Market Advisory Features
Over Exchange Rates
Growing Economies, Gaping Deficits
Global Trade and Poverty
The Price of Free Money
On the Sunny Side of the Street
Isolated as Speech to UN Falls Flat
Japan's Rock Bottom
Iraq’s Rising Price Tag
Road to Nowhere
over exchange rates
The G7 says that markets should set exchange rates. But one of the seven—Japan—thinks they need a little help
IN A joint statement on Saturday September 20th, the G7, a group of rich nations meeting in Dubai, emphasised that markets should set exchange rates. Ironically, for a statement frowning upon intervention, their communiqué did more to sway the markets than any amount of official buying or selling of foreign exchange. During trading on Tuesday, the yen strengthened to 110.85 to the dollar, its strongest level in almost three years. On Monday, the Nikkei suffered its worst percentage loss in two years.
Tokyo, which signed on to the communiqué, may say that markets should set exchange rates, but its money is not where its mouth is. It has spent more than ¥9 trillion this year intervening in the markets to keep the yen artificially cheap. The markets see this weekend’s statement as a sign that the rest of the G7 have lost patience with Japan’s weak yen policy. Tokyo, investors believe, will now be under pressure to stop buying dollar assets on the scale seen so far this year. With their biggest buyer shamed out of the market, traders have been quick to offload dollars and buy yen.
Why does Japan want a cheap yen? A history of mercantilism may be part of it. A cheap yen is one way to capture lucrative export markets. But Japan also hopes that selling yen and buying dollars will release it from its “liquidity trap”. Japan cannot stimulate its economy by cutting interest rates, because interest rates are already zero. It therefore has to find an alternative way to reflate the economy. Debasing the currency is one. Every time the Bank of Japan buys dollars, it creates yen to pay for them. Eventually, it is hoped, the supply of yen will outstrip demand. Depreciation is one result—lowering the value of the yen in terms of dollars; inflation is another—lowering the value of the yen in terms of Japanese goods. The last time America was caught in a liquidity trap it did exactly the same thing. President Franklin Roosevelt devalued the dollar by almost 60% in 1934 to help America recover from the Depression.
The yen could never fall quite that far. Nonetheless, the Bank of Japan’s efforts seem to have gained some traction in recent months. Output grew by 3.9% in the second quarter, outstripping even the United States. In the past two months, J.P. Morgan has raised its growth forecast for 2004 from around 1% to as high as 2.6%. Other banks are not far behind. Given this turnaround in Japan’s prospects, relative to those of the United States, it is perhaps no surprise that the yen is strengthening against the dollar.
But Japan’s recovery might be quite fragile. Much of the economy’s dramatic second-quarter growth was driven by strong capital spending, which increased by over 20%. Some of that strength is probably a statistical artifact: the volume of investment looks big because the price of capital goods has fallen so far. The investment boom is, in any case, unlikely to continue if the stock market takes a hit. The jittery reaction of Nikkei investors to the G7 communiqué suggests that a strong yen was not part of their scenario for a strong Japan.
America wants a cheaper dollar; the Europeans don’t want a stronger euro. But no one wants to jeopardise Japan’s nascent recovery. Over time, stronger demand in Japan will support a stronger yen, not to mention a stronger world economy. But in the meantime, the Bank of Japan needs to continue its aggressive monetary easing, and the exchange rate is one important channel left open to it. To judge by his past statements, John Snow, America's treasury secretary, understands Japan’s predicament. He is eager to see Japan conquer deflation. As treasury secretary, he also knows that the Bank of Japan is one of his best customers, keeping the price of Treasury bills high, and American interest rates low. Up until now at least, Mr Snow has directed his most trenchant criticisms not at Japan's currency regime, but at China's.
The yuan, China’s currency, has remained pegged at 8.3 to the dollar for almost a decade. No one complained when the dollar was strong, but now that it is weakening, the yuan is said to be too competitive. China’s trade surplus with the world is small, but its surplus with America is over $100 billion, at a time when America is fast losing manufacturing jobs. The ire America’s rustbelt is directing at Washington, Washington is trying to re-direct towards Beijing. Mr Snow wants China to loosen its currency peg. He went to China earlier this month to press his case in person, and repeated his call in an unofficial meeting with Chinese officials outside the IMF and World Bank meetings in Dubai this weekend.
If the Chinese were to
loosen their peg, and there is little sign that they will, would it make much
difference? The yuan is not significant in itself—even a 50% appreciation
would translate into just a 5% depreciation of the dollar in trade-weighted
terms—but it is seen by some, such as Jim O’Neill and Dominic Wilson of
Perhaps, then, the G7 communiqué was bound for Beijing, but misdirected to Tokyo. Unfortunately, the markets seem to think the message was intended for Japan, and what the markets think matters, even when they are wrong.
The major foreign-exchange markets are deep and liquid. Central banks wade into them from time to time, but they rarely succeed in turning the tide. In fact, the scholarly consensus is that while central banks can reinforce market trends, they cannot reverse them. Until last week, the Bank of Japan succeeded in keeping the yen above its “line in the sand” of 115 to the dollar. That line is now gone. The Bank hopes the yen will trade at 110 or more to the dollar in the future. But after last weekend's miscommuniqué, that line might soon be swept away as well.
isolated as speech to UN falls flat Showing no contrition for defying the world body in March or the declining
security situation in Iraq, the US president called for the world to set aside
past differences and help rebuild the country: "Now the nation of Iraq
needs and deserves our aid - and all nations of goodwill should step forward and
provide that support," he said.
But the French president, Jacques Chirac, who spoke after Mr Bush, blamed the
US-led war for sparking one of the most severe crises in the history of the UN
and argued that Mr Bush's unilateral actions could lead to anarchy.
