Market Advisory Features

A Question of Interest
Another Oil Shock?
Opec and the G7

Asia’s Stockmarkets Fall Out of Favor
Cheap money, pricey oil
China's economy: The Great Fall of China?
China and the Fed: twin piques
The search for investment paradise

The warrior president
A Remedy for Financial Turbulence?
Cash and carry
Hopeful signs of a job-full recovery

Saudi Arabia and Oil
Oil : Still at its Mercy

The World Economy :Other Reasons to Worry
Buttonwood: The Echoes of History
A U-turn in the desert
The Oil wars : In the Pipeline

The Best Use of Aid?
Warnings to be ignored
The unstoppable, surging yen






A question of interest
Jun 15th 2004
From The Economist Global Agenda

The Federal Reserve may have to push up interest rates less than you may suppose, though for the worst of reasons

HOW quickly the extraordinary becomes the norm. It is easy to forget quite how breathtakingly low interest rates are around the world. In America, Europe and Japan, short-term rates are at their lowest in recorded history. Not for nothing is the Bank of Japan’s policy dubbed the zero interest-rate policy. The Federal Reserve’s might just as well be called the as-close-to-zero-as-makes-no-difference interest-rate policy. In the sweep of history the 1% Fed-funds rate is arrestingly nugatory. It is, after all, only four years (and 13 interest-rate cuts) since American short-term rates were 6.5%. And it is barely 23 years ago (though it seems another age) that, under the chairmanship of Paul Volcker, the Fed-funds rate reached almost 20%, to clamp down on inflation verging on 15%.

Successfully, as it turned out: inflation and long-term bond yields peaked in 1980, and have, with a few bumps, fallen ever since. Now they are rising again, though for how long and how far is moot. Heady growth, creeping inflation and a fear that the Fed might be tardy in raising rates, as it is universally expected to do on June 30th, had recently sent ten-year bond yields to above 4.8%, from their low a year ago of 3.1%. Certainly, the great and the good from the Fed have sounded notably more hawkish about inflation recently, from which many observers have inferred that it might raise rates by more than the quarter-point that the market has been expecting. Perhaps it will, though figures released on Tuesday June 15th showed that the rise in core inflation in May (ie, inflation stripping out volatile things that are currently going up in price, such as oil) was no worse than pundits had forecast. Alan Greenspan, the Fed's chairman, made soothing noises about future rate rises being “measured”—and Treasuries soared.

Although inflation is unlikely to surge just yet, it is clearly picking up. While there will doubtless be inflationary scares aplenty in coming months, the Fed may not have to push up rates as fast as some suppose to keep it in check, and perhaps by less than most think. American consumers, whose heroic lack of thriftiness has kept the economy afloat these few years past, are now so hugely indebted that a rise in rates is likely to have a bigger impact on their spending than in the past. It is, after all, that very indebtedness that has stayed the Fed’s hand in raising rates from their present, derisory level. Unfortunately, keeping them so low for so long has made a bad problem worse, because it has caused a stampede into assets—houses—that are now horridly expensive by any reasonable measure; and because a big chunk of those assets is now financed with floating-rate rather than fixed-rate mortgages.

Extraordinarily low interest rates have encouraged extraordinarily huge borrowing. In 1994 and early 1995, the period in which the Fed doubled interest rates to 6%, households’ financial obligations swallowed about 9% of their disposable income. Despite much lower interest rates, the figure now is double that, as consumers have piled up debt. Ominously, the only time that it was anything approaching this was in 1987, the year the stockmarket crashed. And a startling commentary earlier this month by Benjamin Tal and Avery Shenfeld of CIBC World Markets spells out just how exposed these debts are to rising interest rates.

Historically, Americans have generally plumped for fixed-rate mortgages, which can be swapped, with no penalty, for cheaper ones when mortgage rates fall. Traditionally, only about a fifth of new mortgages have been of the variable-rate variety. That proportion has been climbing sharply in recent years, however, because short-term interest rates (and thus variable-rate mortgages, which follow them) have been so much lower than long-term rates (on which fixed-rate mortgages are based). In April, fully one-half of all new mortgages were variable-rate—the highest total on record.

The rise in variable-rate loans has been greatest in areas such as San Francisco, where house prices are highest, presumably because that is the only way that would-be buyers can afford to get their foot on the property ladder. And almost 10% of those taking out such mortgages—more than double the figure of ten years ago—are dodgy borrowers, though in one of the euphemisms for which American financiers are justly famous, they are known as “sub-prime”. Personal bankruptcies, it is worth noting, are already at record highs.

Fuelled by cheap mortgages, the housing boom has also enabled America’s less-than-thrifty consumers to cash in the equity on their homes. Home-equity lines of credit (helocs) have soared even faster than house prices, are rising at 30% or so a year and now amount to more than $250 billion. Most helocs are variable-rate loans. Add in the surge in non-mortgage household debt in recent years, say the two CIBC economists, and almost a quarter of all household debt would immediately be affected by higher rates—70% higher than in 1994.

All of which would be bad enough, but there is worse. According to The Economist’s house-price indices, property prices in America have risen by more than half since 1997, leaving them at record levels compared with rents and wages. Though property prices there are not as frothy as in some countries (even the normally staid governor of the Bank of England was moved this week to warn about Britain’s giddy house prices), at current interest rates, house prices would need to fall 10% or so to be anything appoaching fair value. They are, in other words, expensive—and in some places very expensive. Together with the prospect of higher rates, perhaps that is why in America they rose by only 1% in the first quarter, the smallest quarterly increase in six years, and fell in some areas.

Were house prices actually to fall across the board, it seems safe to assume that, at the very least, consumption that was paid for by borrowing on the back of rising property values would evaporate. Consumers would also feel poorer, though how much poorer would depend on how much property prices fell. A study by Goldman Sachs reckons that, were house prices to fall to fair value, consumption would fall by 1.5%. The study does, however, have a decidedly finger-in-the-air feel to it. And, as the authors say: “There is, however, a risk that the necessary correction in housing markets accelerates into something worse.”

Isn’t there just? There is absolutely no necessary relationship between low interest rates and buoyant property prices. In real terms, prices in Germany are the same as they were in the early 1970s. But the most striking exception is Japan. If you believed the argument in its most simplistic form, property prices should have gone through the roof in Japan since 1995. They have, in fact, continued their remorseless decline: since 1997, they have fallen by more than a fifth. Japanese consumers, it is worth pointing out, are a lot more flush than their American counterparts. In his idle moments, Buttonwood wonders what would happen to the American economy were property prices to tank, at the same time that oil prices soared and the fiscal stimulus ran out. It wouldn’t look pretty, that’s for sure.




Another oil shock?
Jun 1st 2004
From The Economist Global Agenda

The world depends for low oil prices on an unstable country that seems to be falling apart. No wonder they are rising

BUTTONWOOD had been toying with the idea, horribly clichéd though it may be, of starting this column by telling readers how much it now costs to fill up his Fiat Punto. There were, however, a number of problems with such an introduction. The first is that the Punto took a drubbing on the A12 in Suffolk and has been carted off to the great garage in the sky. The second and third problems are a little more macro: sterling is strong and fuel taxes account for a huge proportion of pump prices in Britain, the combined effect of which is to mute the effects on British consumers (and the economy) of a rise in the price of oil. But the main reason is that the terrorist attack in Saudi Arabia at the weekend made the use of the Punto to talk about oil prices as redundant as Giuseppe Morchio, Fiat’s chief executive until he quit on Sunday.

You could argue that the Khobar attack signifies little. The hostage crisis was, after all, short-lived, and the loss of life relatively small—only 22 died, of the hundreds trapped in the residential complex during the stand-off. Indeed, the attack was not notably worse than most previous terrorist acts in the kingdom. Nobody knows for sure that this latest attack was the work of al-Qaeda, though a statement has claimed responsibility on its behalf. And although most of those killed, who included many foreign workers, were involved in the oil industry, Khobar produces, refines and exports no oil at all. The flow of oil from Saudi Arabia, far and away the world’s biggest producer, has been almost uninterrupted throughout the war in the Middle East. Not only has the country vowed to increase production, it is putting pressure on the other members of OPEC, which meets on June 3rd, to do the same—a big reason, presumably, why oil prices jumped only a bit when markets opened on June 1st.

But all this misses the essential truth. For all that rich countries have weaned themselves off oil in recent decades, they are still hugely dependent for their most important commodity on a nasty, unstable regime in a nasty, unstable part of the world. And both the Middle East in general and Saudi Arabia in particular seem to be becoming nastier and more unstable with every week that passes.

It is hard to overestimate the importance of Saudi Arabia to the oil market. At the moment it produces almost 9m barrels a day. Though oil production in Russia has been catching up fast, Saudi Arabia is still the world’s biggest producer. Two other things make Saudi Arabia more important than any other oil producer. The first is that its reserves are much greater: about a quarter of the world’s proven oil reserves. The second is that, partly as a result, Saudi Arabia acts as a sort of central bank to moderate swings in oil prices. It turns on the taps when oil is in short supply and prices rising; and turns them off again when oil is plentiful and prices falling. But so high is demand around the globe at the moment that other members of OPEC are already operating at close to full capacity, if not at it. And no one knows how much more Saudi Arabia can churn out now. Hence the worries about a big terrorist attack on Saudi oil production, and the fears that the attack at Khobar might herald one.

No Arabist, Buttonwood probably knows as much as most about Saudi Arabia, which is to say very little. The country is in some ways the world’s most absolute monarchy, though there are many warring factions within the ruling house of Saud. It has been run by Crown Prince Abdullah, King Fahd’s half-brother, since 1995, because of the king’s ill health. But the prince has been treading a difficult path between the middle classes, who want more reform and liberalisation, and those—not least the fundamentalist Wahhabis, on whom the ruling family still depends for its moral authority—who think that the centre of Islam has become corrupted and westernised.

A measure of disaffection in Saudi Arabia is that three-quarters of the suicide bombers who attacked the twin towers came from the country. Support for al-Qaeda seems to be widespread: terrorist attacks have been increasing. Though the country’s security services have been cracking down on terrorist suspects, they have so far killed only eight from a most-wanted list of 26 published last December, plus a couple of dozen others that did not make the list. On such a country does the world depend to keep crude prices low.

So it should not come as much of a surprise that the markets doubt that it will, which is partly why prices rise with each new setback in the Middle East. Some people dub this the “terror premium”: the extra few dollars on the price of a barrel from the threat of an attack on a big oil-production facility, in Saudi Arabia or elsewhere. It will subside, so the argument goes, when headlines become less gloomy. Others think that such concerns are overdone: prices are so high only because “speculators”, by which they generally mean hedge funds, have been buying in record quantities—how dare they!—on the New York Mercantile Exchange. When they are forced to sell, oil prices will collapse. Both arguments strike Buttonwood as odd, but the second is of arresting awfulness. It makes many dubious assumptions, but the worst is that those selling oil futures (largely producers, the figures suggest) are less likely to cut their opportunity losses from having sold crude too cheaply than hedge funds are to take profits.

It is as likely that with oil prices refusing resolutely to fall, despite the predictions of most pundits, the opposite could be true, sending prices higher still. However, adjusted for inflation, they would have to rise an awful lot to reach anything like the levels reached in the two oil shocks in the 1970s. Many economists also comfort themselves with the thought that rich economies are now far less dependent on oil than they were, and that the underlying reason for the price rise has as much to do with increased demand, especially from China, as with events in the Middle East. That will make the effects on rich countries much less severe than the two 1970s oil shocks, which were caused by OPEC turning off the taps.

A nice argument, except that a demand shock from China looks very much like a supply shock to anyone else, and worries about the Middle East are arguably just as important. Moreover, the situation looks very different in America, where the effects of rising crude prices flow through to the forecourt much more quickly than in Britain because the dollar has been weak and because taxes account for a smaller proportion of the pump price (23%, versus 75% in Britain). A short-lived third oil shock, in 1990 (just ahead of the first Gulf war) was enough to help tip America into recession. America’s gasoline prices have risen 40% or so since December. The effect of this rise is much like a tax, and it will eat into consumers’ wallets at the same time as the government’s huge fiscal stimulus is wearing off. Unless they can put up prices, companies, too, will have to accept lower profits.

In other words, the rise in the cost of crude oil could be inflationary or it could be contractionary or it could be both. And if Saudi Arabia falls apart all bets are off: for the Americans will be damned if they step in and damned if they don’t; the price of crude will rocket; and the world will be talking about a fourth oil shock.



