can do that. "

Until you have actually seen the vast industrial complex that is China you can't imagine how out of touch with reality that statement is Movie Guy. When I describe China to people I wonder if admiral Yamamoto had the same feelings when he made the following statement (I will attempt to roughly paraphrase the original quote) "Until you have seen the oil fields Texas, the cornfields of Kansas or the factories of Detroit you cannot imagine how vast and powerful the United States is."

This is the best way for me to describe China to most Americans.

The first thing any traveler will notice about Ningbo, is that the roads around the city have no visible pot holes. In addition the roads are often vast in size and capable of accommdating massive amounts of traffic. When you drive into areas adjacent to downtown Ningbo its absolutely to see the number of truly huge factories that surround you. I don't live very far from Irvine and Costa Mesa(at least where there isn't traffic) which would be considered highly "developed" areas by American standards. Costa Mesa and Irvine are at the heart of Orange County which in turn is the heart of Southern California's high tech and manufacturing industries.

The big buildings in Orange County are dwarfed by the huge numbers of large multi story factories around Ningbo. They're everywhere new supermodern factories created with the latest and most gawdy modern architecture. Unlike crowded Orange County the Chinese made provisions for huge and smooth roads that run throughout Ningbo and its adjacent areas. The factory industrial parks present through the the Ningbo area are huge multi story buildings that put our little commercial parks to shame.

In China everything seems to be built in two sizes: huge and outrageous. So what's the implication of this: that the Chinese have an economy of scale that is unmatched anywhere. This in turn allows a huge number of highly specialized industries to thrive because the industrial ecosystem is so large that it can justify their existence.

DongGuan and Shanghai are even crazier with even high concentrations of development. More importantly however areas the outlying the key urban centers in China are cheap enough to provide low setup and land acquisition costs and close enough to easily reach key containers ports.

Jiasan for example is fairly close to Ningbo (about two hours with traffic) and illustrates this point perfectly. The road system in Jiasan is absurdedly huge, its could easily be adequate for a city like Ningbo or perhaps even LA. There are some very large factories that often occupy much more land that the factories in Ningbo. Of course like any other business city Jiasan has a downtown with a few upscale resturaunts.

...This is just one example but to me that Chinese are not just prepared for today but they are prepared to expand well into the future. Its difficult to imagine urban planning ty aking place on this level in a country other than China with its massive population. More importantly that expansion is occuring in a very controlled and systematic way.

...Unfortunately I haven't been to countryside... so I can't say how things are going there. But the urban economic machine in the cities is going full blast on a scale that would be absolutely unimaginable anywhere else in the world.

Of course more importantly China is also doing an outstanding job of producing high tech workers. China produces some 800,000 engineering graduates a year!

THe US also produces far less engineering graduates than China: only 59,445 (as of 2000). To put this in perspective 50,000 engineers joined the IT sector alone in China!

To me this would imply that the place to hire engineers probably wouldn't be the United States. More importantly however it shows that China has a huge edge in producing high quality human capital that is unmatched by any other country in the world.

And finally:

Alex made some very good comments about China’s growth. As one who has traveled extensively in rural areas in both the US and China, I can tell you that the changes in village life is not quite as dramatic... [but] Twenty years ago, any village I saw was just a few decades better off than 1,500 years ago. Now, they are on a par with villages in remote parts of developed economies (say, Sardinia in Italy or Krabi Town in Thailand). Now that’s rapid development!

Sunday, July 10, 2005

Male, female and Einstein's brains

This portrait of neuroscientist Sandra Witelson reveals some interesting details about gender differences in brain structure, and of Einstein's brain. Apparently Einstein's brain had no fissure separating the two parietal lobes.

"What is astonishing to me," Witelson said, "is that it is so obvious that there are sex differences in the brain and these are likely to be translated into some cognitive differences, because the brain helps us think and feel and move and act.

"Yet there is a large segment of the population that wants to pretend this is not true."

No one knows how these neural differences between the sexes translate into thought and behavior — whether they might influence the way men and women perceive reality, process information, form judgments and behave socially.

...As Witelson's research helped establish, however, the mental divide between the sexes is more complex and more rooted in the fundamental biology of the brain than many scientists once suspected.

In the last decade, studies of perception, cognition, memory and neural function have found apparent gender differences that often buck conventional prejudices.