"No one can act alone in the name of all and no one can accept the
anarchy of a society without rules," he said. "The war, launched
without the authorisation of the security council, shook the multilateral
system. The UN has just been through one of the most grave crises in its
Earlier the UN secretary general, Kofi Annan, condemned the doctrine of
preemptive military intervention, arguing that it could lead to the unjustified
"lawless use of force" and posed a "fundamental challenge"
to world peace and stability.
"My concern is that, if it were to be adopted, it could set precedents
that resulted in a proliferation of the unilateral and lawless use of force,
with or without credible justification," said Mr Annan. "This logic
represents a fundamental challenge to the principles on which, however
imperfectly, world peace and stability have rested for the last 58 years."
The Brazilian president Luiz Inacio Lula da Silva, who also spoke before Mr
Bush, said: "A war can perhaps be won single-handedly. But peace - lasting
peace - cannot be secured without the support of all."
Mr Bush's speech was received with polite applause from the 191-member
states, while his critics were given a far warmer reception.
The American president was not just under fire for his decision to wage war
without international consent but also for his refusal to move more quickly
towards handing control of the country back to the Iraqi people.
Both Mr Chirac and the German chancellor Gerhard Schröder, called for a
transition within months, insisting that this was crucial to securing peace. Mr
Bush has not laid out a timetable. "This process must unfold according to
the needs of Iraqis - neither hurried nor delayed by the voices of other
parties," he said.
Mr Bush is under increasing domestic political pressure to outline a strategy
to get out of Iraq, where increasing military casualties and growing financial
burden on a strained economy are draining support ahead of next year's
Having bypassed the UN to bomb Iraq, America returned to the security council
earlier this month asking for military and financial help to assist it with the
costs of the occupation. The resolution is currently before the security
council, where France has the power of veto.
Gary Younge in New York
Wednesday September 24, 2003
George Bush was increasingly isolated on the global stage yesterday as he defied intense criticism from a litany of world leaders at the United Nations over the war on Iraq.
Showing no contrition for defying the world body in March or the declining security situation in Iraq, the US president called for the world to set aside past differences and help rebuild the country: "Now the nation of Iraq needs and deserves our aid - and all nations of goodwill should step forward and provide that support," he said.
But the French president, Jacques Chirac, who spoke after Mr Bush, blamed the US-led war for sparking one of the most severe crises in the history of the UN and argued that Mr Bush's unilateral actions could lead to anarchy.
"No one can act alone in the name of all and no one can accept the anarchy of a society without rules," he said. "The war, launched without the authorisation of the security council, shook the multilateral system. The UN has just been through one of the most grave crises in its history."
Earlier the UN secretary general, Kofi Annan, condemned the doctrine of preemptive military intervention, arguing that it could lead to the unjustified "lawless use of force" and posed a "fundamental challenge" to world peace and stability.
"My concern is that, if it were to be adopted, it could set precedents that resulted in a proliferation of the unilateral and lawless use of force, with or without credible justification," said Mr Annan. "This logic represents a fundamental challenge to the principles on which, however imperfectly, world peace and stability have rested for the last 58 years."
The Brazilian president Luiz Inacio Lula da Silva, who also spoke before Mr Bush, said: "A war can perhaps be won single-handedly. But peace - lasting peace - cannot be secured without the support of all."
Mr Bush's speech was received with polite applause from the 191-member states, while his critics were given a far warmer reception.
The American president was not just under fire for his decision to wage war without international consent but also for his refusal to move more quickly towards handing control of the country back to the Iraqi people.
Both Mr Chirac and the German chancellor Gerhard Schröder, called for a transition within months, insisting that this was crucial to securing peace. Mr Bush has not laid out a timetable. "This process must unfold according to the needs of Iraqis - neither hurried nor delayed by the voices of other parties," he said.
Mr Bush is under increasing domestic political pressure to outline a strategy to get out of Iraq, where increasing military casualties and growing financial burden on a strained economy are draining support ahead of next year's presidential election.
Having bypassed the UN to bomb Iraq, America returned to the security council earlier this month asking for military and financial help to assist it with the costs of the occupation. The resolution is currently before the security council, where France has the power of veto.
economies, gaping deficits
The world economy is recovering its strength, but not its balance
THE International Monetary Fund (IMF) enters its annual meeting in Dubai this weekend expecting the world economy to grow by 4.1% next year. The IMF issued the same projection in April, but five months down the road, with the Iraq war over, deflation at bay, and economies finally responding to macroeconomic policy, the prediction can be held with more confidence. The threats to world growth have receded—though they have not disappeared.
Much of this renewed confidence is inspired by America’s gathering momentum. But the country’s surprisingly strong recovery in the second quarter was eclipsed, even more surprisingly, by Japan’s. Japan grew by 3.9% in the quarter (at an annualised rate), America by 3.1%. The IMF has duly revised upwards its growth projection for Japan, but at 1.4% for 2004, it still looks conservative compared, for example, with the 2.6% growth predicted by J.P. Morgan.
Nonetheless, the guiding theme of the IMF’s outlook on the world economy remains correct: America is still the main motor of global growth. If the Japanese economy has four cylinders, America has ten: growth of 3% in America’s vast ten-trillion-dollar economy adds much more to world output than 3% growth in Japan’s four-trillion-dollar economy. Besides, Japan tends to follow the world economy, not lead it. It relies on foreigners to buy much of what it produces, whereas America relies on foreigners to finance much of what it buys.
Therein lies the principal threat to the IMF’s projections: will the rest of the world, principally East Asia, continue to finance America’s trade deficit, and, if not, how will that deficit unwind? Will it close via a welcome rise in foreign demand, an unwelcome fall in American demand, or through a realignment of currencies, switching demand towards American goods and away from the goods of its trading partners?
American demand, of course, has already fallen from the heady peaks of the last decade. But the current-account deficit has continued to widen. Why? In so far as the private sector has slowed its spending (and households have not slowed much), the American government has taken over. The IMF forecasts a deficit of over 6% of GDP this year in the combined federal and state budgets. Over half of America’s impressive second-quarter growth was driven by military spending. “The United States has the best recovery that money can buy,” said Kenneth Rogoff, the IMF’s chief economist.
