Former U.S. Federal Reserve Chairman William McChesney Martin once claimed that the role of the central bank is to take away the punch bowl just as the party gets going. Today, ironically, several of the world’s central banks may be doing exactly the opposite. Just when the great global bull market of the past decade seemed to have run as far as it could run, and with deep rumblings in real estate and credit markets, the actions of several central banks in Asia may give global markets another big push towards rising prices and tightening credit spreads.
Every period of globalization in the past has had its origins in one or more events that gave a big boost to global liquidity. As liquidity expanded and risk appetite rose, capital poured into various risky ventures—from nimble new companies exploiting the latest technology to developing countries at the fringes of global markets. Whether it was the rapid creation of new joint-stock banks in the 1860s, the massive accumulation of gold in the U.S. in the 1920s, or the recycling of petrodollars in the 1970s, the secular bull markets that are a part of every globalization cycle were fueled by events that created growing underlying liquidity and rising risk appetite.
The most recent globalization cycle had its beginnings in the increase in liquidity caused by the securitization of U.S. mortgages, which converted one of the largest pools of assets in the world from very illiquid bank loans into some of the most liquid securities. But it seems reasonably certain that what has powered the boom in the last decade has been the recycling of the massive U.S. trade deficit. As central banks and sovereign funds around the world accumulate reserves as the flip side of the U.S. trade deficit, excess U.S. consumption is being converted into global excess savings.
If this is the case, predicting the ability of this bull cycle to continue means predicting two things: the future size of the U.S. trade deficit, and the way in which the recycling takes place. Predicting the future path of the U.S. trade deficit is not easy and involves complex predictions about currency, economic and political changes. But it is probably safe to assume that whatever happens to the trade deficit, the changes will take place slowly and gradually.
The way in which the trade deficit is being recycled, however, seems to be undergoing a material shift. With currency reserves among Asian central banks and OPEC nations swelling to levels never before achieved, governments of surplus nations are increasingly focusing on achieving higher returns than those with which their central banks have traditionally been happy.
When the primary goal of reserve management is to protect a country from interruptions in its ability to pay for imports and to service external debt, it was necessary to invest reserves in very safe, liquid and, for that reason, low-yielding securities. But reserves have soared to levels way beyond those recommended by even the most conservative economists. With nearly $1 trillion of reserves, Japan is estimated to need only one-quarter of its reserves for normal liquidity purposes. China, whose reserves are approaching $1.5 trillion, probably needs not much more than one-half of that amount. Smaller Asian countries, and the OPEC nations as a bloc, are also carrying levels of reserves well beyond their liquidity needs.
Since they have excess reserves, one of the hottest questions in reserve management has been what to do with these excesses. In this respect China has been among the leaders. For years there have been rumors of Chinese central bankers stretching for yield by purchasing securities that were riskier than those normally held by central banks—bonds issued by certain Latin American governments, mortgage residuals and the like. Earlier this year the government approved a more explicit measure. It plans to carve out $200 billion of reserves to be managed separately and more aggressively by a separate government entity.
With China’s reserves currently accumulating at the rate of over $100 billion per quarter, this already large number can easily grow. Other countries are explicitly or implicitly following China’s lead, and although the total amount of money that is being driven into riskier assets than those normally held by central banks is murky, there is little doubt that it is large.
With the massive hoards of reserves held by Asian and OPEC institutions being invested down the credit spectrum into riskier assets, the net result will be a material increase in global risk appetite that will show up in ever tighter credit spreads. From time to time, as happened with the emerging-market correction in May 2006, and as is happening now, the overall trend of the market will be interrupted and the market will be filled with momentary panic, but when this happens, markets will quickly stabilize and resume their upward trend.
Credit spreads for risky assets are at historic lows, and certainly for older and more experienced traders and investors it is hard to imagine any good fundamental reason for spreads to stay at these levels or, even harder to imagine, to continue narrowing. But whatever the fundamental arguments, there are good technical reasons for assuming that the party isn’t over yet. The large-scale shift of global reserves into what are being called sovereign wealth funds may provide the party with at least one more bowl of industrial-strength punch. Tomorrow’s hangover may get nasty, but for now the party is still going strong.
I enjoyed your oped in the paper today - and look forward to reading more of your blog!
one small quibble about the post though. I completely agree that many Asian countries and oil exporters have much higher official assets than likely are needed for liquidity purposes. this is definitely true of Saudi Arabia, if one includes the non-reserve foreign assets of its monetary agency. but for the rest of the GCC, most of the oil savings are likely being directed to the types of higher-yielding investments you mention.
African OPEC members are a different case - They are mostly amassing large reserve allocations (though Nigeria's reserves have levelled off so far this year). Even as a higher proportion of oil revenues are spent this year, as estimates indicate, there seems likely to be no shortage of such inflows.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
Subscribe to this Site
Comments (1) for "My Op Ed in today's WSJ"
December, 2007
.