From Amsterdam to Beirut
May 28th 2004
From The Economist Global Agenda

Worried by rising oil prices, the rich world's finance ministers have called on oil producers to pump more oil. OPEC, the producers’ cartel, is split over whether to oblige

IN A previous incarnation, Manhattan was known as New Amsterdam—its earliest European settlers hoping it might one day stand comparison with the great Dutch trading hub. Last week, the new-world upstart found itself once again in the shadow of Old Amsterdam. As New York played host to finance ministers from the Group of Seven (G7) rich nations, the real action was in the Dutch capital, where the oil ministers of the Organisation of the Petroleum Exporting Countries (OPEC) met informally to discuss the price of oil.

That price has been uncomfortably high of late. Last week, the benchmark price for West Texas crude reached a record of $41.85. Of course, adjusted for inflation, this is still only half the level prices reached in the oil-price shock of the 1970s. And western economies are now only half as dependent on oil as they were then. But if current record oil prices are less shocking than the hikes of yesteryear, they are quite upsetting enough for the G7 finance ministers. Prices at America's petrol pumps are at their highest for almost two decades, reaching a national average of $2.06 per gallon on Monday, up almost 58 cents on last year. Higher oil prices are already feeding through into headline inflation figures. In the euro area, inflation jumped to 2.5% in May, from just 1.6% two months ago, according to first estimates released on Friday.

With such concerns in mind, the G7 finance ministers have called for all oil producers to pump enough crude to bring prices down to “levels consistent with lasting global economic prosperity and stability”. Saudi Arabia, OPEC’s leading member, seems keen to oblige. Even before the Amsterdam meeting, the kingdom made a unilateral commitment to turn out 9.1m barrels per day (bpd) in June—about 800,000 more than it produced in April, and over 1.4m barrels more than its official OPEC production quota of 7.64m bpd. Other OPEC members, including Kuwait, the United Arab Emirates and Nigeria, have also said they will do their bit, according to Spencer Abraham, America's energy secretary.

The world's oil consumers are now waiting to see whether these assurances will become official OPEC policy. The cartel reassembles for a formal meeting in Beirut on June 3rd. Its total production quota, which currently stands at 23.5m bpd, could be raised by 2.3m bpd. Or quotas could be suspended entirely. The aim, says Purnomo Yusgiantoro, OPEC's president, is to have "a psychological impact” on the market.

That impact is already being felt: the price of crude fell below $40 on Thursday. But two doubts remain. Not every member of OPEC is happy to support such a big rise in production limits; and the formal quotas may in any case be beside the point: they are not a binding constraint on supply.

Libya's oil minister has already described the Saudis' decision to pump more oil as a “mistake”; others in Amsterdam also voiced scepticism or dismay. Longstanding divisions within the cartel resurfaced. The Saudis, keepers of a quarter of the world's oil reserves, are anxious to protect the long-term future of the oil market as a whole. They know that if prices stay too high for too long, the oil-consuming nations will find ways to economise on the black stuff. The smaller players within OPEC, however, are itching to cash in now. They are keen to increase their share of the market, and care less about the long-term size of the market as a whole.

These lesser players are already cheating on their quotas, and may already be producing as much oil as they can. Their physical limits, not the official limits set by OPEC, are what constrains their supply. Raising or removing quotas would simply bestow the cartel's blessing on what these countries are doing anyway. No matter how OPEC votes on June 3rd, it will not change the fact that the world is operating with less spare capacity than at any time in the past 30 years: down to just a few million bpd.

Both the Saudis and the Russians, who are not in OPEC, are looking at ways to add to this stretched capacity, exploiting new oilfields and opening new pipelines. On Wednesday, Vladimir Putin, Russia's president, vowed to end the bureaucratic bottlenecks that have prevented Russia from pumping and piping more oil while prices are hot. The Saudis are moving faster. According to the Wall Street Journal, they could tap new wells worth 800,000 bpd by the autumn. They could add almost as much again within 18 months. “Our wheels are moving,” said Abdallah Jumah, president of the Saudi state oil company.

Such prompt action should be enough, for the moment, to head off another oil-price shock. Prices of $50 per barrel no longer look an immediate prospect. But, by the same token, prices of $25 per barrel appear now to belong to a bygone age. The “history of cheap oil may have ended,” Venezuela’s energy minister proclaimed in Amsterdam, according to the Financial Times. In its place comes a time of political insecurity, which inhibits long-term investment in under-exploited Middle Eastern oilfields, and new economic dynamism: China now consumes about 6m barrels of oil per day, and India spent an estimated $15 billion on its oil imports last year. In the face of these fundamental trends, there may be little anyone, in New Amsterdam or Old, can do.




Saudi Arabia and oil

What if?
May 27th 2004
From The Economist print edition

Terrorists are now targeting Saudi Arabia's oil infrastructure. How bad could things get?

NOT SO long ago, a certain well-known international figure penned a heart-felt speech he called his “Letter to the American People”. In it, he said: “You steal our wealth and oil at paltry prices because of your international influence and military threats. This theft is indeed the biggest theft ever witnessed by mankind in the history of the world.” The author was Osama bin Laden.

The impact of those chilling words is still being felt in today's chaotic energy markets. Oil prices have recently been above $40 a barrel. Politicians in oil-consuming economies are up in arms. Saudi Arabia, the head of the Organisation of Petroleum Exporting Countries (OPEC), has promised relief. It is trying to persuade reluctant cartel members to increase production when they meet on June 3rd in Beirut.

Typically, a decision by OPEC to increase quotas cools prices. This time may be different. A soaring world economy has sucked global inventories dry. Nearly every OPEC producer, save Saudi Arabia, is already producing about as much oil as it can. That means that any new OPEC promise of oil will have to come chiefly from the Saudis themselves—and that is not good news.

The main reason for worry is the so-called “terror premium”. Oil traders report that fears of terrorist attacks that might disrupt Middle-Eastern oil exports may account for as much as $8 of the current per-barrel price. That may be because what was once unthinkable now seems possible, perhaps even inevitable: a major terrorist attack, or series of attacks, on oil facilities within Saudi Arabia.

But how well-founded are these fears? For the terror premium to be justified, one needs to consider three questions: Is Saudi Arabia really so important? Would it in fact be easy to pull off a serious attack inside the desert kingdom? And even if such an attack were to take place, would the oil markets suffer so badly?

First, is Saudi Arabia so important? Until the recent rise in prices, most headlines had trumpeted the growing importance of other oil producers. The revival of Russia , overtaking even Saudi output, was supposed to undermine OPEC. Oil from Alaska would give America “energy independence”. The quest for oil in the Caspian Sea was called the “Great Game”. Striking oil in the waters off Brazil and west Africa was even likened to hunting elephants.

Surely all this investment and discovery prove that the Saudis are ever less important to the oil market these days? Nonsense. Ignore the headlines and look instead at geological and market realities, and it quickly becomes clear that Saudi Arabia remains the indispensable nation of oil. The Saudis not only export more oil than anyone else, but they also have more reserves than anyone else—by a long shot. Fully one-quarter of the world's proven reserves lie in Saudi Arabia. Four neighbours—Iran, Iraq, the United Arab Emirates and Kuwait—each have about one-tenth. Russia, Nigeria and Alaska put together do not match Saudi reserves.

Even more important is Saudi Arabia's role as swing producer. Unlike other countries, the Saudis keep several million barrels per day (bpd) of idle capacity on hand for emergencies. Today Saudi Arabia is the only country with much spare capacity available (see chart 1), though the precise amount is a matter of intense debate. Nansen Saleri, an official at Saudi Aramco, the country's state-owned oil company, will say only that Saudi output will rise in June to about 9m bpd, and that the country can raise its output above 10m bpd “rapidly”.

This spare capacity allows the Saudis to moderate oil-price spikes. They have done precisely this at various times: during the Iran-Iraq war, when output from both countries was disrupted; during and after the first Gulf war, when output from Iraq and Kuwait was lost; and last year, when civil strife in Venezuela and Nigeria curbed output from both countries on the eve of last year's invasion of Iraq (which itself disrupted Iraqi output).

Produce the juice

The Saudis remain keen to moderate prices by using their buffer capacity. Last week, when some OPEC ministers rebuffed a Saudi proposal to raise output quotas at the Beirut meeting, they offered to lift production unilaterally. That might cool prices a bit, but would also leave the Saudis with less spare capacity to prevent a further oil shock.

That points to the second question: how vulnerable is Saudi Arabia's oil industry to terrorist attack? Not long ago, this desert kingdom was seen as a reliable and supremely safe source of oil. Indeed, some called it the central bank of oil.

After the September 11th attacks, such assessments seem too rosy. Terrorism is now clearly a serious problem. Not only were most of the 9/11 suicide attackers Saudi (15 out of 19), but reports suggest some Saudis are fighting against American-led coalition forces in southern Iraq. And increasingly, Saudi terrorists are striking targets at home—including oil infrastructure. On May 1st, one group killed several foreigners working at a petrochemical complex in Yanbu, the biggest oil-export terminal on the country's Red Sea coast (see map, above).

Not everyone is worried. Nawaf Obaid, an adviser to the Saudi royal family, argues in the latest issue of Jane's Intelligence Review that the risk of a successful attack on oil facilities remains “very low”. He explains: “At any one time, there are up to 30,000 guards protecting the Kingdom's oil infrastructure, while high-technology surveillance and aircraft patrols are common at the most important facilities and anti-aircraft installations defend key locations.” Mr Obaid claims that the Saudi government has added $750m over the past two years to its security budget (which totalled $5.5 billion last year, according to him) specifically to fortify the oil sector.

A sitting duck?

Kevin Rosser of Control Risks Group, a business-risk consultancy, agrees. He observes that there is plenty of redundancy built into the Saudi network—through multiple ports, pipelines and excess capacity—that should ease the blow from any attack. Besides, he insists, to do any real damage terrorists would have to hit bottlenecks, not just blow up random bits of pipeline. Mr Rosser quips that, “the golden goose is not a sitting duck.”

Maybe so, but other security experts think that goose may yet be cooked. James Woolsey, a former head of America's Central Intelligence Agency, is unimpressed by talk of improved security: “Guards and fences are easy to put up, but they don't defend against the real threats.” Trucks have to come in and out of facilities, he observes, and Aramco employees and security guards have to move about. He thinks that several attacks, if co-ordinated by terrorists who have infiltrated Aramco, could cripple the Saudi system.

How, exactly? Robert Baer, an intelligence expert, offers some suggestions in his disturbing recent book, “Sleeping with the Devil”. He reckons that Ras Tanura, a port on the Gulf, is a vulnerable terrorist target. With an output of perhaps 4.5m bpd, this is the biggest oil-exporting port in the world. Mr Baer thinks a small submarine or a boat laden with explosives (as happened in October 2000 with the attack on the USS Cole off the coast of Yemen) could knock out much of Ras Tanura's output for weeks, or even longer.

An even scarier possibility raised by Mr Baer is the crashing of a hijacked aeroplane into Abqaiq, the world's largest oil-processing complex. If done with the help of insiders, he speculates that the facility's throughput (nearly 7m bpd, on his estimate) would be choked off to as little as 1m bpd for two months—and might remain as low as 3m bpd for seven months.

Mr Woolsey adds that an attack using weapons of mass destruction (especially “dirty bombs”) would be even more devastating than one that used mere aeroplanes. All told, the pessimists reckon that well-co-ordinated attacks could take as much as 6m-7m bpd of Saudi output off the market for weeks, and perhaps longer.

Taking stock

How would the world oil market react to such a blow? The world is clearly better equipped to handle a supply shock than it was during the turbulent 1970s. For a start, the rich world is much less energy intensive. Unlike three decades ago, OECD countries now maintain large “strategic reserves” of petroleum, and co-ordinate the release of these during emergencies through the International Energy Agency (IEA). The rise of energy futures markets over the past two decades also offers some scope for the world to deal better with short-term price shocks.

Even so, there is good reason to worry. The unprecedented prospect of Saudi Arabia under attack from within exposes the vulnerabilities of the world's two chief forms of insurance against oil shocks: IEA stocks and Saudi swing capacity.

As chart 2 reveals, strategic petroleum stocks (which are stored in such places as salt domes in Louisiana) cannot be drawn down all at once. If a loss of Saudi output is anything like as long-lived as Mr Baer fears, or if other Middle Eastern output is also lost at the same time, then strategic stocks may prove inadequate. Prices will soar, and the market will return to equilibrium only through painful cuts in consumption and accompanying losses in economic output and welfare.

The more troubling revelation surrounds Saudi swing capacity. There is the obvious point, of course, that this particular insurance policy will not be worth very much if there is a serious supply crisis inside the kingdom. However, even if the horror scenarios never happen, the global spare-capacity crunch is still alarming.