Who is financing America’s overspend? The foreign investors, many of them European, who used to buy up American equities have largely withdrawn. Asian central banks, buying American Treasuries and agency debt, have taken their place. Asia holds about $1.66 trillion in foreign-exchange reserves, most of them in dollar assets. If America’s twin deficits, a current-account deficit matched by a budget deficit, are reminiscent of the 1980s, the rapid accumulation of dollars in foreign capitals is somewhat reminiscent of the slow demise of the Bretton Woods era in the late 1960s and early 1970s.
The appetite of Asian creditors for American assets is preventing the broad weakening of the dollar that the IMF and many in America would like to see. From its peak in early 2002 to mid-May, the dollar fell by a modest 12% in trade-weighted terms. Exports have begun to respond, with volumes growing by more than 20% over the past three months. But some reckon the dollar would have to fall by as much as half to get America’s current-account deficit back under control.
Can the dollar fall again? The euro has borne the brunt of its fall so far, appreciating by 20% against the dollar since early 2002. Indeed, a strengthening euro is slowing recovery in Europe, according to the IMF. Exports have led Europe out of previous recessions; but their pull has been weak this time round. In previous recoveries, by this stage euro members would expect their exports to have grown by over 13% from their lows. But they have grown by less than 10%. The IMF cautions the European Central Bank (ECB) to stand ready to cut interest rates again if the euro strengthens further. Inflation across the euro area as a whole is a healthy 2.1%, slightly above the ECB’s ceiling. But if that average disguises near-deflation in Germany, it may not be the best guide to ECB policy, the IMF warns.
Japan is also worried about the falling dollar. Its monetary authorities spent $78 billion between January and August this year selling yen and buying dollars. The IMF supports Japan’s strategy of holding the yen down as a way to reflate its economy, but not everyone is so sympathetic. On Thursday, just days before Japan’s finance minister was to meet the other leaders of the G7 economies in Dubai, the yen strengthened to under 115 to the dollar for the first time in two-and-a-half years. Some speculate that Japan is letting the yen appreciate to deflect criticism of its weak yen policy at this weekend’s meetings.
Japan will not be the only country whose exchange rate is in the spotlight at Dubai. China, not yet a member of the G7, is nonetheless a favourite topic of conversation. As the dollar has weakened, China’s yuan has tracked its fall. China is now running a conspicuous trade surplus with America at a time when the latter is fast losing manufacturing jobs. John Snow, America’s treasury secretary, visited Beijing this month to impress upon China the case for loosening its currency peg of 8.3 yuan to the dollar. He and other finance ministers will likely repeat this call in a planned unofficial meeting with Chinese officials on the margins of the G7 meeting. To appease Mr Snow, China might soften its peg slightly, allowing the yuan to bobble within a slightly wider band.
But that will not be
enough to realign the dollar, let alone to halt the tectonic shifts going on in
the geography of manufacturing employment. To make a real difference to the
dollar, according to recent calculations by
trade and poverty JOSEPH Stiglitz, the 2001 Nobel laureate for economic science, puts it
bluntly: The United States and Europe subsidize their cows at two dollars per
day, more than what a human being in many parts of the world earn in a day.
Randy David (Philippine Daily Inquirer)
I have come across more disturbing figures. An article by Hamish McRae for a South African financial newspaper reports that "the European Union subsidy for each of its cows - 913 dollars -- is greater than the average income per head of a sub-Saharan African - 490 dollars. The Japanese subsidy is 2,700 dollars per cow." To support its 25,000 cotton farmers, the US government, says Stiglitz, spends four billion dollars a year in subsidies, which is greater than the value of the cotton itself.
For a variety of reasons, governments in the developed world continue to support the costly operations of their farmers through huge price-distorting subsidies and tariff walls against cheaper imports. The agricultural lobby in the developed countries is a powerful one, drawing its energy from a reservoir of political clout, cultural appeal and chauvinism. In the eyes of the affected communities, what they are defending is an entire way of life, a whole tradition from which the society draws its symbols-and not just jobs.
One wishes that less-developed countries, like the Philippines, were even half as predisposed to protect their own farmers, instead of allowing them to drown in the floodwaters of globalization. In permitting the entry of cheap onions, garlic, and chicken meat into the country, we work under the illusion that our farmers would be forced to be more efficient in order to be able to compete. In fact, few manage to survive. After they are driven out of business, they are prompted to sell their lands and try their luck abroad as unskilled contractual workers. All over the country, farming is dying as a way of life; many farms are untilled, awaiting conversion to non-agricultural uses.
Unlike the farming communities of Europe and America, our own small farmers are not sufficiently organized to mount a strong lobby to defend their interests. There is no agricultural vote in our country. Moreover, our people are conditioned to think that capitalist globalization is inescapable, and that all we can do is accept its terms and find our niche in a fast evolving world economy. While globalization may be inevitable, the forms it takes are not. The fight of the anti-globalists is not against globalization as such, but against globalization directed by the multinationals.
The justification for a World Trade Organization rests on the proposition that opening doors to international trade should produce development for everyone provided certain rules were observed and enforced. Since the WTO founding in 1995, however, the results for poor countries have been the opposite. They could not effectively gain access to developed markets because of non-tariff barriers. They lacked the resources to modernize and support their agriculture fast enough to compete in the world market. Even as Europe and America were increasing their subsidies to their farmers, less-developed countries could not deliver even the promised safety nets to those who were adversely affected by trade liberalization. They lowered their tariff to permit cheaper imports to come in, but suffered a double squeeze in the process. Local producers went out of business and government revenues went down.