Women's brains, for instance, seem to be faster and more efficient than men's.

All in all, men appear to have more gray matter, made up of active neurons, and women more of the white matter responsible for communication between different areas of the brain.

Overall, women's brains seem to be more complexly corrugated, suggesting that more complicated neural structures lie within, researchers at UCLA found in August.

Men and women appear to use different parts of the brain to encode memories, sense emotions, recognize faces, solve certain problems and make decisions. Indeed, when men and women of similar intelligence and aptitude perform equally well, their brains appear to go about it differently, as if nature had separate blueprints, researchers at UC Irvine reported this year.

"If you find that men and women have fundamentally different brain architectures while still accomplishing the same things," said neuroscientist Richard Haier, who conducted the study, "this challenges the assumption that all human brains are fundamentally the same."

[Einstein's brain:]

Witelson and her colleagues carefully compared the 40-year-old tissue samples with dozens of normal male and female brains in her collection. She also compared them with brains from eight elderly men to account for any changes due to Einstein's age at the time of his death.

She found that one portion of Einstein's brain perhaps related to mathematical reasoning — the inferior parietal region — was 15% wider than normal.

Witelson also found that it lacked a fissure that normally runs along the length of the brain. The average human brain has two distinct parietal lobe compartments; Einstein's had one.

Perhaps the synapses in this area were more densely interconnected.

"Maybe this was one of the underlying factors in his brilliance," she said. "Maybe that is how it works."

Saturday, July 09, 2005

Bond bulls

Barrons presents the case for a bullish view on long bonds. As mentioned previously here, both Bill Gross of PIMCO and Stephen Roach of Morgan Stanley seem to have thrown in the towel, and are now bulls themselves.

The main question is: are rates low now because of Asian central bank buying of US debt (a very unstable situation), or is it due to a longer term secular trend of overcapacity and disinflation caused by economic globalization? Will we see 10y yields at 3-3.5% in the next few years?

...indeed the decline in long rates is a global phenomenon, belying the contention that the recycling by Asian central banks of U.S. trade and current-account deficits into Treasuries is the primary factor keeping American rates so low. Bond rates have plummeted to multidecade lows in much of Europe and Australia and in China, Taiwan, Singapore and Japan are below U.S. long rates.

...the game had changed dramatically with the fall of both the Bamboo and Iron Curtains and the "integration" (Greenspan's favorite word) of India into the global economy. Hence, inflation and inflationary expectations were likely to wither over a number of years as huge new reservoirs of productive capacity and cheap labor were unleashed.

As a result, Big Business and Big Labor, the oligopolistic bulwarks of the post-World War II affluent society, would lose their pricing power. Mass migrations of rural workers to higher-wage areas like China's coastal cities, South American and Indian urban centers and across the Mexican border to El Norte would continue unabated for years, putting a lid on labor costs. And the economies of scale now possible in today's vastly larger global trading markets would only bolster the disinflationary forces at work.

In fact, Hoisington and Hunt argue that the last time such an integrated global market existed was from 1871 to 1949, when long-term Treasury bond rates averaged 2.8%; annual inflation, 0.7%. This even with two World Wars and debilitating trade wars that flared up during the 'Thirties. But all of that ended with the onset of the Cold War in the late 'Forties and the splitting asunder of the global economy.

ADDING TO THE DISINFLATIONARY FORCES has been the capital-spending boom since the 'Nineties in the U.S. and overseas, which has created sharp rises in productivity and mountains of excess capacity. Hunt notes that from 1994 to 2004, real, non-residential fixed investment averaged 10.9% of real U.S. GDP, compared with an average of 7.6% from 1919 to 2004.

The other period that nearly matched this spate of investment was 1919-1928, when implementation of Ford assembly-line techniques and the electrification of industry and homes revolutionized American society. Meanwhile, Chinese capital spending recently hit an off-the-charts 40% of GDP.

"Look at the efficiency gains and disinflation that occurred after the 'Twenties capital-spending boom or even deflation that took place in the decades after the post-Civil War railroad boom, and one gains an inkling of what may lie ahead for the U.S. and perhaps the global economy," Hunt asserts. "It's certainly fair to expect that the IT [information technology] and Internet revolution of recent years will have as profound effect on inflation and interest rates."