Amy Jaffe of the Baker Institute, at America's Rice University in Texas, observes that in 1985 OPEC maintained about 15m bpd of spare capacity—about one-quarter of world demand at that time. In 1990, when Iraq invaded Kuwait, OPEC still had about 5.5m bpd of spare capacity (about 8% of world demand). That, argues Ms Jaffe, meant that the cartel could easily and quickly expand output to absorb several disruptions at once.

That is simply no longer true. Today's fast-shrinking spare capacity of about 2m bpd is less than 3% of demand—and it is entirely in Saudi hands. And yet, “normal” threats to supply that fall far short of doomsday terrorist scenarios remain. Venezuela and Nigeria both face political tests in coming weeks that could cripple oil exports. The coalition in Iraq is due to hand over power to local authorities at the end of June, and terrorist attacks are possible. Whether the Saudis can handle the consequences of all this is entirely unclear.

And yet somehow they must. There is little chance that the Saudis will be dislodged as swing producer anytime soon, even by a resurgent Iraq. One reason is cost: the Saudis sit atop the cheapest reserves in the world. Another is the fact that Saudi oil remains in state hands. Aramco does not have to justify to shareholders the billions it wastes on idle fields—a luxury that privatised Russian firms and western oil majors do not enjoy. Even if Iraqi oil remains in state hands, as appears likely, a cash-starved independent Iraqi government could not justify developing fields that will remain idle.

A witch's brew

Of course, disaster might not happen. The Middle East may cool down, Osama bin Laden may be nabbed and al-Qaeda disrupted, and a speculative bubble in American gasoline may burst. Oil prices could yet moderate. If they do, however, it would be wise to remember just how precariously the world's oil markets are balanced now—and may again be in future, if things take a wrong turn in Saudi Arabia.

A witch's brew of soaring oil demand, private-sector destocking and lack of investment in new production capacity by OPEC has left the world with an extraordinarily tight oil market today. There is less spare capacity than at almost any point in the past 30 years. As Edward Morse, an energy expert at HETCO, an oil-trading firm, puts it: “The world has been living off surplus capacity built a generation ago, and thought it could get by. It turns out not to be the case.” Building a new surplus will inevitably take a long time. Until then, the potential instability of Saudi Arabia's oil supply will remain a strategic weakness for the world economy.




Still at its mercy
May 20th 2004
From The Economist print edition

The world economy remains vulnerable to the price of oil

TURMOIL in the Middle East is once again helping to unsettle the market for oil and testing nerves in central banks and economics ministries. As The Economist went to press this week, the benchmark price of crude had subsided a little from the high it touched on May 17th, but at around $40 a barrel, oil is still dear enough to make economic policy much more complicated than anybody except OPEC would have wished during the next few months.

It is true that even at $40 a barrel, oil is still far cheaper in real terms than it was during the spikes of the 1970s. But don't relax too much: oil caused a worldwide slump back then, let's not forget. At the current price, oil may be incapable of causing mass unemployment, double-digit inflation, extraordinary political turmoil and losses of global economic welfare on a scale hitherto associated with total war—but just how reassuring is that? If oil is only $10 a barrel higher than it would otherwise have been, and stays there a while, prices in general will rise, output and incomes will be reduced, and unemployment, at least for a while, will be raised. That vicious combination of higher inflation and lower growth—stagflation, to recall a term from the 1970s—is about the worst scenario an economic policy-maker can contemplate. Economies may not be as exquisitely sensitive to oil as they were 30 years ago, but make no mistake, oil still matters (see article).

Predict at your peril

What is driving the increase, and how much worse might things get? Reading the oil market is never easy. Forecasting the price of oil, as this newspaper can readily attest, is a dangerous enterprise. Still, a couple of things, at least, are plain. For a start, shortfalls in supply are not the immediate cause of the recent run-up. You might be forgiven for thinking otherwise: OPEC, under heavy diplomatic pressure from the United States and other countries, is debating whether to increase its output quotas in order to dampen the price. That seems to suggest that supply is the issue. But not really. Production is already high. OPEC is currently exceeding its quotas; with the notable exception of Saudi Arabia, which could bring further production on-stream quickly if it chose, the cartel's members are producing flat-out. And at $40 a barrel, well they might.

The debate over quotas is not about how much more oil to put on to the market next week, but about what signal to send to their biggest consumers, and each other, regarding the medium-term future. The balance they want to strike is between, on the one hand, avoiding the appearance of caving in to pressure from America for lower prices and, on the other, deflecting measures aimed at economising on the use of oil which would trim their longer-term incomes. None of this has much to do with short-term supply.

If that is not the issue, what then has caused the recent rise in prices? Three related things, or so it seems: surging demand; petroleum-distribution bottlenecks, especially in the United States; and speculation aimed at pricing in the risk of some big future setback in supply. Demand is high worldwide at the moment, because growth in the world economy is strong. This is especially so in America, with its apparently vigorous economic recovery and the approach of the summer “driving season”. But oil that is in principle available to meet this demand is being held up by blockages in domestic petroleum-distribution channels. This drives up gas prices, which in turn washes back on the underlying commodity. This should be temporary, however. Before long the blockages will clear, the gasoline market will stabilise and the underlying balance of supply and demand, consistent with a much lower price than $40 a barrel, should reassert itself in the market for crude.

This still leaves the third factor: the risk of future interruptions in supply. This is where the real danger resides. Part of the problem is that the prospect of a secure resumption in Iraqi supply is receding: the country is far from pacified, and some oil investors are doubtless betting that things may yet get worse. More important, however, is the new risk of a severe and lasting interruption in Saudi supplies. Terrorists in the kingdom have begun to strike at energy targets—a shrewd tactic. Perhaps it is unlikely that they will succeed in curbing supplies by much or for long, but Saudi Arabia is so overwhelmingly important to the global oil market that even a small risk of a very bad outcome is enough to justify a substantial “terror premium”. Those who watch the oil market reckon that this is currently worth between $4 and $8 a barrel. An intensification of terrorist efforts, or one spectacular success, could drive that up a lot. Needless to say, if al-Qaeda actually succeeded in shutting Saudi production down, prices would rocket, and comparisons with what happened in the 1970s would no longer be idle.

In short, sensitivity to oil continues to bedevil the world economy. Incomes and jobs around the world still hinge on the price of a commodity which comes chiefly from extremely unstable parts of the world, supplied through a market that is rigged at every turn. When the price does next subside, and the opportunity again arises to use taxes to weaken OPEC by discouraging western consumption of oil, America's government, especially, might bear this in mind.



Other reasons to worry
May 19th 2004
From The Economist Global Agenda

The world recovery continues apace, with Japan and even Europe defying the doubters. So why are the markets still fretting?

ECONOMISTS of a saturnine disposition are used to thinking of old Europe and ageing Japan as their intellectual homelands: the economic climate has long been gloomy, the news reliably grim. But as world markets worry about tighter money in America, overheating in China and dearer oil everywhere, Europe and Japan are, contrary to tradition, providing havens for optimists. Japan’s economy, in particular, continues to beat expectations even as it raises them. Numbers released on Tuesday May 18th showed that Japan’s output grew at an annual pace of 5.6% in the first quarter of this year, its eighth straight quarter of growth. Even the money value of its output managed to rise by a healthy 3.2%, despite a continuing fall in prices.

The euro area’s rebound is less marked and less impressive. But the latest figures, released last Friday, were still good enough to deny the euro-pessimists satisfaction. Euro-area GDP grew at an annual pace of 2.4% in the first quarter, faster than at any time since the beginning of 2001. France was looking positively sprightly: it grew by 3.2%.

This is welcome news from an unexpected quarter. But some fear that the euro area may be a late arrival at a party that is almost over. Interest rates are at historic and unsustainable lows, while oil prices are uncomfortably high. This combination of cheap money and expensive oil strikes many as a dangerous, inflationary cocktail.

China and the United States in particular are awash with liquidity and thirsty for petroleum. According to the International Energy Agency, China now consumes 6m barrels of oil per day, 1m more than a year ago. America, which consumes about 20m barrels per day, begins its summer “driving season” at the end of this month, placing new demands on the country’s petrol pumps. Higher oil prices will eventually feed through into higher consumer-price inflation. In China, consumer prices are already rising at their fastest clip for seven years, a rate of 3.8% in the year to April. In the United States, consumer prices rose by 2.3% over the same period. Producer prices are surging.

The oil world relies on Saudi Arabia, with its large reserves and spare capacity, to act as its “swing producer”, pumping a little more when prices rise too high, a little less when they drift too low. But Saudi Arabia does not always time its swings to perfection. It urged the Organisation of the Petroleum Exporting Countries (OPEC) to cut production quotas in February for fear of a price crash this spring. That decision now looks like a serious miscalculation. Saudi Arabia’s energy minister, Ali al-Naimi, is now urging petroleum exporters to raise the supply of oil in order to bring prices down. But any extra Saudi oil released now will be too late in arriving and too heavy a grade to keep America’s drivers happy.

Meanwhile, the financial world relies on Alan Greenspan, chairman of the Federal Reserve, to act as its swing producer, pumping a little more liquidity into the system when prices are soft, a little less when they drift too high. The markets are in no doubt which way he will swing. The futures market suggests that American interest rates, still at 1%, will double before the end of the year, and reach 3.5% by the end of 2005. Mr Greenspan himself, however, shows no signs of being rushed. On Tuesday, he was formally renominated for a fifth successive term by President George Bush, and now looks set to remain as Fed chairman until 2006, when his tenure on the board expires. As he plots the first moves of his new term, his pace, as he promised in the Fed’s most recent statement, is “likely to be measured”.

Will a measured pace be quick enough? In the 1980s and 1990s, the Fed pursued a hawkish doctrine of pre-emptive strikes against any inflationary pressures it could espy, even if they did not yet show up in headline consumer prices. If you waited until you could see inflation, so the doctrine went, it was already too late. Now, some are asking whether the Fed has fallen “behind the curve”. In fact, the Fed has advertised its behind-the-curveness at every opportunity, telling the markets that rates would stay low for a “considerable period” and that it could be “patient” before raising them. Last year, the Fed felt that deflation was a remote but disturbing possibility; a little inflation would provide a welcome cushion against falling prices. It therefore made a strategic decision to stay behind the curve, making sure that modest inflation had returned before it tightened monetary policy.

The Chinese monetary authorities cannot afford such patience. In recent months, they have pulled on one lever after another in an attempt to stop the overlending and overinvestment that threaten to destabilise the economy. Reserve requirements for banks have been raised three times since last summer, to no avail: banks still managed to lend 21% more in the first quarter than a year ago. On Friday, the Chinese authorities ordered financial institutions to “immediately stop fresh credit” to projects in a long list of sectors that are growing too fast for comfort.

Some media reports had suggested that the Chinese authorities might raise interest rates for the first time in nine years as soon as the Golden Week holiday ended last week. But raising rates could break China’s brittle state enterprises and lure in more speculative capital from abroad. China’s monetary policy must also be guided by the need to maintain the yuan’s peg to the dollar. Until Mr Greenspan raises interest rates, China’s monetary authorities will find it difficult to do so.

They clearly feel that the growth of credit in the economy is unsustainable at its current pace. Either it slows at their behest, or it will collapse of its own accord. Given that China accounted for about a third of the growth in the world economy over the past three years (in purchasing power terms), a serious credit crunch in the Middle Kingdom could also spell trouble for lands to the east and west. Japan, in particular, owed as much as 37% of its GDP growth last year to China, according to Goldman Sachs. It is not quite so dependent now. But if China were to stall, the economic pessimists would be quick to reclaim Japan as their native land.



Asia’s stockmarkets fall out of favour
May 18th 2004
From The Economist Global Agenda

Last year investors lapped up Asian shares. Now, it seems, they have had their fill, despite the region’s economies being in pretty good shape

BUTTONWOOD spent a small part of Sunday delving into “Galahad at Blandings”, a novella by the incomparable P.G. Wodehouse. Contained in the opening paragraphs is this gem: “There had occurred that morning on the New York Stock Exchange one of those slumps or crashes which periodically spoil the day for stock exchanges.” By coincidence, the morning after your columnist had reluctantly placed the book on his bedside table, a newsreader announced that Indian stocks had crashed. All great truths, it struck Buttonwood forcibly, are universal.

Their day spoiled and their exchange shut temporarily by the authorities, the members of the Mumbai Stock Exchange, not normally a breed given to public outburst, took to the streets in protest. When the market opened again, government-owned institutions bought heavily, and shares rebounded. Having fallen by 17% at one point, the market finished down 11%. By Monday’s close, Indian shares were some 30% below their peaks of earlier this year, spooked by a combination of local and international concerns. But it is not just in Mumbai that investors are glum. The mood in financial circles across Asia seems to darken by the day.