The so-called Doha round of trade talks in November 2001 was meant to redress such imbalances in world trade. The working agenda on which the negotiations were to be conducted contained a slew of items, with liberalization in agriculture topping the list. The conference of trade ministers that closes today in Cancun, Mexico is meant to facilitate these negotiations. The basic idea is to arrive at a broad consensus on the framework for the negotiations in accordance with the commitments made at Doha.
A new element in these negotiations is China's entry as a player. That country has joined India and Brazil, and 20 other less-developed countries, including the Philippines, to form a bloc to push for a common set of demands. Foremost of these are substantial cuts in farm subsidies and removal of export subsidies for agricultural producers in rich countries, and greater access by poor countries into the markets of developed countries.
The rich countries, however, are not going to offer any concessions in any of these areas without exacting their pound of flesh. They want stricter enforcement of their patents and intellectual property rights, further liberalization of investments, and elimination of barriers to capital flows, including speculative capital. Stiglitz suspects that the commitment to redress trade imbalances made at Doha was nothing more than an attempt to get the poor countries to sit down and negotiate these items in exchange for a few concessions.
The possibility that the Cancun round may yield an agreement is remote. But, as Stiglitz says, no agreement might be better than having a bad one.
JOSEPH Stiglitz, the 2001 Nobel laureate for economic science, puts it
bluntly: The United States and Europe subsidize their cows at two dollars per
day, more than what a human being in many parts of the world earn in a day.
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Japan's rock bottom
The root of Japan’s problem is that it had the mother of all economic bubbles in the 1980s—bigger by far than America’s recent efforts—and has never dealt with its aftermath; nor, perhaps as importantly, has it done much by way of reforming the financial and economic systems that led to the bubble. Japan’s policymakers—its politicians and the mandarins at the finance ministry and the Bank of Japan (BOJ)—have made the timid Gussie Fink-Nottle of P.G. Wodehouse fame look positively Napoleonic. They have simply thrown government money at the problem every once in a while. Despite making reformist noises, Junichiro Koizumi, the current prime minister, has turned out to be depressingly similar to his predecessors. It sometimes seems that Mr Koizumi’s only daring feature is his haircut.
Thus have government debts risen (to 150% of GDP) and companies’ debts fallen too slowly. In the case of the latter, earning enough money to service these, let alone pay them off, has been complicated by overcapacity in every business from banking to theme parks, which has sharply reduced profitability. Worse, this overcapacity has led to persistent deflation, which drives up the real worth of those debts. Andrew Smithers, a London-based economist who runs his own research firm and a man who has been very gloomy about Japan for years beyond count, reckons that, properly measured, corporate Japan is insolvent.
Thus, too, have financial markets registered the dreadful deterioration in the country’s position. As deflation took its icy grip from 1998, so government-bond yields have broken one record after another. Ten-year yields dropped to a low earlier this year of 0.4%—far and away the lowest bond yields in recorded history. From its peak of 38,915 in December 1989, the Nikkei average has dropped to a little over a quarter of that level. Shares in Japanese banks, once apparently the world’s strongest and the linchpin of the Japanese economy, fell by 93% from peak to trough.
But the mood among Japanese financial and business folk has noticeably improved since the spring. From being the world’s worst-performing big stockmarket this year, Japan’s is now the best: the Nikkei is currently at its highest level in more than a year. Although this is fuelled in part by foreign buying, domestic investors have been getting back into the market: turnover is at levels last seen in the late 1980s. Ten-year government-bond yields have quadrupled, to 1.6%. Economic recovery seems to be gathering speed: according to revised figures published on Wednesday, the economy grew at an annual rate of 3.9% in the second quarter.
There seem to be three reasons for this new-found optimism. The first is that Japanese companies do seem in fact to have restructured quite drastically. Profits for non-financial firms on the Tokyo Stock Exchange are now 30% higher than at the peak of the bubble, which is perhaps why bank lending is still falling: companies have been using profits to pay down debts. (Banks are also securitising more of their lending, which makes the fall more pronounced.)
The second reason is that in March the government appointed Toshihiko Fukui, a former deputy governor of the BOJ, as its governor. He has been a breath of fresh air. He replaced Masaru Hayami, who had in most important respects followed the lead of his two predecessors, Yasuo Matsushita and Yasushi Mieno, both hard-money men. It was Mr Mieno who was responsible for popping the bubble and he was far too late in realising how much damage this would do to the economy. His successors were too conservative to do much by way of unorthodox policy, and the bank sat on its hands, bleating that the real economy needed to be reformed. Indeed it did, and still does, but that is very much a secondary problem. The main problem is Japan’s deflationary spiral.
On this question, Mr Fukui and his deputies seem to be much more open to ideas. His first act as governor was to call an emergency meeting of the policy board to get new ideas. They have come thick and fast but a common thread is that the best way for the BOJ to jump-start the economy and affect inflation and inflationary expectations is through asset markets—notably the stockmarket—by the use of its own balance sheet. It has increased its purchases of shares from capital-strapped banks who have wanted to sell them from ¥2 trillion ($17.1 billion) a year to ¥3 trillion. It has jacked up bank reserves at the BOJ from ¥20 trillion to ¥27 trillion. And it has opened a ¥1 trillion credit line to lend to smaller companies. Symbolically, it has also stopped mopping up the yen that it creates when it intervenes in the foreign-exchange markets, as it has repeatedly done to stop the yen rising against the dollar. Thus has it squirted some ¥10 trillion into the money supply. Base money is now rising at an annual rate of 20.5%, good news for those who think that inflation is a monetary phenomenon.
The bail-out in May of Resona, a big regional bank, marked another, even more important change in thinking among policymakers, says Peter Tasker, author, strategist and as subtle a thinker on Japan as they come. For once, they seem not to have been at loggerheads: the whole thing took little more than a weekend, compared with the many months of tortured talks before LTCB and NCB, two long-term credit banks, were nationalised in 1998. This in itself was a big change, not least because the economics minister and head of the Financial Services Agency, Heizo Takenaka, had previously taken a very hard and controversial line against banks and their bad loans. In October last year, he said in an interview with Newsweek that no bank was too big to fail.
