John Hussman’s words of wisdom

These two concluding paragraphs from the latest market comment of John Hussman are worth paying attention to:

That doesn’t mean that stocks can’t advance further, and it’s impossible to rule out potential enthusiasm that the Treasury “public-private partnership” idea might engender. But the relentless failure to properly respond to this crisis has increased the probable duration of the economic downturn, deepened the likely extent of job losses and deleveraging, and has lowered the expected level of future profit margins, all which erode the fundamental value of U.S. companies. Meanwhile, with the market no longer deeply compressed, there is less pressure for a rebound on the basis of easing risk aversion.

In all, I view the general market’s condition somewhat less favorably than when we first observed these levels last year. Too much has gone wrong in factors that will have persistent effects, and having consolidated the losses, prices are not nearly as compressed as they were then. It is very true that the market tends to bottom when the economic news is still poor, but the economic difficulties here are well outside the norm, and we should at least allow for valuation extremes that are similarly outside of the norm. [More here]

Proposals for a new global reserve currency

China’s central bank governor posted a note on the web site of the People’s Bank of China proposing a new global reserve currency. The key points are here:

They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand.

The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists.

 When a national currency is used in pricing primary commodities, trade settlements and is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies.

The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.

Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.

The proposal has met with predictable response from the West. After some confusion, m/s Geithner and Bernanke have rejected the proposal as did Mr. Gordon Brown. ‘Economist’ struck a cautious tone while Brad Setser sounded unsure.

China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

He is bang on target on this one. This proposal should be delinked from the question of China’s foreign exchange reserves. China’s foreign exchange reserve accumulation to keep its currency lower or prevent it from appreciating, has created a lot of domestic and external imbalances. More importantly, China’s growth has come at the expense of growth in other smaller Asian exporters whose currencies too suffered from excessive appreciation up to 2007 and then from excessive depreciation, partly because ironically, the banks and the exporters were resigned to and were too prepared for a steadily appreciating currency (e.g., Korean won).

The United States shouldn’t — in my view — be opposed to the development of an Asian reserve currency, or a set of Asian reserve currencies, that generally float against the dollar and the euro. After World War 2, the DM — and then the euro — emerged as Europe’s reserve currency. And European countries moved from pegging to the dollar to managing their currencies against the DM and then to the euro. That hasn’t been bad for the US.

Exactly. The United States can and should accept a multiple reserve currency world.  The key point that the PBoC governor makes is that it imposes costs on the reserve-currency country itself. We have seen that now. That point is ignored because it is being made by China and hence perceived to be in its self-interest only. That is unfortunate. The point made by the PBoC governor and reproduced below again deserves to be heeded by the US but also pressed upon it by other nations:

The frequency and increasing intensity of financial crises following the collapse of the Bretton Woods system suggests the costs of such a system to the world may have exceeded its benefits. The price is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies.

Brad: Shifting too a more balanced world economy may not require something as ambitious as an international reserve currency; a bit more exchange rate adjustment, a bit more floating and a bit less reserve growth might do the trick.

Zhou is right: Excessive reserve growth poses problems for the US as well as the countries adding to their reserves.

After acknowledging that the governor was right, Brad backpedals. I doubt if exchange rate adjustment on the part of China, bit more floating and bit less reserve accumulation would persuade the United States to learn to live with its means and not consume beyond what it produces.

The key point that the PBoC governor makes is that the costs of the current system have exceeded the benefits and that has nothing to do with the size of their foreign exchange reserves. If the global reserve and transaction currency country engages in solely national-interest driven monetary and fiscal policies, it gives rise to more frequent asset price booms and busts and emerging market currency crises, with little time for them to adjust. That is the experience of the world in the last 35 years of fiat currency global dollar standard.

Finally, Brad manages to end on the right note:

Zhou’s proposals lead naturally to a discussion not just of reserve currencies, but exchange rates, exchange rate regime and reserve growth. That is a discussion that the G-20 ultimately needs to have.

One point that Economist makes is worth reflecting upon: 

America would resist, because losing its reserve-currency status would raise the cost of financing its budget and current-account deficits

Many other countries – Japan, Germany and Switzerland to name a few –  have not enjoyed global reserve currency status but managed to have low cost of funding because their central banks were more particular about preserving the purchasing power of their currencies, were stridently anti-inflation and their households saved while borrowing within limits, if at all.

It is significant to note that two countries that almost always had weakening currencies, low savings and higher interest rates than these three were the UK and the US both of whom had gotten accustomed to low cost of debt and seigniorage benefits of being reserve and global transaction currencies.

Therefore, it is in the interest of the United States to accept higher interest rates that come with the loss of the polar reserve currency status. It is an incentive to savers and disincentive for borrowers – exactly the long-term adjustment that America needs. 

That is why when commentators (e.g., Paul Krugman) question Europe  and China’s fiscal stimulus sizes compared to that of the US or the UK, it is not clear to us whether the former are too tight-fisted and the latter are too profligate because of habit and because of low funding costs now (e.g., U.S).