It is true that Tuesday was a good day for the region’s stockmarkets: Hong Kong, Japan, China, Singapore, South Korea, Malaysia and Thailand, as well as India, all clawed back some of their recent losses. But generally speaking, the change from last year and earlier this year, when the mood was so bright, could not be starker. Then, low dollar interest rates propelled a tidal wave of money around the world in search of higher returns. Asia became a magnet for foreign money, largely thanks to the lure of China’s rapid expansion. Portfolio investment in Asian shares and bonds rose to $29 billion last year, from $3 billion the year before. Asian shares reached a point 72% above their lows of 2002.

India, of course, has its own charms, but it attracted money too, from a particular sort of investor who thought it would be the next China. Between April last year and March this year, foreigners poured perhaps $10 billion into Indian shares, and from recent trough to peak (in January this year) Indian shares more than doubled.

The panic in Mumbai on Monday was sparked by domestic politics—namely the defeat of the ruling, reformist BJP in the marathon general election that ended late last week. Investors fret that the new coalition government, centred on the Congress party, will have to rely on the Communist party, not known for its sympathy for business, to stay in power. Hedge funds, those footloose pariahs of the international investment community, are apparently unwilling to stay around long enough to find out. Reuters reported one stockbroker as saying that they were selling at any price, a decided change of heart from last year when they seemed to be buying at any price.

But disenchantment with Indian shares also reflects wariness of risky assets in general and Asian shares in particular. An index of Asian shares produced by Morgan Stanley Capital International fell by 3% on Monday, to its lowest point since November. According to data from Nomura International, more than $5 billion has flowed out of Asian stockmarkets in the past three weeks.

Four fears weigh heaviest: the tense situation in the Middle East and more general concerns about terrorism; a surging oil price (Asian economies are especially intensive users of energy); the threat of higher interest rates in America, which would lessen the need for investors to seek higher returns elsewhere; and, last but by no means least, a fear that the Chinese authorities will pour cold water on the country’s overheating economy. As the region’s economies benefited from China’s rude health, so they will catch a chill when China does. The Economist’s man in Delhi says that when he arrived in India some 18 months ago, everyone was worried about China’s success; now everyone is worried about its failure.

These worries are unlikely to go away any time soon. The war in Iraq shows no sign of ending; the oil price remains stubbornly above $40 per barrel; the Federal Reserve has yet to put investors out of their misery by raising rates; and it is anyone’s guess what will unfold in China. Still, for Asian equities at least, the fears seem overdone. Granted, economic statistics generally reflect what has been, and markets are supposed to predict what will be, but the numbers coming out of Asia show scant sign of a region in economic distress.

Last Friday, China announced that retail sales had risen by 13% year-on-year in April, though inflation crept up to 3.8%, its highest for seven years, and the central bank said that lending to a few particularly hot industries would be restricted. But the situation is nowhere near as bad (not yet, anyway) as it was in the mid-1990s, when GDP grew by around 14% and inflation reached 28%. Just as investors were too optimistic on the upside, they are perhaps too pessimistic on the downside.

This is particularly true of Japan, a country whose stockmarket Buttonwood had tipped for greater heights, but which, as the favoured Asian play of many foreigners, has instead sputtered. This scribbler is not deterred. Most economic statistics point to an economy growing at a fair old clip. According to figures released on Tuesday, Japan’s real GDP grew by an annualised 5.6% in the first three months of the year; deflation is easing; Japanese companies are raking in cash and paying off their debts; and the big banks have eaten away their mountain of bad loans. Moreover, the stockmarket is relatively cheap: the Topix, a broad index of Japanese shares, trades on a modest 14 times last year’s earnings and 1.4 times book value. A bad few days need not spoil the whole year.



Cheap money, pricey oil
May 14th 2004
From The Economist Global Agenda

The monetary authorities in America, Europe and China are all “behind the curve” on interest rates, but they are not all equally relaxed about it

CHEAP money and expensive oil sounds to many like a dangerous, inflationary combination. Nominal interest rates remain at historic lows in the United States, Japan and the euro area, while oil prices (unadjusted for inflation) are hovering around 13-year highs. China in particular is both awash with liquidity and thirsty for petroleum. Inflation there is at a seven-year high, with consumer prices rising by 3.8% in April compared with the year before, according to figures released on Friday May 14th. Meanwhile, sales of petroleum and related products grew by more than half over the same period. According to the International Energy Agency, China now consumes 6m barrels of oil per day, 1m more than a year ago.

Saudi Arabia, with its large reserves and spare capacity, remains the “swing producer” of the oil world. Its energy minister, Ali al-Naimi, has already urged petroleum exporters to raise the supply of oil in order to bring prices down. Many now fear that Alan Greenspan—who, as chairman of the Federal Reserve, acts as the swing producer of the financial world—will rush to tighten the supply of money. The futures market suggests that American interest rates, still at 1%, will double before the end of the year, and reach 3.5% by the end of 2005. Mr Greenspan himself, however, shows no signs of being rushed into anything. Oil prices may be surging and China may be overheating, but inflation in America remains manageable. According to figures released on Friday, consumer prices rose by 0.2% in April, month-on-month (the figure for the year to April was 2.3%). Mr Greenspan’s pace, then, as he promised at the Fed’s last meeting, is “likely to be measured”.

In the 1980s and 1990s, the Fed pursued a hawkish doctrine of pre-emptive strikes against any inflation-related activities it could espy, even if they did not yet show up in headline consumer prices. If you waited until you could see inflation, so the doctrine went, it was already too late. Now, some are asking whether the Fed has fallen “behind the curve”. In fact, the Fed has advertised its behind-the-curveness at every opportunity, telling the markets that rates would stay low for a “considerable period” and that it could be “patient” before raising them. Last year, the Fed felt that deflation was a remote but disturbing possibility; a little inflation would provide a welcome cushion against falling prices. It therefore made a strategic decision to stay behind the curve, making sure that modest inflation had returned before it tightened monetary policy.

The European Central Bank (ECB) of course is famous for falling behind the curve. It was slow to cut rates when the euro area stalled in 2001, and it refused to cut them despite a strengthening euro and a flagging recovery last year. But the ECB has remained stuck in place for so long that, like a clock that is 11 hours slow, it now looks to be ahead of events, not behind them. According to figures released on Friday, euro-area GDP grew at an annual pace of 2.4% in the first quarter, faster than anyone expected and faster than at any time since the first quarter of 2001. France grew by 3.2% at an annualised rate. Though modest by American standards, growth at this pace shows a euro-area economy beginning to fulfil its potential. The ECB, therefore, can afford to sit on its hands for the foreseeable future.

China’s monetary authorities do not have that luxury. In recent months, they have pulled on one lever after another in an attempt to stop the overlending and overinvestment that threaten to destabilise the economy. Reserve requirements for banks have been raised three times since last summer, to no avail: banks still managed to lend 21% more in the first quarter than a year ago. On Friday, the Chinese authorities ordered financial institutions to “immediately stop fresh credit” to projects in a long list of sectors that are growing too fast for comfort, including light industry, construction and textiles.

The Chinese authorities are attempting to restrain and redirect the flow of credit by fiat, because they are reluctant to raise its price. Some media reports had suggested that they might raise interest rates for the first time in nine years as soon as the Golden Week holiday ended last week. But raising rates could break China’s brittle state enterprises and lure in more speculative capital from abroad, exacerbating the overheating problem. China’s monetary policy must also be guided by the need to maintain the yuan’s peg to the dollar. Until Mr Greenspan raises interest rates, China’s monetary authorities will find it difficult to do so. His stately calm, then, is one reason for their frantic hyperactivity.

Some fear that China is destined for a hard landing. The growth in credit is unsustainable. Either it slows at the behest of China’s authorities, or it will collapse of its own accord. Given that China accounted for about a third of the growth in the world economy over the past three years (in purchasing power terms), a credit crunch in the Middle Kingdom could also spell trouble for lands to the east and west. Still, if China’s growth does sputter and stall, it will at least take the pressure off the oil price.



China's economy

The great fall of China?

May 13th 2004
From The Economist print edition

If China's soaring economy has a hard landing, the rest of the world will feel the bump

A FASCINATING drama is about to be played out in the world's biggest country. China's economy is growing too fast for comfort, and the country's leaders know it. In recent weeks they have promised forceful measures to cool things down, but it is not clear what they will or can do. Rumours are rife that China's central bank may raise interest rates for the first time in nine years.

The authorities have tried to restrain investment, prices and lending through administrative fiat. The challenge facing them would be difficult for policymakers anywhere: to slow the economy enough to ensure sustainable growth, but not so much as to cause a damaging crash, the much-feared hard landing. But the task of China's policymakers is doubly difficult because they have far fewer tools at their disposal than their counterparts in developed countries (see article). Thousands of state-owned firms, as well as the banking system, do not respond much to pricing signals or interest rates. It is not only 1.2 billion Chinese who should hope that their leaders succeed despite these handicaps. The rest of the world also now has a huge stake in China's continued economic health.

During the past three years China has accounted for one-third of global economic growth (measured at purchasing-power parity), twice as much as America. In the past year, China's official GDP growth rate has surged to 9.7%. Even this may underestimate the true rate, which some economists reckon was as high as 13%.

China's scorching growth has helped to prop up other economies by sucking in imports, which surged by 40% last year alone. While America's industrial output has shrunk over the past three years, China's has increased by almost 50%. As a result, its demand for commodities has skyrocketed, driving up prices. Last year it consumed 40% of the world's output of cement. It also accounted for one-third of the growth in global oil consumption, 90% of the growth in world steel demand, and more than the whole of the increase in copper demand. If China's economy slows sharply, commodity prices will fall everywhere, especially hurting producers in countries such as Russia, Brazil and Australia, which have gained so handsomely from China's boom.

The biggest losers from a hard landing in China would be its Asian neighbours. China accounted, on average, for almost half of the total export growth of the other East Asian economies last year. By some estimates, Japan's exports to China and capital spending linked to its export industries accounted for one-third of Japan's total GDP growth last year. Indeed, a slowdown in China would expose the chronic weakness of private consumption in Asia. The recent burst in growth in the region has been much too dependent on exports to China. Although Japan's GDP grew at an annual rate of 4.5% in the second half of 2003, consumer spending rose by only 1%. In South Korea, Hong Kong, Taiwan and Singapore, consumer spending fell slightly, on average, last year.

A slump in China would have a much smaller impact on America and Europe, but some companies would be hurt. Exports to China accounted for about one-fifth of total export growth last year in America and the European Union. However, the biggest risk to these economies lies elsewhere—in the indirect effect of a sharp slowdown in China on financial markets. Another risk lies in the fact that America depends on China to help finance its budget and current-account deficits. China's purchases of American Treasury bonds, along with purchases by Japan, have helped to hold down yields and hence American mortgage rates. If China's economy continues to overheat, its current-account surplus could soon turn to deficit, and then its central bank would no longer need to buy American Treasuries to hold down its currency.

Fortunately, there are some reasons to hope that avoiding a hard landing in China, despite the difficulties, is possible. This time China's policymakers are stepping in to cool things down earlier than they did in the early 1990s, when inflation was far higher and investment and credit were growing even faster than today. And unlike the East Asian countries which suffered so badly during their economic crisis in the late 1990s, China has a current-account surplus and little foreign debt.

Perhaps the biggest worry for the world economy is the prospect of a “twin tightening” of monetary policy in both China and America. Interest rates of 1% in the United States are dangerously low for an economy with 5% real GDP growth. If America's Federal Reserve is forced to raise rates more rapidly than expected and this happens at about the same time that China's economy slows sharply, stockmarkets would take a beating and global growth could stall. Monetary-policy announcements from Beijing are still not as important as the Delphic words of Alan Greenspan, the Fed's chairman. But as the weight of China's economy in the world continues to grow over coming years, one day they will be.



The echoes of history
May 11th 2004
From The Economist Global Agenda

As the Fed prepares to raise interest rates, the financial markets are bracing themselves for a reversal of fortune every bit as painful as the one they suffered ten years ago

“THIS year’s dramatic rally [in bonds] has assumed that inflation is conquered, at least for the foreseeable future. Rising yields would indicate a change in that sentiment. As for Wall Street, its giddy share prices are partly explained by low bond yields, so it would presumably suffer a sharp correction if those yields rose…at current levels the bond market deeply trusts the Federal Reserve’s ability to deliver low inflation.” Plus ça change. Buttonwood wrote the above sentences in October 1993, a month after joining The Economist, and ended his piece by quoting an analyst who expected a rise in rates by the Fed “to cause anything from panic to riot”. And a riot of sorts there was. As the Fed doubled rates in 1994, to 6%, bond yields shot up, the mortgage-backed securities market fell apart and stockmarkets had a horrid time. So did emerging markets: spreads over Treasuries on emerging-market debt soared and the year ended with Mexico’s tequila crisis.