Mr Takenaka seems subsequently to have been persuaded that his hard line was the wrong one. The bail-out of Resona was astonishingly generous. For possibly the first time in history, a bank was rescued with shareholders taking almost no hit: equity for existing shareholders was preserved. The government has pumped in so much money that the bank, which needs 4% capital against its loans but in fact had only 2%, now has one of the strongest capital ratios of any Japanese bank.
What makes this different from previous, failed bank rescues? In the past, the banks receiving taxpayers’ money were widely known to be complete dogs, and it was an open secret that they would be taken under the wing of the state. Moreover, on each occasion, regulators said that this was the last time. This time, in contrast, rumours were almost non-existent and regulators made no such claims, presumably because the rescue was designed to placate shareholders, not frighten them.
Nobody knows for sure that the Resona rescue is a new template for dealing with financial uncertainties. The important point is that markets clearly think that it is. Last year, nobody knew which big banks or borrowers would be allowed to fail. But the message markets took from the bailout was: nothing vaguely big. The reaction in bond and equity markets has been to buy anything with the vaguest sniff of risk—Alan Greenspan couldn't have done a better job of stirring up investors' animal instincts. In January, there were 200 companies on the Tokyo Stock Exchange trading below ¥100, which in Japan means that they are on the brink of bankruptcy. Now there are fewer than 30. Spreads of corporate bonds, which had soared following the bankruptcy of Mycal, a big retailer, in the autumn of 2001, have narrowed astonishingly rapidly—and to levels that assume there is no risk of their going bust. Shares in Mizuho, a big bank with bigger problems, have tripled. As Jesper Koll, an old Japan hand, notes dryly: “You don’t want to own the best of class.” In this way, Japan has gone back to its previous model: in effect, it has nationalised the banking system, socialised credit and removed bankruptcy risk. Clearly, there is a hazard that credit thus allocated will be allocated badly. Equally clearly, it is important that it be allocated at all.
Apart from the stockmarket, the effects of all of this elsewhere in the economy are as yet fairly intangible. True, consumer-price deflation has been easing for some time. But the GDP deflator, a better measure, has bounced only in the last quarter, and is more volatile. Rising long-term bond yields might snuff out a recovery, but the BOJ has been anxious to reassure investors that it will not put up rates until inflation has turned consistently positive, which should put a lid on yields. Mr Koll, though few others, expects inflation to be positive next year.
There are still huge problems, not least the mountain of debt owed by companies and government alike. A stronger yen would snuff out exports. But the only way for Japan to get rid of its debt and to stop the yen rising is inflation, and lots of it. A falling yen would also make the hundreds of billions of dollars owed to Japan by America (in the form of the Treasuries in the country’s foreign-exchange reserves) more valuable. It seems much safer than it used to be to assume that policymakers have realised all of this—and are at last doing something about it. Fingers crossed.
Iraq’s rising price tag
Bush has said he plans to ask Congress for $87 billion in extra spending on Iraq
and Afghanistan. Meanwhile, Britain is sending more troops to the Gulf
FOUR months after declaring the war in Iraq essentially over, President George Bush told the American people on Sunday September 7th that their commitment in Iraq would be “difficult and costly”. Continuing violence, he noted, had claimed the lives of American and British soldiers, aid-workers and Iraqi moderates. Mr Bush also said that he was asking Congress for $87 billion in extra spending on Iraq and Afghanistan, most of it to pay military costs. This is substantially more than many had expected him to request, and essentially amounts to an admission from the White House that the situation in Iraq is more troubling than it had previously acknowledged. Britain, America’s chief ally, is also facing up to the difficulties in Iraq: it announced on Monday that it was sending 1,200 more troops there.
Mr Bush hopes to justify the extra spending on Iraq by stressing that the stakes are high. In his speech, he described Iraq as the “central front” in the war on terror that was launched following the September 11th attacks two years ago. Though a connection between Saddam Hussein’s regime and al-Qaeda has yet to be proved, there are increasing reports that foreign fighters are slipping into Iraq to do battle with America. “They know that a free Iraq will be free of them—free of assassins and torturers, and secret police,” said Mr Bush. Making democracy work in Iraq is also crucial to America’s efforts to reshape the Middle East. On Sunday, Mr Bush vowed that despite the setbacks, America would stay the course: Iraq, he said, will be no Beirut or Somalia.
His words, ringing with references to freedom, were intended to rally a nation that is increasingly worried about the Iraq mission. Mr Bush originally told Americans that the war was about getting rid of an evil dictator armed with weapons of mass destruction. So far, no such weapons have been found, and the near-daily deaths of American soldiers at the hands of militants have led to muted murmurings about Vietnam. Mr Bush’s poll ratings are slipping (though the economy is also to blame for this) as the 2004 presidential-election campaign heats up. Newly emboldened Democratic candidates no longer think he is untouchable on matters of security.
With the news from Iraq (and still-troubled Afghanistan) still bad, Mr Bush’s frank talk is welcome, if overdue. For months the White House has been trying to put a brave face on grim news, and it has been vague about the price-tag of Iraq. No longer. The $87 billion that Mr Bush will request, which will go mostly to Iraq, is a vast sum—about one-and-a-half times Iraq’s estimated pre-war GDP. That comes on top of previous spending on Iraq of nearly $80 billion. Members of Congress are likely to approve Mr Bush’s request, albeit with a few shudders. If so, it would push America’s already-record budget deficit next year to well above $500 billion.
Over the long term, though, this is unlikely to be enough. Reconstruction costs will account for only around $20 billion of the budget request. This does not reconcile well with the estimate by Paul Bremer, America’s top administrator in Iraq, that providing clean water alone will cost $16 billion. Iraq’s vast oil resources will contribute some cash, but not as much as the administration hoped: oil production and exports have been slowed by sabotage and antiquated equipment.