Demographic trends inform much of David Rosenberg's bullishness on long-bond rates. As the Merrill Lynch economist sees it, aging baby boomers -- some 76 million strong -- are on the cusp of becoming huge buyers of Treasury bonds and other long-dated fixed instruments.

...The leading edge of the boomers hits 60 next year and begins to seriously consider retirement. Income will become paramount over growth. Thoughts will also turn to assets' staying power, with life expectancies anticipated to increase several years a decade from the current level of around 78. Finally, says Rosenberg, capital preservation will become an imperative. The time to make up any losses will be dwindling. "In short, no assets serve all these needs quite as well as Treasury bonds," he asserts.

If so, the transition could have a galvanic impact on future government-bond rates, according to Rosenberg. For one thing, the latest Federal Survey of Consumer Finances (done in 2001) shows that the boomers, in particular, are wildly overweighted in stocks and underinvested in bonds for the stage of life they are in. Secondly, the quantity of long-dated U.S. government bonds has dwindled since the Treasury suspended in 2001 the sale of 30-year maturities to $458 billion from a peak in 2000 of $562.5 billion.

...France in February issued 50-year government bonds and Germany is considering a similar move. The French issue was wildly oversubscribed, and has rallied sharply to a yield lower than the current U.S. 10-year bond. The U.K. also recently issued 30-year debt in response to market demand, and is mulling a 50-year issue.

Friday, July 08, 2005

Our Asian creditors

Worldwide reserve holdings from Bloomberg. Note the rapid rate of reserve accumulation by China, Taiwan and Korea. Acquisitions like Lenovo-IBM PC, Haier-Maytag and CNOOC-Unocal are just the beginning. It's unrealistic to think our creditors would be happy just holding our bonds. Why shouldn't they diversify into other assets?

Current holdings | Percentage of Total | YOY growth
Worldwide $3,816.57 | 100% | 17.9%
Japan $824.97 | 21.6% | 3.3%
China $691.00 | 18.1% | 50.7%
Taiwan $253.62 | 6.6% | 10.2%
Korea $206.38 | 5.4% | 26.1%
Eurosystem $178.95 | 4.7% | 1.5%

Tuesday, July 05, 2005

Einstein quotes

"[W]e do science when we reconstruct in the language of logic what we have seen and experienced. We do art when we communicate through forms whose connections are not accessible to the conscious mind yet we intuitively recognise them as something meaningful." 

 "After a certain level of technological skill is achieved, science and art tend to coalesce in aesthetic plasticity and form. The greater scientists are artists as well." 

From Alice Calaprice, The New Quotable Einstein, Princeton.

Monday, July 04, 2005

Cheap solar power?

Bill Gross of Idealab has a new company called Energy Innovations, which is introducing an innovative solar generator called the sunflower. Their generator is a "concentrator" which uses mirrors to focus direct sunlight onto a stationary photovoltaic cell (PVC). Since the PVC is the most expensive component of a solar generator, this makes good economic sense if the mirror array is cheap and robust. Gross and company claim to have solved this problem, using cheap microprocessors and a custom bearing array with only two motors. The sunflowers are built in China and are designed to fit in a shipping container. Gross claims that businesses with flat roofs in states like AZ or CA can pay for the machines in only 3-5 years from electricity savings! (Compare to 20 years for ordinary flat solar panels.)

Friday, July 01, 2005

The real smart guys

Jim Simons and Renaissance want to raise a $100B fund! And why not, they're the best in the hedge fund business. In an earlier post I compared them to Long Term Capital Management. Let's see, two economics Nobelists (Merton and Scholes) who invented options pricing and a bunch of overconfident Salomon traders, versus a bunch of physics and math PhDs. I know who I'd bet on!


Renaissance's Man: James Simons Does The Math on Fund
July 1, 2005; Page C1

It is getting harder for hedge-fund managers to generate above-average returns when their funds grow too big, right?

Tell that to James Simons.

Mr. Simons, a world-class mathematician who runs Renaissance Technologies Corp., is creating a buzz in the hedge-fund world because he is about to launch a fund that he claims could handle $100 billion -- about 10% of all assets managed by hedge funds today. It will have a minimum investment of $20 million, and is aimed at institutional investors, according to early marketing materials.