Memories of that carnage continue to haunt dealing rooms around the world, which is one reason why markets have been so spooked by a mere hint from the Fed that it will put up rates at some point. That point, think markets, is much sooner than it was, following the stronger-than-expected payrolls number last Friday and a few signs—a high oil price among them—that inflation may be less quiescent than it was. In the topsy-turvy, good-news-is-bad-news world of financial markets, bond prices have fallen sharply again, pushing the yield on ten-year Treasuries from 3.65% in mid-March to 4.8%; stockmarkets have taken a pummelling, with the Dow closing below 10,000 for the first time since December on Monday; and emerging markets are once again being treated like lepers.

Strategists are busy trying to work out how much more financial assets will fall—or, indeed, if the worst is over. Many are wondering, and worrying, about a possible repeat of 1994. The Fed—whose chairman, Alan Greenspan, was also in charge back then—is all too aware of this. The language of its recent statement seemed calculated to soothe the market’s fears that it would raise rates as fast or as far as it did a decade ago, and made it clear that every move will be well telegraphed. Moreover, if the Fed is simply reacting to strong growth rather than creeping inflation, as it mainly seems to be, that should be good for corporate profits, and thus for equities and corporate bonds. The recent falls, on this argument, simply reflect a blowing-off of the froth on financial markets.

Perfectly decent this rationale may be, but Buttonwood doesn’t believe it for the reason that investors are always prone to think that this time things are different. Few of those that were around in 1994 are the ones making the decisions now; everyone is under pressure to generate stellar returns in an environment of rock-bottom interest rates, and they all seem to think that they can get out before being trampled under foot by everyone else heading for the exit. That includes the hedge funds and big investment banks that have been loading up on anything offering more than meagre returns. Though they all claim to be more sophisticated these days, it requires a huge amount of sophistry to justify the claim that after the extraordinary rises of last year, risky assets are still worth buying. As investors discover the hard way that they aren’t, events might turn out even nastier than they did in 1994.

For one thing, the incentive to bet on all manner of sure-fire winners has been much greater this time. Investors have been encouraged to keep gambling by the Fed, which will be raising rates later and from a lower level than it has done in past cycles. That matters for stockmarkets in part because the best of the rise in corporate profits, which have been helped by low rates, is probably over. Earnings are 14% above trend, according to Credit Suisse First Boston; in 1994 they were below trend. Financial stocks, which tend to do badly when rates rise, now account for 22% of stockmarket capitalisation compared with about 13% then. And the overall stockmarket is, of course, a lot more expensive now than it was then. Worryingly, retail investors have been seduced into putting their money into a rising market: flows into mutual funds at the beginning of this year were only a smidgen less than they were at the beginning of 2000, and far higher than they were in 1994.

Not that American stockmarkets have been the worst performers of late. The S&P 500 is down only 6% from its high. In contrast, Japan’s stockmarket fell by almost 5% on Monday alone, its sixth-worst daily performance since 1980. And anything related to emerging markets—especially China, which is trying to rein in its overheating economy—has suffered horribly. An index of emerging markets compiled by Morgan Stanley has now fallen by 17% from its peak. Argentine and Brazilian stockmarkets are both down by almost 30% from their recent highs.

Brazilian shares have, however, been something of a safe haven compared with its bonds. Since early January, their spread over Treasuries has widened by some four percentage points, which is quite an achievement given that Treasuries themselves have not seen the best of times. Indeed, emerging-market bonds in general seem to have gone out of fashion as quickly as the Spice Girls. The spread of J.P. Morgan’s EMBI+ index is now some 48% wider than it was on January 8th.

Which may or may not be a sufficient fall to make such bonds attractive. Devotees point out that American companies’ junk bonds—a market with which emerging-market debt is often compared—have held up remarkably well in recent weeks, perhaps because the buoyant economy helps leveraged companies and the number of companies defaulting continues to fall. On the other hand, low interest rates and investors’ huge appetite for risk have helped many companies that would otherwise have gone bust to refinance their debts. Many of these companies will default when conditions tighten, if history is any guide. It usually is.



A U-turn in the desert
May 11th 2004
From The Economist Global Agenda

Just three months after calling for OPEC's oil-production quotas to be cut, Saudi Arabia is now calling for them to be raised

SAUDI ARABIA, the oil industry’s swing producer, has become its flip-flopper. In February, it persuaded the Organisation of the Petroleum Exporting Countries (OPEC) to cut its total production quotas by 1m barrels per day (bpd), to 23.5m, as a precaution against an oil-price crash this spring. That fear has since been replaced by its opposite. The price of West Texas crude hit $40 last week, its highest since the eve of the first Iraq war (see chart), prompting concerns that higher oil prices could sap the vigour of America’s recovery and compound the frailty of Europe’s. On Monday May 10th, Ali al-Naimi, Saudi Arabia’s energy minister, called on OPEC to raise quotas, by at least 1.5m bpd, at its next meeting on June 3rd.

Of course, OPEC's quotas do not mean quite what they say. Its members are currently producing at least 2m bpd more than their quotas officially allow. Some think that raising these limits will simply validate what OPEC members are doing anyway. Certainly, Purnomo Yusgiantoro, Indonesia's energy minister and president of OPEC, doubts his organisation's ability to bring down the high oil price. “There is not much OPEC can do,” he told the Financial Times in an interview published on Tuesday. The oil market, however, begs to differ. It responded to the Saudis' call for a quota rise on Monday by pushing the price of crude back below $39. Perhaps the market assumes that OPEC members, insofar as their capacity allows, will breach their higher quotas by much the same margin as they breached their lower ones.

Thus far, the high oil price has been largely a consequence of good things, such as a strengthening world economy, rather than a cause of bad things, such as faster inflation or slower growth. China’s burgeoning economy guzzled about 6m bpd in the first quarter of this year, 15% more than a year ago, according to Goldman Sachs. Demand was also strong in the rest of Asia, excluding Japan, growing by 5.2% to 8.1m bpd. As the year progresses, the seasonal rhythms of America’s drivers will dictate prices, at least of the lighter, sweeter crudes. Americans take to the roads en masse in the summer, and speculators are driving up the oil price now in anticipation of peak demand in a few months’ time.

Until recently, the rise in the dollar price of oil was offset outside America and China by the fall in the dollar itself. But the currency has regained some ground in recent weeks, and the oil price has continued to rise. Even so, talk of another oil-price shock is premature. The price of oil, adjusted for inflation, is only half what it was in December 1979, and the United States now uses half as much energy per dollar of output as it did in the early 1970s. But if oil cannot shock the world economy quite as it used to, it can still give it “a good kick”, warns Goldman Sachs. If average oil prices for the year come in 10% higher than it forecast, it reckons GDP growth in the Group of Seven (G7) rich nations will be reduced by 0.3%, or $70 billion.

The Americans are certainly taking the issue seriously. John Snow, their treasury secretary, called OPEC’s February decision “regrettable”, and the rise in prices since then “not helpful”. Washington pays close heed to the man at the petrol pump, who has seen the average price of a gallon of unleaded petrol rise by 39 cents in the past year. And the Saudis, some mutter, pay close heed to Washington.

Besides, the high oil price may have filled Saudi coffers, but it has also affronted Saudi pride. Mr al-Naimi thinks the high price is due to fears that supply might be disrupted in the future. These fears, he says, are “unwarranted”. But the hulking machinery in the Arabian desert that keeps oil flowing round the world presents an inviting target to terrorists should they tire of bombing embassies and nightclubs. On May 1st, gunmen killed six people in a Saudi office of ABB Lummus Global, an American oil contractor. Such incidents add to the risk premium factored into the oil price, a premium that the Saudis take as a vote of no confidence in their kingdom and its ability to guarantee the supply of oil in the face of terrorist threats. Oil infrastructure elsewhere is also vulnerable. A pipeline in Iraq carrying oil to Basra was struck by saboteurs last Saturday, slowing Iraq's output of oil by about a fifth until repairs are made. Kuwait is strengthening security at its ports in response to American warnings about possible sea-borne attacks.

As the markets fret over the spot price of oil (ie, for delivery now), Alan Greenspan, chairman of the Federal Reserve, is looking further ahead. The price of crude oil for delivery six years hence has risen dramatically in recent years, he noted in a recent speech. Futures prices were remarkably stable throughout the 1990s, despite wide fluctuations in spot prices. But they have risen from about $18 per barrel in 1999 to more than $27 per barrel now. Mr Greenspan is in little doubt as to the cause: “fears of long-term supply disruptions in the Middle East”.

Until recently, the long-term price of oil was driven by advances in geology and technology. Now, into that price-setting equation must be added the creeping advances in terrorism.




China and the Fed: twin piques
May 5th 2004
From The Economist Global Agenda

China and America are both about to start tightening monetary policy to ward off inflation. Financial-market traders have reasons to worry

FEW people can hold a candle to Alan Greenspan, the chairman of the Federal Reserve, when it comes to opaque utterances on monetary policy. But this week’s statement from the Fed was unusually clear. No longer would it be “patient” in raising interest rates; its ultra–loose monetary policy “can be removed at a pace that is likely to be measured”. The futures market thinks that the Fed will raise rates by a quarter of a percentage point by the time of its next meeting, in August. What is happening to interest rates in China, on the other hand, is anyone’s guess—including, it seems, the good folk at the People’s Bank of China, the central bank. In a recent visit, The Economist’s economics editor asked a couple of senior officials at the bank what the current interest rate was. After some embarrassed shuffling of papers, she was advised to look in the bank’s annual report of, erm, 2002. Yet no matter how much or how little Mr Greenspan or his counterparts in Beijing say, or how opaquely they say it, one thing is clear: monetary policy in both America and China is tightening. Many a rich-country investor has been fleeing low interest rates by placing bets on global reflation. Such trades will be sorely tested in coming months.

It is increasingly clear that short-term interest rates in America are about to rise, and given the wealth of robust data in recent weeks, that point will come sooner rather than later. The Fed has done little to dampen the market’s expectations that rates will rise to ward off inflationary pressures. In China, on the other hand, the price of money plays little or no role in allocating capital: you either get the money or you don’t. In recent years, most companies have, which is partly why the Chinese economy has been growing so fast. Understandably worried that rampant economic growth is stoking inflation—the economy grew by an annualised 9.7% in the first quarter, growth in fixed investment has been soaring by 170% in some sectors, and new lending at a few banks is rising at 40%—officials have been calling for restraint. Last week, the central bank upped banks’ reserve requirements for the second time in eight months, and apparently took the novel step of telling a clutch of big banks to stop lending for a bit.

Which will have the greater effect—tightening by the Fed or the People’s Bank—is a moot point (another way of saying that your columnist hasn’t the foggiest). Undeniable is the fact that the combined impact has already been big. Most obvious has been the effect on government bonds, and especially those issued by the United States government. In a few weeks, the yield on ten-year Treasuries has risen from a low of 3.65% to 4.5%. The threat of higher interest rates and inflation at home has played its part in this move, of course, but so have the effects of rising inflation (or falling deflation in the case of Japan) in Asia, since Asian central banks have lately intervened much less in foreign-exchange markets to stop their currencies rising. (They had been popping the dollars they bought into Treasuries.) As inflationary pressures rise in China, expect the chatter about revaluing the yuan against the dollar—to which it is pegged—to become noisier again.

If the attractions of Treasuries have waned, investors have started to look in horror at emerging-market bonds. The spread of J.P. Morgan’s EMBI+ index over American Treasuries has risen by more than a percentage point from its low on January 8th, a statistic that does not fully capture how badly such bonds have performed, since Treasury prices are themselves a lot lower. Last year’s poster children have become this year’s street urchins. Bonds issued by the likes of Brazil, Turkey and Russia have, to quote one normally sober investment bank, suffered “violent re-pricing”. Down, that is.

Stockmarkets have stumbled everywhere, caught between the joys of heady economic growth and the potential pain of higher interest rates. The riskiest are among the hardest hit. Despite the hoopla surrounding the IPO of Google, the Nasdaq index is lower than it was at the start of the year. Any currencies that had strengthened in recent months from the “carry trade” (investors fleeing low interest rates in America in search of higher yields), such as sterling or the Australian dollar, have weakened sharply. The latter has also been clobbered by falling metals prices, as fears mount that China may not provide an inexhaustible source of demand: The Economist’s dollar metals index has fallen by 6.4% from its peak on April 20th. Worries about the sustainability of Chinese growth have also knocked many an Asian stockmarket.