As the financial and human costs of occupying Iraq mount, the Bush administration has begun energetically seeking outside help. Last week, American officials circulated a draft United Nations resolution to members of the Security Council urging other countries to commit money, troops and other support towards the rebuilding of Iraq. This is a marked shift for an administration that sidestepped the UN on its march to war. The draft resolution sanctions the creation of a multinational force under “unified” command—ie, with America still in charge. It also endorses the American-backed Governing Council of Iraq, and suggests UN oversight of the council’s plans for a new constitution and elections.
Still, the draft resolution may not go far enough to win international backing. Already, President Jacques Chirac of France and Chancellor Gerhard Schröder of Germany have implied that the resolution still leaves America with too much control of post-war rebuilding. Without a UN resolution, potential contributors of troops, such as India, are unlikely to join the American-led coalition. Meanwhile, America has extended the time its National Guard and reservists must spend in Iraq, the Washington Post reported this week—though Donald Rumsfeld, the defence secretary, has so far resisted calls from congressmen and others to send more American troops to the region.
Might other countries be persuaded to contribute money, if not troops? America certainly hopes so. At a meeting last week in Brussels, prospective donors agreed to create a fund, controlled by the UN and the World Bank, that would distribute donations independent of the coalition. But how much other countries will contribute to the American effort—with or without a new UN resolution—remains to be seen. America will be sure to press its richer allies for commitments ahead of an aid donors’ conference in Madrid in late October. That battle, like the military one, is far from over.
of Free Money
Friday September 5, 12:04 pm ET
By Donald Luskin
Right off the bat I'll admit that obviously it isn't always true that bonds are safer than stocks. Since June 13 long-term Treasurys have lost 10.7% while the S&P 500 index has been virtually unchanged. And it's not just that bonds fell while equities stayed afloat. What's so remarkable about this period is the immense volatility of bonds at a time when the stock market has been so quiet. Extraordinary forces were clearly at work, as is usually the case whenever markets temporarily violate a principle that's practically a law of economic nature. Here's what happened.
Like so many great events, it all started with a simple misunderstanding. In the early spring, with the federal-funds rate at 1.25%, the bond market thought it heard Alan Greenspan say something that the Federal Reserve chairman never really quite said. What the bond market thought it heard Greenspan and other Fed officials say — in official statements and during various speeches — was that the central bank intended to keep rates at that level or even lower for the indefinite future. The reasoning was two-fold: The Fed was going to build a firebreak against any possibility of deflation, and saw no risk whatsoever of inflation; and the Fed saw no evidence that economic recovery was substantially accelerating.
So here's what the big bond traders at the Wall Street banks did, starting in April. They borrowed billions of dollars in the overnight market at 1.25%, confident that this rate would soon be reduced to 1% or even 0.75%, and then stay there practically forever. The big bond traders then took that borrowed money and bought long-term government bonds. At that point the 10-year Treasury note yielded about 4%.
Try to see the world the way the bond traders saw it. You borrow money at 1%, and you earn 4% on the notes you bought with the borrowed money. Your profit is 3% for every year you can keep that position in place. Maybe 3% doesn't sound like a lot to you? Then you're missing the point. That 3% was to be earned on what amounts to an investment of zero — it was all done with borrowed money. That's functionally an infinite return. Sweet. Wall Street calls it the "carry trade," because a trader is effectively being paid by the Fed to carry bonds in his trading account. Free money! By mid-June Wall Street had put the carry trade on so big that the 4% yield of the 10-year note had been driven down almost all the way to 3%.
The carry trade wasn't the only force moving Treasury yields lower. Hedging activity in the market for mortgage-backed securities took the trend set in motion by the carry trade and made it into a monster move.
Mortgage-backed securities, bonds that are collateralized by packages of mortgage loans, have become the largest segment of the U.S. bond market — even bigger than the enormous market for Treasurys. Mortgage-backed securities, or MBSs, are tricky instruments that can be much riskier than normal bonds. As the MBS market has gotten larger some of its risk has started spilling over into the bond market at large.
What's so tricky about MBSs is that you never really know the maturity. When you buy a 10-year Treasury bond, there's no question about it. But mortgage borrowers tend to refinance home loans when rates fall and hang on to them when rates rise. So when rates are declining (and most bond prices are rallying), MBSs suddenly get repaid. All that interest income you expected to earn over the years? Forget about it.
That means that when rates fall quickly, as they did from April to mid-June, MBS traders need to buy larger and larger positions in Treasurys to hedge the falling value of their portfolios. And of course their buying drives interest rates even lower — it's a classic vicious cycle, and nowadays it tends to exaggerate the magnitude and duration of any move in interest rates and bond prices.
With 10-year Treasury notes yielding just a bit more than 3% in mid-June, traders who had put the carry trade on just a month before, with bonds yielding 4%, were sitting on profits of billions on an investment of nothing. And that, of course, is when reality started to set in.
On June 15 Alan Greenspan, in his semi-annual monetary report to Congress, hinted that economic growth might be accelerating just a little faster than the Fed had previously thought. Then 10 days later, the Federal Open Market Committee met and lowered interest rates to 1% — but not all the way down to the 0.75% that the carry-trade holders had hoped for.
Suddenly the bond market started to re-evaluate what it had understood to be a promise by the Fed to keep rates low. Just weeks before the buzz had been that there wouldn't be even the smallest rate hike until late 2004. Suddenly mid-2004 was a possibility; then early 2004. Panic started to set in as bond prices began to fall.
Why? Because the carry trade is only free money as long as bond prices either stay steady or rise. As soon as they start to fall, the losses in just a few days can swamp that 3% a year the trader expected to earn. As bonds fell, suddenly the idea of making an infinite return on an investment of zero started looking like the opportunity to take an infinite loss.