Mr. Simons, whose net worth has been estimated at $2.5 billion, has seen Renaissance's $5 billion flagship Medallion hedge fund earn an average of 34% annually since it began in 1988, making it the most successful fund during the period. These returns, which are audited, come even after fees that now are -- get this -- 5% of assets and 44% of all investment gains. That is more than double what other hedge funds typically charge.

So far this year, Medallion is up about 12%, amid losses for the overall market. Mr. Simons has done it with computer-driven, short-term trading in various markets. The firm won't divulge details of its strategy, even to its own investors. Other funds use the same strategy but are far less successful.

The new fund will take a different approach: focusing on the U.S. stock market and holding investments for more than a year.

Medallion hasn't been open to new investors for 12 years, and Mr. Simons, 67 years old, has been returning money to existing investors, convinced that returns would suffer if the fund got too big. In fact, the firm is expected to return outside investors' remaining money at year's end, leaving Mr. Simons and his employees as Medallion's sole investors and the fund about as large as it is now. Dealing with few investors has helped the publicity-shy Mr. Simons stay below the radar screen.

Mr. Simons declined requests for comment. A Renaissance spokesman wouldn't comment on the new fund, which will be called the Renaissance Institutional Equities Fund.

The latest effort -- even if it never reaches the $100 billion mark -- would seem to run up against Renaissance's instincts to keep a lid on assets. Indeed, many managers have found that more money under management can put a crimp on results. Investors briefed on the new fund say it will differ from the existing Medallion hedge fund by aiming for tamer returns that would enable it to handle the greater sums.

The new fund marks the latest encroachment of hedge funds into the lucrative market of investing money for pension plans and other institutional investors, turf that traditional money-management firms like mutual funds have clung to. The fund will use complex quantitative models, developed by the 60 or so mathematics and physics Ph.D.s on staff. The fund will aim to beat the returns of the Standard & Poor's 500-stock index but with lower volatility.

Though Mr. Simons isn't well known, even on Wall Street, his track record likely will spur strong interest in the fund, investors say. Renaissance's 34% annual average returns since 1988 top every other hedge fund in that time period, according to Antoine Bernheim, who publishes the U.S. Offshore Funds Directory, which tracks over 1,000 hedge funds. By comparison, George Soros's Quantum Fund has climbed about 22% annually since 1988, while the Standard & Poor's 500 rose 9.6% annually.

Medallion, which hasn't had a down month in the past two years, according to one investor, has distributed so much money to its investors over the years that they haven't been able to reinvest these gains to take advantage of the big returns -- likely whetting investor appetite for the new fund.

Though prior performance doesn't guarantee the new fund's success, it will share Medallion's scientific approach, and is based on Medallion's "technology," according to the marketing materials.

"Renaissance's returns are 10 percentage points higher than legendary investors such as [Bruce] Kovner, Soros, Paul Tudor Jones, [Louis] Bacon and [Mark] Kingdon," Mr. Bernheim says. "He's in a different class from everyone else."

But while Mr. Simons will levy lower fees, such as about 2% of assets, to attract interest in his new fund, he also may have to disclose more details about trades than he is accustomed to. That is because pension plans, and their consultants, usually require a full briefing about strategies of firms they invest with.

"It's pretty much a black box. People that work there are sworn to secrecy; it's a proprietary trading strategy," says Jeffrey Tarrant, president and chief investment officer of Protege Partners LLC, based in New York, an investor in Renaissance.

Mr. Simons began his career as a professor of mathematics, teaching at the Massachusetts Institute of Technology and Harvard University. He helped develop a geometry theorem, called Chern-Simons, that is a critical tool for theoretical physics.

"It's startling to see such a highly successful mathematician achieve success in another field," says Edward Witten, professor of physics at the Institute for Advanced Study in Princeton, N.J., and considered by many of his peers to be the most accomplished theoretical physicist alive.

After breaking military codes for the government during the Vietnam War, Mr. Simons turned to money management. He hires specialists in applied math, quantum physics and linguistics for Renaissance's office in East Setauket on New York's Long Island. Hardly any have a Wall Street background. The firm relies on a system to make thousands of rapid-fire, short-term trades daily to take advantage of small, fleeting anomalies in various markets.

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