In America, the fretful will tell you, there are striking similarities to 1994, when inflationary pressures were rising, the Fed was forced to double interest rates (to 6%) and there was widespread carnage in the bond market. The sanguine reply is that the Fed will move rates much more cautiously than last time—and telegraph every move to a market that is all too aware of those similarities. Buttonwood has his doubts: because returns are far lower than in 1994, leverage in the financial system is far higher.

China has also been here before, as it happens at about the same time. In 1993-94, investment grew at over 60%, GDP growth rose to over 15% and inflation peaked at 28%. Things didn’t turn out too well after that. Back then, though, the world probably didn’t care very much because China didn’t play such a big part in either global growth (of which the country has accounted for a full quarter over the past five years, on a purchasing-power-parity basis) or as a source of growth elsewhere. Buttonwood is, of course, aware of the old saw that history never repeats itself, but he can’t help worrying that two of the most important economies in the world are about to start tightening monetary policy at the same time. And no one knows how fast or how far they will have to go.



The oil wars

In the pipeline

Apr 29th 2004 | BEIJING AND MOSCOW
From The Economist print edition

China and Japan are locked in a fierce diplomatic and economic struggle to win access to Russian oil

THE oil city of Daqing, in the bleak plains of north-eastern China, was once a proud symbol of the country's self-reliant spirit. The discovery of huge reserves there in 1959 allowed China to end its dependence on Soviet oil supplies, and fortified the country in its subsequent cold-war struggle with its fellow communist neighbour. Daqing's ubiquitous rigs still pump away, but output from the ageing field is dropping off. Meanwhile, China's economic boom has produced a growing hunger for energy that only foreign supplies can satisfy. Energy strategists in Beijing now see great promise in the former Soviet Union. Unfortunately, so too does China's old rival, Japan.

If China has its way, Daqing would be the terminus of a crude-oil pipeline beginning 2,300km (1,430 miles) away in Angarsk, at the southern end of Lake Baikal in eastern Siberia. And if Daqing has its way, it would become a refining centre for the Russian oil, which would help revive the fortunes of a city plagued a couple of years ago by large-scale protests involving laid-off oil workers. The pipeline could provide 20m-30m tonnes of crude a year, the equivalent of up to 30% of China's current imports. But Japan's rival idea is to pipe the oil instead to the port of Nakhodka, where it could be shipped to Japan and other markets (including China). A branch line could in theory be built to Daqing, but doubts abound on all sides as to whether there would be enough oil in Angarsk to fill it.

Promising though eastern Siberia's oil resources appear to be, they have yet to be tapped commercially. Even to be sure of filling the original proposed pipeline to Daqing, Russia would have to depend initially at least on supplies from the better developed fields of western Siberia. But this did not stop Japan wading in a year ago with its proposal for a route that would cost nearly twice as much (about $5 billion) and take far longer to build than the Daqing line—to the intense fury of the Chinese who thought they had a deal sewn up.

Many analysts believe that the Russians may now favour Japan over their “strategic partners” in China. The Japanese scheme would avoid dependency on a single market. It also includes provisions for billions of dollars of Japanese investment in oil exploration in eastern Siberia—much needed if Russia is to realise the full potential of the area (though possible Japanese investors, worried about the economic viability of the project, have been lukewarm to the idea). And the chief Russian backer of the Daqing proposal, the private oil company Yukos, suffered a severe blow to its political influence with arrest of its chairman, Mikhail Khodorkovsky, last year on charges of fraud and tax evasion.

Oksana Antonenko of the International Institute for Strategic Studies in London believes the Russians have already decided on the Nakhodka route. This, she says, would fit better with Mr Putin's plans to develop the Russian Far East, since the Nakhodka line would be better able to supply domestic markets as well as foreign buyers. The possibility of building a branch line to Daqing would theoretically be kept open, “but this diversion would simply not ever happen.”

Where would this leave China? Its biggest concern is protecting itself against the price volatility of international markets. At present, China imports about a third of its oil requirements. This could rise to some 60% by 2030. More than half of China's oil imports come from the Middle East. The oil is shipped through the Malacca Strait between Malaysia and Indonesia, an area notorious for well-organised piracy. China's navy is ill-equipped to carry out duties much beyond its shores. Instability in the Middle East, and its impact on prices, has focused the minds of policymakers across North-East Asia on the need to diversify their supplies.

Uncertainty over the Daqing scheme and worries about the Middle East have made China all the keener to explore other options. A long-standing proposal for an oil pipeline from Central Asia to China, which had made little headway because of cost concerns, is back on the table. President Nursultan Nazarbayev of Kazakhstan is due to visit Beijing in mid-May and is expected to sign an agreement on the construction of a 1,200km cross-border section of the pipeline from Atasu in Kazakhstan to Dushanzi in China's Xinjiang region. Work could begin this summer and be completed possibly within a couple of years.

The pipeline would link up with Kazakhstani pipelines connecting to the Caspian Sea region, far to the west. Even so, the oil would still have far to go before reaching the booming coastal areas of China where it is needed most. It is an extremely costly proposition (Chinese reports suggest around $3 billion just for the route from Kazakhstan to Xinjiang) for a projected supply of 20m tonnes a year. But Scott Roberts of Cambridge Energy Research Associates, a consultancy firm, says that while the costs are high “there is a strategic value at stake. China's oil security is increasingly important to its overall economic and political security and from that standpoint, yes, it makes great sense if you can ensure that the supply reaches your market reliably.”

China has offered a spectacular demonstration of its willingness to lavish money on strategically important energy schemes, with its 4,000km (2,500 mile) natural-gas pipeline from Lunnan, in Xinjiang, to Shanghai. This $15 billion project, one of China's costliest-ever infrastructure developments, is due to become fully operational later this year, ahead of schedule. China sees the development of Xinjiang's backward economy as important to the country's stability. It is also eager to promote the use of gas, which is less polluting than China's main energy source, coal. By the time the Xinjiang gas reaches consumers in eastern China, its price will hardly be competitive with that of alternative fuels. But that is of little concern in Beijing.




The search for investment paradise
Apr 27th 2004
From The Economist Global Agenda

As the world’s leading search engine prepares to announce its stockmarket flotation, some words of caution

FOR two days in a row Buttonwood has tapped the words “Google” and “IPO” into the Google search engine. Yesterday there were 269,000 hits, and when he started writing this morning there were 293,000. The number will doubtless be still larger tomorrow, for the crescendo of speculation about when the company will announce its stockmarket flotation has reached Mahlerian proportions. Google, reported the Wall Street Journal this week, has appointed Morgan Stanley and Credit Suisse First Boston to lead the issue. The “IPO of Google…could trigger a new wave of IPO filings among other technology companies,” say the reporters. Recalling the listing of Netscape in 1995, which kicked off the dotcom bubble, they go on to say: “With nearly insatiable investor interest, it could put a price tag of $25 billion on a company that didn’t exist a decade ago.” To those many technology junkies in this dangerous state of euphoria, Buttonwood has one word of advice: resist.

The creative destruction that propels all economies forward is nowhere more evident than in the technology sector. In the pre-bubble days of long ago, when Google’s two founders, Larry Page and Sergey Brin, were still at high school, investors emphasised the destructive part. Tech companies came and tech companies went. Rare was the company that traded on a price-to-earnings (p/e) multiple of more than 20, because waiting twenty years to get your money back seemed more than a little risky if the company was unlikely to be around in ten. Even those that survived and prospered were treated with caution. In 1985-97, when Microsoft's sales were growing by a compound 44% a year, its p/e ratio ranged between 18 and 29.

In these more heady times, technology investors emphasise the creative part. Yahoo!, another search engine (among other things), and the yardstick by which Google’s worth will doubtless be measured, trades now on a p/e ratio for last year’s earnings of 131, a prospective p/e of 64 and enjoys a market capitalisation of $37.9 billion. Earlier this month, the company announced first-quarter numbers that were described by one analyst as “just incredible”. For the record, Yahoo! made $101m of net profits.

Nobody knows how much Google is making: the company makes North Korea look a model of openness. Even its bankers are being kept in the dark by all accounts. Still, it seems to have a good enough business model, perhaps even a very good one. Google’s is the most widely used search engine and it has found a way to make money from this by delivering advertisements to those that use it.

Such “contextual advertising”, in which sponsored links pop up whenever users put in words that are related to their products, allows companies to target their adverts more effectively. Not only do they pay only when a user clicks on a sponsored link, they know how many of these translate into sales. The only problem is that some companies, including Axa, a big French insurer, are suing Google, claiming that such techniques infringe their trademarks on certain words and phrases. Unabashed, Google is expanding the basic idea to other areas, such as shopping comparisons and a free service that would allow companies to track subjects in e-mails and advertise accordingly. Yahoo!’s revenues from such businesses in the first quarter were $635m—an increase of 235% from the year before, and Google’s search-engine technology is more sophisticated.

For now, at least. Yahoo!, which used Google until earlier this year, is getting into the search business. And as a listed company it can use its shares as a currency to buy the technology that it needs, much as Cisco did so successfully in the 1990s in another area: internet infrastructure. Microsoft, too, is developing its search-engine technology. It wants to be able to incorporate its engine into its technology so that users need not open up a browser. And Microsoft, in case you hadn’t noticed, has a habit of subsidising such projects with the huge amounts of cash that it makes elsewhere.

In short, then, Google’s position is not cast in stone; the technology is constantly developing. As Fred Hickey, editor of High-Tech Strategist, puts it: “Technology is a constantly moving market; there is a risk of obsolescence.” Netscape, remember, was all but destroyed by Microsoft, a risk that applies to all internet companies. Such considerations, points out Mr Hickey, dryly, “do not seem to be reflected in the $25 billion valuation”.

What does seem to be reflected is a lot of enthusiasm, which some might describe as bubble-like. To be sure, things are looking up in the world of technology. E-commerce is growing by leaps and bounds. Some of the dotcom survivors, such as Amazon (which is also developing a search engine) and eBay, as well as Yahoo!, are prospering. There are even signs of recovery in Silicon Valley. “Everyone is excited by the dotcom recovery,” says Mr Hickey.

Including, one assumes, the venture capitalists who want to cash in their chips on a successful investment to compensate for their many dotcom disasters, and who seem to be putting pressure on Google’s two founders to list. Given the heady valuations that the company is likely to attract, the two would be wise to do so. For the same reasons, punters would be much wiser to read about Google’s IPO than to invest in it, if only to tell their children about a company they haven’t heard of because it no longer exists.



The best use of aid?
Apr 23rd 2004
From The Economist Global Agenda

As the World Bank holds its spring meetings with the IMF in Washington, it reports that aid is flowing a little more generously, but a lot more strategically. For that, thank—or blame—the war on terror

NO ONE knows better than Rodrigo Rato how terrorism can change everyone’s priorities. On March 10th, the former Spanish finance minister was expecting his Popular Party to be re-elected. On March 11th, the Madrid bombings shifted the electoral calculus in favour of the Socialist opposition. Mr Rato is now slated to be the next head of the International Monetary Fund, which begins its spring meetings with the World Bank in Washington on Saturday April 24th. If and when he is confirmed as the Fund's managing director, he will enter a business of lending and giving to poor countries that has also been transformed by the war on terror.

In the summer of 2001, for example, the IMF was anxiously shepherding Pakistan through a potential debt crisis. The country’s foreign debts were approaching 55% of GDP and its foreign-exchange reserves were falling short of the IMF’s target of $1.6 billion. That all changed after September 11th. The IMF’s loans were dwarfed by generous grants, loans and debt write-offs from the rich world. Pakistan’s reserves now stand at over $11 billion. Its current-account deficit, over 2% of GDP before September 2001, is now a surplus. Being on the front line of the war on terror can do wonders to the bottom line of the national accounts.

The World Bank, in its Global Development Finance report, published in advance of its spring meetings, fears that strategic thinking may be dominating charitable feeling in the capitals of the big donor countries. “The allocation of aid according to strategic considerations can impair aid effectiveness,” it says. “Where aid is provided to corrupt, repressive or incompetent governments it can strengthen their legitimacy, encourage poor governance, and prolong the duration of the regime.”

As the Bank notes, the cold war provided plenty of examples of corrupt, repressive and incompetent regimes, strengthened, encouraged and prolonged by aid. Much of America’s largesse in that period was intended to alleviate communism first, poverty second. Donors worried little about how the money was used, and rather more about whose side the beneficiary was on. Some canny governments, such as India’s, squeezed aid out of both sides by playing hard to get. While the threat of communism dictated America’s aid flows, the ties of colonialism shaped Europe’s.