As traders scrambled to get out of the carry trade, bond prices collapsed. Yields blew back through 4% where billions of dollars of the trade had been initiated, and just kept on rolling. The mortgage traders got into the act, of course, and it was the vicious cycle all over again — just in reverse. All the Treasurys bought just weeks earlier now had to be dumped. At the worst of it several weeks ago, the yield on the 10-year Treasury note got as high as 4.6%. Losses have run in the tens of billions of dollars — which, by the way, has a lot to do with why the financial sector (the S&P 500's largest sector by cap weight) has been among the worst performers this month.
Many commentators have said that the Fed lied — that it has blown its credibility by promising to keep rates low, and then not following through. But as I said at the outset, I think it was a stupid misunderstanding, not a lie. All the Fed ever promised to do was to keep an accommodative monetary policy in place. What Wall Street had to learn is that the Fed can be just as accommodative as it is today even with higher interest rates.
How's that again? Well, go back and read what I wrote three weeks ago when I explained why rising interest rates go hand in hand with accelerating economic growth. As growth revs up, opportunities increase and capital becomes more valuable. People will pay more to rent it; i.e., interest rates go up.
For the Fed to stay accommodative, all it has to do is keep the fed-funds rate relatively low in comparison to real opportunities in the economy. For a stagnant economy that relatively low rate will be 1%. But as the economy begins to cook again, that relatively low rate could be 2%, 3% or more. A year from now the Fed could be just as accommodative at 3% as it is today at 1%.
And when the traders holding the carry trade started to get that message, they had no choice but to face the facts and take their losses. Of course with everyone on Wall Street massively long Treasurys, and the mortgage traders trying to sell at the same time, who was there to buy them? No one. And that's why bonds — good ol' "safe" bonds — have lost over 10% in a little over two months.
So what's the lesson here? The guys with the carry trade learned that free money can be the most expensive kind. And we've learned that even a seemingly axiomatic truth like "bonds are a safer investment that stocks" isn't always true.
Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at firstname.lastname@example.org.
Road to nowhere
in the Middle East with little sign of any effort to restore the tattered
“road map” peace plan. An official report criticising the Israeli government
and police over Arab deaths in riots in 2000 seems unlikely to satisfy
Palestinian calls for justice
ISRAEL has resumed its assassinations of Palestinian militant leaders with a vengeance since last month’s suicide bombing of a bus packed with Jewish families in Jerusalem, which killed 21 people, including several children. In the latest such assassination, on Monday September 1st, missiles from Israeli helicopters blew up Khader al-Husari, a leader of Hamas's military wing. Israeli strikes have now killed 11 militants (and five bystanders) since the bus bombing. In strictly military terms, the policy is proving successful in eliminating those Israel accuses of organising terrorist attacks. But it makes any return to a ceasefire and any hopes of progress on the internationally backed “road map” to peace seem ever more remote prospects.
Hawks in the cabinet of Israel’s prime minister, Ariel Sharon, are pressing him to go further and expel Yasser Arafat from his base in the West Bank, accusing the Palestinian Authority’s president of encouraging terrorism. Leading Palestinians admit that a fight between Mr Arafat and his prime minister, Mahmoud Abbas, for control of the PA’s security forces is making it easier for Israel to justify its targeted killings of militants, by arguing that the Palestinians themselves are too busy squabbling to curb the bomb-makers.
On Monday, an inquiry into the deaths of 13 Israeli Arabs and the wounding of dozens more in riots in October 2000 severely criticised the Israeli government, its then prime minister, Ehud Barak, and the police. The inquiry, led by an Israeli Supreme Court judge, called for a number of police chiefs to be banned from senior positions; it condemned an ingrained anti-Arab prejudice among police officers and a culture of filing false reports on fatal incidents; it flayed the government for its failure to respond to the deep resentment among Israeli Arabs; and it referred some shooting incidents for further investigation, possibly leading to criminal charges. But it made no recommendation against Mr Barak, who is considering a comeback to national politics.
The inquiry’s report has attracted much public debate in Israel, especially because of its sweeping condemnation of government policies towards the Arab minority and its grim warnings that discrimination could push communal relations to “the point of no return”. The report also faulted some Arab politicians for helping to foment the tensions that led to the violence three years ago. It is unlikely to satisfy Arabs, either the 1m or so in Israel itself, or the 3.5m Palestinians in the West Bank and Gaza strip, areas which have both been under Israeli control since the 1967 war
The rioting came shortly after Palestinian militants had declared their second intifada (uprising) against the occupation. It was triggered by a visit by Mr Sharon, then the main opposition leader, to the rocky outcrop in Jerusalem that Jews call Temple Mount, Muslims call Haram al-Sharif (the Noble Sanctuary) and both regard as among the holiest of places on earth. In 2002, the year after he came to office, Mr Sharon sent Israeli troops into the West Bank and Gaza, arguing that the PA was doing nothing to stop militants’ attacks. In April this year, under international pressure, Mr Arafat appointed the more moderate Mr Abbas as prime minister and, in June, President George Bush got Mr Sharon and Mr Abbas to shake hands on the road map, a peace plan drawn up by America, the European Union, Russia and the United Nations, which envisages an independent Palestinian state by 2005. During a fragile truce agreed shortly afterwards, Israel withdrew troops from most of Gaza and had begun pulling back from parts of the West Bank when the ceasefire was shattered by last month’s bus bombing and Israeli assassinations of militant leaders.
Palestinian leaders say the assassinations make it impossible, in the court of Palestinian opinion, to act against Hamas and other hardline groups, whereas Israel’s renewed military build-up in Gaza makes it impossible not to. The result is reluctant, half-hearted gestures that satisfy no one: shovelling earth into tunnels under Gaza’s frontier with Egypt, which are allegedly used to smuggle weapons; freezing the accounts of Islamic charities because they may be used to fund Hamas’s military wing; and dispatching PA police to try to stop mortars being fired at Jewish settlements.