From Table-2 of the note prepared by IMF (Global Economic Policies and Prospects, Note by the Staff of the International Monetary Fund for Group of Twenty Meeting of the Ministers and Central Bank Governors March 13–14, 2009, London, U.K.), the combined projected average annual change in 2008-10 over 2007 in the overall budget balance including automatic stabilizers and discretionary measures (as % of GDP) is 6.1 for China, 6.3 for the EU, 6.6 for Japan, 7.8 for the US and 9.0 for the UK.

I am not sure if these are average annual change. If so, the cumulative change during the period is unusually (or, unacceptably) large. The other explanation is that I do not understand the table. 

(p.s: Russia has made a similar suggestion as part of a comprehensive eight-point proposal. That got some attention. But not this much. The good thing about Russia’s proposal is that included financial literacy).

The Swiss franc devaluation

‘Economist’ has  a story on the Swiss National Bank (SNB) deciding to buy foreign currencies aggressively. It ends the story with these two paragraphs:

Back in the 1930s many countries had to choose whether or not to abandon the gold standard. Those that did so soonest tended to suffer least during the Depression. In these days of floating currencies, it is no longer necessary to announce a formal devaluation; benign neglect can allow the currency to fall. Some Europeans suspect this has been happening with the British pound.

But it is still a form of subtle protectionism, relying on someone else to take the strain. To raise the most worrying example, Chinese exports are down by more than a quarter from a year ago. What if the Beijing authorities decided that, in order to generate their targeted 8% economic growth, a bit of depreciation was required? After all, what’s good for the Swiss… [More here]

It is easy to answer the question they have posed. China has two trillion dollars worth of foreign exchange reserves accumulated over the years by intervening to smooth or hold down the value of the Chinese yuan against other currencies in the world. Switzerland has very little foreign exchange reserves, if at all. Hence, the starting points are very different.

Swiss banks have a lot of foreign currency assets. This move would raise the value of such assets. Second, it also mitigates the loan burden held by some of the residents of some C&EE countries in Swiss francs. This move on the part of the SNB has other positive pay-offs as well, thus.

Should the Indian government borrow abroad?

T. K. Arun makes a suggestion that Indian government should borrow abroad. He mentions a sizable sum of USD 20 billion.
The government should meet a part of its huge borrowing programme by issuing bonds abroad. Non-resident Indians would lap it up. So would a number of invitees to the forthcoming G20 summit: it shouldn’t take all that much of diplomacy to persuade them to park a tiny fraction of their multi-trillion dollar forex reserves in Indian bonds.
India can choose to be a little aggressive on interest rates, too. The rupee would appreciate from the present panicky levels, and soften the cost of external borrowings. Even $20 billion of such inflows would increase domestic credit flows, bring down yields and shore up the rupee. [More here]
I shall ignore his opening paragraph about whether we are too downbeat or too upbeat. He tones down and says that things are not wrong but not desperately wrong. Let us not quibble and leave the quibbling to him.
To the extent that India is interconnected with the world more than before via capital flows (incl. remittances which have multiplier effects), caution on the world economy does translate into caution for India. of course, it applies to many other developing countries too, including China.
But, his proposal for external commercial borrowing (ECB) by Government of India (GoI) is not a bad one. GoI can check out the likely market reaction by talking to potential lead managers. After all, Indonesia completed a USD 3 billion borrowing programme rather well just a month ago. The bonds are trading well above par.
As for his conclusions/forecasts in the last paragraph, he races into them too fast and without a proper framework. They too are best ignored.
Any thoughts on his suggestion?

De-coupling skeptics have to explain this

Nearly a month ago, Indonesia successfully placed two sovereign bond issues successfully for a sum totaling USD 3 billion. The news article is here. Earlier this week, a British gilt auction failed to receive 100% response. A German five-year bond auction narrowly missed the same fate. Here is a FT news report on these two matters.

The FT wrote thus on March 26th:

Yesterday was the fourth time a gilt auction has failed since they were introduced to raise public debt in May 1986.

Now, to further drive the point home, Indonesia’s bonds are trading well above par one month later. May 2014 paper with coupon of 10.375% is being quoted at 106-107.00. March 2019 11.625% paper is quoted at 109.5-110.50.

I guess it is time for people to start re-examining standard definitions of Emerging markets, sovereign risks

Now, that is a classic

Received from a friend:  


March 24, 2009

The Editor

Financial Times

Sir: Structured investment vehicles to invest in tranched mortgage-backed securities with plenty of leverage have been duly condemned for the huge problems and losses they caused.  So to solve the problems the United States Treasury now brings us structured investment vehicles to invest in tranched mortgage-backed securities with plenty of leverage provided by the taxpayers.  Hair of the dog?

Yours faithfully,

Alex J. Pollock, Resident Fellow, American Enterprise Institute, Washington, DC


My friend who sent me this letter adds that if we went to and searched for all of Alex’s letters over the past two years, we would find some of the most erudite commentary on this crisis.

One heck of a punch-line for Wall Street

From Chrystia Freeland in FT on the denial among top financial types on public anger:

… in the days after the Bolshevik revolution, Russia’s bourgeoisie didn’t think much had happened, either, and stock prices held steady on the Petrograd exchange. 

The full article makes a lot of sense. The denial about public anger is due to denial over one’s culpability arising out of the belief that they did nothing wrong or that they would not have done anything different. I have some thoughts on this that I hope to flesh out in my MINT column, coming Tuesday.