The cold war showed that aid was good at propping up bad regimes. But was it good for anything else? Many started to doubt it after the cold war was won, and the rich world’s aid budgets fell from a peak of over $60 billion in 1992 to just $48.5 billion in 1997. The World Bank in particular and the development industry in general came under pressure to show that aid could help countries to grow and poverty to fall. In 1998, David Dollar, working in collaboration with Lant Pritchett at the World Bank, showed that aid given willy-nilly did little good at all. Poor countries are often poorly governed, and poorly governed countries make poor use of aid. But, Mr Dollar and Mr Pritchett argued, countries with “sound” economic policies (low inflation, a budget surplus and fairly free trade) and “good” institutions (rule of law, not much corruption, an effective bureaucracy) could make good use of aid.

Their results have been challenged: some say economies grow more quickly when they receive more aid, regardless of the government's policies; others find no correlation at all. Nonetheless, a new conventional wisdom has formed around the principle that aid flows, to be effective, must be selective. The World Bank now rates countries’ policies, institutions and governance. Honest governments, committed to sound policies, should get aid, it believes, while equally poor countries that display no such commitment should not.

That conventional wisdom is being challenged afresh by America’s new strategic imperatives. Central Asia, for example, is no one’s idea of a well-governed region. Stephen Kotkin of Princeton University has coined the term “trashcanistan” to describe the tin-pot kleptocracies and autocracies that emerged out of the debris of the Soviet Union. And yet OECD aid to Tajikistan, Turkmenistan and Uzbekistan, as well as Afghanistan and Pakistan, increased from $1.1 billion in 2000 to $3.7 billion in 2002 (see table). Last year, the Bush administration sought another $3 billion for Pakistan.

Of course, not all aid that serves strategic ends is necessarily ineffective. America’s post-war Marshall plan for Europe was both a strategic triumph and an economic masterstroke. As the World Bank concedes, it patched up Europe’s war-blasted economies and cemented a western alliance against the Soviet Union. Likewise, not all aid that might be effective in alleviating poverty makes strategic sense. The Hizbullah militia, for example, provides schools, hospitals and job training—largely free from corruption—to the impoverished Shia population of Lebanon. But Hizbullah is also a terrorist organisation, and America would never consider giving such a group aid.

As the World Bank concedes, when aid is perceived as a strategic necessity, donors tend to be more generous. Just six months after the September 11th attacks, donors met in Monterrey, Mexico, to review their aid commitments. “Galvanised” by the attacks, as the Bank put it, they promised to raise their aid budgets by almost a third by 2006. Whether donor governments live up to those commitments remains to be seen. But one conclusion seems clear: where no strategic concerns intrude, international aid is likely to be less distorted. It is also likely to be less.




The warrior president
Apr 22nd 2004
From The Economist print edition

Militarism is still George Bush's best card

GEORGE BUSH may not have been the most diligent student at Harvard Business School; but the one class that he certainly seems to have absorbed was brand-management. In 2000 he branded himself as a “compassionate conservative”—and stuck to that message remorselessly. This year he is equally relentlessly branding himself as a “war president”.

Mr Bush is forever giving speeches surrounded by troops, and forever emphasising the importance of courage and commitment. The Republican convention in New York this September is intended to drive one point home: that ever since September 11th 2001, a warrior president has been engaged in an all-out war on Islamofascism.

Two years ago this re-election strategy looked like a “slam dunk” (to borrow George Tenet's unfortunate phrase about weapons of mass destruction). Even a year ago it looked hard to resist. Now the context has changed dramatically. To understand how dramatically, consider who is more likely to use footage of Mr Bush's “mission accomplished” landing on the USS Abraham Lincoln last year—the Democrats or the Republicans?

The first blow to Mr Bush's warrior strategy was the Democrats' decision to nominate a Vietnam war hero rather than an anti-war blowhard. John Kerry's campaign has hardly got off to a rip-roaring start. But he is nevertheless well-placed to undermine Mr Bush's core message by branding himself as “the real thing” when it comes to war leadership: a man who fought in Vietnam rather than skulked in the National Guard. Mr Kerry's war record—brave in the field, sceptical afterwards—could well become an appreciating asset as more people become convinced that Iraq is another Vietnam.

Mr Bush's warrior strategy has suffered two further blows since the Democratic primaries. The first is the September 11th commission. It is no wonder that the White House fought tooth and nail against the establishment of this commission. It has shone a bright spotlight just where the administration did not want it, on its “failure” to prevent September 11th. It is now clear that the administration had plenty of warnings that al-Qaeda was planning an earth-shattering attack on American soil, and that both the FBI and the CIA failed to act on specific leads. Far from being a warrior president, Mr Bush risks being thought of as asleep on his watch, holidaying in Crawford rather than bullying his cabinet to focus on the mounting terrorist threat.

The commission would never have materialised without the lobbying of a group of September 11th widows—particularly a quartet known as the Jersey Girls. These widows are likely to remain a thorn in the warrior president's side for the rest of the political season. They have already made a fuss about the Republicans' decision to use pictures of the flag-draped remains of victims of September 11th in an election ad, and may cause an even bigger fuss if Mr Bush's people try to exploit Ground Zero during their convention. Indeed, Republicans are already worrying that Karl Rove's “masterstroke” of holding the Republican convention in New York may yet be remembered as a crass attempt to exploit a national tragedy for partisan gain.

But the biggest problem for Mr Bush's warrior strategy is the deteriorating situation in Iraq. Michael O'Hanlon, a hawkish Democrat at the Brookings Institution, puts it nicely. If you want to play the part of John Wayne, it is not enough just to walk with a swagger; you need to make sure that your gun is loaded and that you have sized up your opponent correctly. Mr O'Hanlon points out that America's warrior president is currently suffering one of the biggest indignities imaginable—being out-thought by a bunch of “Baathist dead-enders”.

So has Mr Bush made a fatal error in deciding to brand himself as a warrior president? Not really. First, consider the alternatives. Mr Bush's poll numbers for “compassion” are surprisingly robust for a Republican. But when it comes to actual policies, compassionate conservatism has produced little more than warm wind. Yes, the economy is beginning to roar back, but by some counts 80% of the jobs created are part-time ones that usually come without health care and other benefits. And Americans are obsessed with the spiralling price of petrol.

Second, look at how well Mr Bush's image as a warrior president has withstood the extraordinary battering of the past few weeks. The credibility of the September 11th commission is collapsing like a poorly cooked soufflé in a mess of partisan finger-pointing and publicity-chasing. While Americans may have adjusted their view of the warrior president, they draw the line at blaming him for September 11th (and will probably punish any Democrats who dare suggest it). Even the Jersey Girls are in danger of overplaying their hand by often appearing to blame the Bush administration more than the hijackers. As for Mr Kerry, the Democratic senator still sounds hopelessly confused about Iraq, thanks partly to his own convoluted voting record on the war and partly to the deep divisions within his own party between the anti-war left and the moderate middle.

Even the mess in Iraq is not producing the sort of backlash against the warrior president that you might expect. The latest opinion polls, taken after several terrible weeks in Iraq, show Mr Bush increasing his lead over his rival, as attention focuses on security. Mr Bush still leads Mr Kerry by about 20 points when pollsters ask Americans about issues like “protecting the country” and “fighting terrorism”. For the time being at least, anything that shifts the focus to terrorism benefits Mr Bush.

Running as a warrior president is certainly no slam dunk. But it is the best card the president has; and, on the current evidence, it has a slightly-better-than-even chance of success of trumping anything Mr Kerry puts on the table.



Economics focus

A remedy for financial turbulence?

Apr 15th 2004
From The Economist print edition

In the first of a series of articles on the Copenhagen Consensus project*, we look at financial instability

THE severity and frequency of financial crises, especially the combined currency and banking collapses of the past decade, have made financial instability a scourge of our times, one that bears comparison with damage inflicted by famine and war. In a new paper for the Copenhagen Consensus, Barry Eichengreen, from the University of California, Berkeley, has reviewed the literature, attempted to count these costs, and to weigh them against the costs of a particular proposal for remedial action.

The costs can be reckoned in stalled growth and stunted lives. The typical financial crisis claims 9% of GDP, and the worst crises, such as those recently afflicting Argentina and Indonesia, wiped out over 20% of GDP, a loss greater even than those endured as a result of the Great Depression. According to one authoritative study, the Asian financial crisis of 1997 pushed 22m people in the region into poverty. For developing countries, currency crises are an important subset of financial crises. Mr Eichengreen, while cautioning against taking the precision of such estimates too seriously, reckons that the benefit which emerging-market countries would reap if such crises could be avoided altogether would be some $107 billion a year.

One ready way to secure those benefits, you might think, would be to stifle financial markets. In impoverished parts of Africa, for example, credit crunches are relatively rare, because credit is always hard to come by. But as a rule such a solution would be more costly than the problem. Wherever financial markets are absent or repressed, savings go unused, productive economic opportunities go unrealised and risks go undiversified. If India's banks and stockmarkets were as well developed as Singapore's, India would grow two percentage-points a year faster, according to one study.

To grow fast, and keep growing quickly, countries need deep financial markets—and the best way to deepen financial markets, most economists agree, is to liberalise them. Does this mean that countries must open their financial markets to foreign capital, thus exposing themselves to the risk of currency crises? Or should they impose capital controls, confining the perversity of financial markets to national borders, where the central bank retains the power to offset it? Foreign direct investment aside, China's capital markets are still largely closed to outsiders. Yet it has no shortage of credit. For other countries, though, the evidence is mixed. A fair reading of the studies, and there have been many, suggests that, for most countries, opening up to foreign capital will deliver faster growth in most years—punctuated by a damaging financial crisis about every ten years. Some economists argue that periodic credit crunches are the price emerging markets must pay for faster growth.

What might be done to make financial crises less common? The answer depends on the causes of financial meltdown. Governments bring some crises on themselves by pursuing fiscal and monetary policies that are inconsistent and unsustainable. Such self-defeating policies may be the symptom of deeper flaws in the body politic. If so, there is little outsiders can do. But some countries' financial fragility results simply from their need for foreign investment. In the most susceptible countries, firms and banks borrow heavily in dollars, while lending in local currencies. If the value of the local currency wobbles, this mismatch between domestic assets and foreign liabilities is cruelly exposed.

Why are the assets and liabilities of emerging markets so ill matched? Perhaps because poorly supervised and largely unaccountable managers have scant reason to be careful with other people's money. But Mr Eichengreen offers another reason. International investors are very choosy about currencies. Most consider only bonds denominated in dollars, yen, euros, pounds or Swiss francs. This select club of international currencies is locked in for deep historical and structural reasons. Thus, poor countries that want to borrow abroad must bear currency mismatches through no fault of their own.

If this is the problem, possible solutions follow naturally: either create a common world currency, used by rich and poor alike, or invent a liquid, international market for bonds denominated in the pesos, bahts and rupiahs that emerging markets are obliged to use. The first solution, even if it were desirable, is politically impossible; the second is merely very difficult. Mr Eichengreen spells out in his study an ingenious plan to make it a little easier. Briefly, he proposes the creation of a market for lending and borrowing in a synthetic unit of account, a weighted basket of emerging-market currencies. Such bonds would be popular with investors, since the currency would be more stable than the sum of its parts and, at first at least, carry attractive yields. Importantly, such a market, if it could be established, would eventually let emerging-market economies tap foreign capital without currency mismatches. This is because those, such as the World Bank, that issued such bonds would be keen to reduce their exposure to the basket by lending to the countries in that basket in their own currencies.

However, there is a cost: the extra yield that the Bank and others would need to offer to attract buyers of the new instruments. Mr Eichengreen estimates that this initial cost would be no more than $545m a year—a small sum compared with the $107 billion that would be saved if currency crises could be avoided.




Warnings to be ignored
Apr 20th 2004
From The Economist Global Agenda

American banks continue to make vast profits. Will the good times end when the Fed raises interest rates?

IN RECENT years, Buttonwood has written many an article on the American banking system. Learned, pithy and opinionated, the only thing about his analysis that could possibly be faulted is that it sometimes turned out to be spectacularly wrong. In the late 1990s, faced with banks’ record profits, Buttonwood opined that it could not last. The gist of the argument (and there were, you can be sure, many subtleties) was that although there were good reasons why banks had become more profitable—such as a robust economy and a more diverse set of businesses—the biggest reason was that they were taking more risk. And since risk was not being rewarded properly in the febrile 1990s, your columnist was convinced the banks would come a cropper. The occasion when Buttonwood delivered these forthright views at length to a deeply sceptical Alan Greenspan (who thought he must be looking at a different country) has gone down in Economist folklore.