While the Israeli assault shows no sign of letting up, Palestinians see their leadership imploding. In line with the road map—and under American pressure—Mr Abbas is trying to bring the PA’s security forces under the control of his security chief, Muhammad Dahlan. Mr Arafat, backed by most of his Fatah movement, insists the forces must remain answerable to himself. The two leaders “hate each other now”, said the Palestinian parliament’s speaker, Ahmed Korei, on Monday. Mr Korei said he and other mediators were trying to rebuild relations between the squabbling leaders ahead of a meeting of the parliament, on Thursday, to assess Mr Abbas’s first 100 days in office. On Wednesday, the PA's information minister, Nabil Amr, said Mr Abbas would tell the parliament he will resign unless his officials are given full authority over security and other key policies.
Mr Arafat, meanwhile, has been warned that, should he topple Mr Abbas by means of a confidence vote, he would lose what little “engagement” America has in the road map. Though efforts are being made to reach a compromise that keeps Mr Abbas in office, it is hard to imagine one that will give him all the authority he needs to crack down on the militants.
Unless that happens, Israel is bound to continue tackling the threat from Palestinian terrorism in its own way. It may even consider expelling Mr Arafat, who is currently holed up in his shell-damaged headquarters in the West Bank town of Ramallah. The hawkish Israeli defence minister, Shaul Mofaz, this week repeated his call for Mr Arafat’s expulsion, arguing that the government had made an “historic mistake” in not kicking him out after it came to power two years ago. So far, Mr Sharon has overruled Mr Mofaz’s demands. But with Palestinian leaders too busy bickering to take the initiative and revive the peace process, the Israeli prime minister may well see it as one way to break the deadlock.
Thus has Buttonwood watched as stockmarkets around the world have bounced from their lows in March, just before the invasion of Iraq, wondering what to make of it all. The bounce has certainly been sharp: the S&P 500 has risen by 26%, the FTSE 100 by 28%, and shares in the euro area by 39%. But it has been in Japan, for so long shunned by investors as a graveyard for optimists, where the rise has been most dramatic. The Nikkei 225 index, up by 41%, has soared through 10,000 to a 14-month high. Its rise, especially swift recently, has proved infectious for shares elsewhere in the region. Strategists think more rises are on the cards. In fact, you would trawl largely in vain for a strategist who thinks that shares are about to plunge in any of the big markets. For once, Buttonwood is in agreement—though only up to a point.
Economic growth in America and Japan in particular has been surprisingly good and getting better, which should help corporate profits. America’s economy grew by a revised 3.1% at an annual rate in the second quarter (up from an original estimate of 2.4%), and many forecasters are now betting that it will grow by 4% or thereabouts in the second half, and by perhaps 3.5% next year. Even Japan grew by 2.3% in the second quarter and more of the same is expected for the rest of the year and indeed next year. Most economic statistics in the world’s two biggest economies are pointing in the right direction. A few are even muttering that the euro area is growing a bit, which may be stretching it. In such circumstances, it is difficult to see stockmarkets falling out of bed; indeed, as more good news comes in, it would be surprising if they did not rise further.
The optimists, of which there are a fair few, think that America is having a normal recovery after a remarkably shallow recession following the bursting of the dotcom bubble in 2000. Bank lending, falling corporate credit spreads, rising bond yields and stockmarkets: all have been pointing to recovery in America, for years the motor of the world economy. In Japan, meanwhile, rising business confidence, stockmarkets and bond yields (which have tripled since their lows) all suggest that the economy is finding its feet.
But Buttonwood doubts that either the recession or the recovery is normal; and the forces spurring growth in America and Japan seem unsustainable. The recession in America was abnormal, at least for modern times, because it was sparked not by the Federal Reserve jamming on the monetary brakes, but by the spontaneous bursting of the stockmarket bubble. The excesses of that bubble have not disappeared, nor have they in Japan some 13 years after that country’s stockmarket crashed. Economic bubbles are created on a mountain of debt, which is both deflationary and inflationary: deflationary because of the excess capacity created with an over-abundance of cheap capital, and because following the bubble’s bursting companies and households must reduce their debts rather than spend; and inflationary because, in the end, stoking higher prices by printing money is probably the only way to get rid of these debts. Both Japan and America are still in the first stage.
It is the abnormal nature of the recession which makes the recovery in America abnormal, too. It would be surprising, indeed, if America’s economy was not growing at the moment, given vast tax cuts, hefty government spending and low interest rates. As in Japan for brief periods in its lost decade, notably in 1996, extravagant government spending is able to get the economy moving for a while. But the result is higher government debt: the Bush administration has turned huge projected surpluses into huge deficits; in Japan, the government’s debt is now an uncomfortably large 150% of GDP and growing.
Saddled with debt and deflation though it is, Japan seems to many observers to be on its way to a sustainable recovery at long last. Do not count on it. This is the fifth cyclical recovery since the bubble burst, and on each of the previous occasions investors have been fooled into thinking that this time was different. Japan may be due a bounce: in 2001, it had its worst recession since the second world war. But the fact is, it has done little since the bubble burst to ensure that this recovery will last. Taken as a whole, its corporate sector is probably insolvent, and as a result its banks are still stuffed full of non-performing loans. There has been precious little deregulation or tax reform. Japan needs inflation to wipe out its huge debts. But rapidly rising prices would also wipe out the country’s massive savings.
In America, crucially, private spending has also been supported by very low interest rates, which have fed a housing-finance boom, among other things. Private-sector debt is now 180% of GDP and on the up. If America does not save, others must finance those debts, which is why the country’s current-account deficit is 5% of GDP and rising by one percentage point a year. As economists are wont to say, this is unsustainable—and so, presumably, is the stockmarket recovery.