Mr Greenspan’s scepticism, you might not be surprised to hear, was warranted. American banks cruised through the downturn following the stockmarket crash of 2000 with barely a dent in the bumper, and since then their profits have accelerated. Last year Citigroup, the largest financial firm in the world, made more money than any other company has ever made before. In the first quarter of this year, it made another $5.3 billion, putting it on course to break last year’s record. Bank after bank has announced a sharp increase in profits in the first quarter. And yet bank shares have foundered: the banking bit of the S&P 500 is some 7% off its high. Investors, it seems, doubt whether the good times can continue. And the reason for these fears is a slew of robust economic statistics suggesting that the Fed is likely to raise interest rates sooner rather than later. This, they think, will hurt banks.

Though fully in agreement with these views, his dismal track record at the very least requires Buttonwood to put the case for the defence. Far from falling, bank profits could actually rise when the Fed puts up rates. All things equal, says David Fanger of Moody’s, a rating agency, banks make more money when interest rates are high than when they are low, because they benefit more from paying low or no interest on checking (current) accounts and so forth. The attraction of such cheap sources of funding is the main reason why banks have built up their branch networks in recent years, helping them to suck in deposits, which have been growing at almost 10% a year. The cheap funding from deposits, says Mr Fanger, accounts for 25-40% of profits, depending on the bank. It would mean still more profits were rates to rise.

But while banks’ funding will benefit from the rise in short-term rates, they will lose out (in one way, at least) if higher long-term rates do not rise too. Banks essentially take two risks. The first, dubbed “maturity transformation” risk, involves borrowing short and lending long. The bigger the difference between short- and long-term rates, the more money banks make. Thanks to the largesse of the Fed and its 1% short-term rates, the yield curve—the difference between short and long rates—has been at or near a record high over the past couple of years. The difference between two- and ten-year Treasuries—a good way of measuring the slope of the curve—has been two-and-a-half times its average of the past 20 years, says David Hendler of CreditSights, an independent research firm. As a result, he says, “you could have strapped any monkey to a trading chair and made money.”

Banks have played the yield curve for all they are worth, in the sure knowledge that the Fed will give ample warning before it alters short-term rates. Although commercial lending has dropped, banks’ holdings of government securities have grown, as have their investments in mortgage-backed securities, which have gone up by almost $100 billion, or a third, since last September. The market for interest-rate swaps is another favoured playground. Here, banks simply pay a low, short-term floating rate and receive a high, fixed one. Half the top 20 American banks get at least 10% of their profits from this spread, according to Mr Hendler; for J.P. Morgan Chase, it was an astonishing 33% last year.

The fear, of course, is that banks could lose heavily if long-term rates rise sharply, because the securities that they have bought already would fall in value (although, of course, they would be able to earn a decent spread on new ones). And many other investors have also taken full advantage of the steep yield curve, which might mean a decidedly nasty fall as they head for the exits at the same time.

Most economists put “fair value” of ten-year Treasuries at 5.5% or so. This would mean big losses on all those bonds and swaps positions that banks had taken out when rates were a lot lower and prices higher. It would, however, be mainly a valuation loss, and banks might avoid the worst of it by transferring positions to that part of their balance sheet that they do not have to mark to the market price. They would, however, be left with low-yielding assets at a time when the cost of their liabilities in the capital markets was rising. Of course, banks are not stupid: they know that the Fed will raise rates at some point. But the pressure on them to increase profits is so great that most of them have stayed put for as long as possible. All of this means, at the very least, lower profits on existing positions. And if short-term rates rise sharply, as they did in 1994, banks will be in trouble.

But the second risk that banks take—credit risk—is just as big a concern in a rising interest-rate environment. Credit costs have fallen sharply in recent years for consumers and companies alike, thanks to a buoyant economy and low rates. Mr Fanger argues that those costs are likely to remain low because the Fed will be raising rates at a time when the economy is humming along nicely. But given how high consumer and corporate debts are, and how low the price now charged to lend to riskier borrowers is, such a view seems overly sanguine. You may feel, however, that such warnings can be safely ignored.



Cash and carry
Apr 9th 2004
From The Economist Global Agenda

Good news on jobs in America may have troubling repercussions for emerging markets

IN FINANCE as in medicine, prevention is better than cure. The International Monetary Fund’s Global Financial Stability report, published on Tuesday April 6th, is the equivalent of a twice-yearly check-up for the international financial system. At the moment, the system seems to be in rude health, the report says. The IMF does worry, however, that proper precautions for the future are not being taken. Unfortunately, in finance as in medicine, no one listens to the doctor until nasty symptoms start to show.

As the report confirms, the past 12 months have seen the re-emergence of emerging markets. A strengthening world economy has rediscovered an appetite for their goods, and a raging thirst for their bonds. Spreads—the premium creditors demand from emerging-market governments, over that asked of more trusted governments—have fallen dramatically, despite rising somewhat in February (see chart above). Brazil’s turnaround has been among the most dramatic. As a presidential candidate in 2002, Luiz Inácio Lula da Silva struck fear into the hearts of Brazil’s foreign creditors. But as president, in 2003, he raised $4.4 billion from them. Even Indonesia, laid low by the Asian financial crisis in 1997, got back on its feet in March with its first bond issue for eight years.

What explains this renewed enthusiasm for emerging markets? Their “fundamentals” have certainly improved. Exports are strong, public finances are more stable, and currencies more flexible. Countries that once sought to maintain currency pegs with inadequate reserves now do the opposite. With some exceptions, they no longer have an official parity to defend, but they have accumulated large, sometimes vast, stocks of foreign exchange anyway.

Emerging markets, then, have become better bets. But that, the IMF judges, is not the main reason why they have enjoyed so much custom from foreign punters recently. More important is the fact that investors have more money to play with and nowhere better to place it. With short-term interest rates pinned to the floor by the Federal Reserve, the rich world has grown unprofitable for yield-hungry prospectors. Emerging markets look enticing by comparison: J.P. Morgan’s index of emerging-market bonds, the EMBI+, returned about 30% last year.

Flat yields in mature markets make emerging markets look good. But there is more to it than that. The ample liquidity sloshing around in the rich world is also an invitation to enter into the so-called “carry trade”. Carry traders borrow at low, short-term rates. They then invest the proceeds in higher-yield assets. Some simply buy long-dated American bonds. But the more adventurous look further afield, betting on richer-yielding emerging-market bonds with money borrowed at cheap rates in mature markets.

The problem is those cheap rates may not last much longer. Interest rates in Britain have already started rising. On Thursday April 8th, the Bank of England held rates steady at 4%, but it is expected to raise them another notch next month. When the Federal Reserve follows suit, the liquidity that lubricates the carry trade may dry up. A warning shot came late last week: America’s monthly jobs report was surprisingly strong—308,000 workers were added to the payrolls in March. That was followed up on Thursday by the news that the number of Americans making initial jobless claims fell to 328,000 in the week ending April 3rd, the lowest for more than three years. This gathering strength in the labour market threatens to remove the Fed’s last, best excuse for keeping interest rates at 45-year lows.

The market, of course, is not wholly unprepared—it knows the Fed will tighten monetary policy. But it does not know when, or by how much. Many analysts expect a rate rise before the summer is out. Others still maintain that the Fed will wait until after America’s November presidential election. When the Fed does finally get going, most assume it will take cautious, baby steps. But no one really knows how quickly it will move.

The IMF fears the bond market will be caught out in 2004, much as it was in 1994. Back then, markets were similarly bracing themselves for a gradual shift to a tighter monetary policy. Short-term interest rates were low and longer-term rates high, in anticipation of the economy reaching full strength. As a result, the “yield curve” at the beginning of 1994 was unusually steep—almost as steep, indeed, as at the start of this year (see second chart).

Sure enough, in February 1994, the Fed started raising rates. But it went further and faster than anyone had anticipated: seven hikes in 12 months doubled the federal funds rate to 6%. As short-term rates caught up with long, the yield curve flattened out. The liquidity tap was turned off; the carry trade miscarried. Investors could no longer borrow cheap money to lavish on emerging markets. Emerging-market bond yields shot up. The result was Mexico’s “tequila” crisis, in which the country found itself with more debt than it could repay and a currency peg it could not defend.

This time might be different. In 1994, Alan Greenspan acted so precipitously because he was spooked by the prospect of inflation. But the spectre that haunted him then is no longer a worry: Mr Greenspan, if anything, thinks inflation today is too low. More importantly, few emerging markets are any longer in the business of defending unsustainable currency pegs, as Mexico was in 1994. If emerging markets do fall out of favour with foreign investors, their exchange rates can take some of the strain.

The IMF is still worried, however. “Valuations on emerging-market bonds, especially sub-investment grade bonds, appear vulnerable to an increase in underlying US treasury yields,” it says. As the Fund points out, the notion that this time it’s different has led many an over-optimistic soul to repeat this time exactly the same mistakes he made last time.



Hopeful signs of a job-full recovery
Apr 2nd 2004
From The Economist Global Agenda

At last, American firms are hiring again in earnest: payrolls grew by 308,000 in March. If the job gains continue, interest rates will rise, and so will President George Bush’s fortunes

FOR months, America’s jobless recovery has bemused economists, bound the hands of the Federal Reserve and benighted the administration of George Bush. Despite impressively fast economic growth, firms have been depressingly slow to hire. Last month, however, America’s corporations made up for lost time: 308,000 workers were added to the payrolls in March, according to figures released on Friday April 2nd. That is twice the number hoped for by even the most optimistic forecaster. Has spring finally arrived for America’s barren labour market?

Actually, the weather may have helped. The construction industry, which lost 21,000 workers in February, gained 71,000 last month thanks to the balmier climate, which brought many building plans out of hibernation. The resolution of a strike by Californian grocery-store workers also boosted the job figures for retailing, which added 47,000 workers in March. This was a welcome, but one-off, development: strikes only end once. More promising was the great strength showed by service industries, which hired an extra 230,000 people in March. Even manufacturing, which lost jobs for 43 months in a row, seems to have finally hit bottom: the sector's payrolls were unchanged in March.

Paradoxically, despite these widespread gains, the unemployment rate—the percentage of the workforce who are not in fact working—edged up from 5.6% to 5.7%. But the paradox is only apparent: many Americans, despairing of ever finding a job, had dropped out of the workforce altogether in recent months and were therefore not counted as unemployed. New glimmers of hope about their job prospects may have tempted some of them back into the labour force and thus back into the unemployment statistics.

Good news for the jobs market is bad news for the market in bonds, the price of which falls when interest rates rise. The Federal Reserve has so far stayed its hand, keeping the federal funds rate at 45-year lows, mainly because of the slack in the labour market. With so many workers standing idle, the Fed has argued, the economy is performing well below its potential and is thus still in need of a stiff monetary stimulus. That argument will be a little harder to make after Friday’s figures. If they mark a sustained turn in the labour market, interest rates may also now turn upwards before the summer is out.

And what of Mr Bush’s political fortunes? Will Friday’s figures defuse one of the more incendiary charges laid against him by his Democrat critics: that he has presided over the worst jobs record since the Depression-era president, Herbert Hoover? They will certainly help. But even after last month’s strong hiring, payroll employment is still down almost 1.9m from where it stood when Mr Bush came to office. Voters’ perceptions of the economy will also take time to change. Only economists and political campaigners pay much attention to the statistics; ordinary people wait to see how they and their neighbours are doing. Until those feelings of job insecurity pass, Mr Bush's own job security will be far from assured.



The unstoppable, surging yen
Apr 1st 2004
From The Economist Global Agenda

The yen is surging again. Will the Japanese authorities halt its rise? Can they?

“THIS intervention is stupid,” said Fumihiko Igarashi, an opposition politician in Japan’s lower house of parliament. “It’s a fight we can’t win.” Indeed, on the day he spoke, Wednesday March 31st, the Japanese monetary authorities ceded one round in their fight with the currency traders. They watched the yen strengthen past ¥105 to the dollar, having intervened furiously in the markets only last month to keep it from crossing that threshold. The defeat became a rout as the yen pushed on to reach a four-year high, at ¥103.4 to the dollar. Traders and analysts are now anticipating the day when the yen is worth a full cent.

Did the finance ministry, which sets Japan’s yen policy, go down fighting, its interventions overwhelmed by the sheer weight of market sentiment? Or had it already thrown in the towel and given up intervening altogether? In the whole of March, the authorities sold a massive ¥4.7 trillion ($45.2 billion) in their attempt to keep the currency down. But analysts reckon most of that ammunition was fired in the first part of the month. For the past couple of weeks, the ministry has been denying rumours that it has given up on its efforts to keep the yen down. It insists there has been no change in policy. On Wednesday, currency traders obviously concluded that the ministry doth protest too much.

Japan’s GDP grew at an annualised rate of 6.4% in the final quarter of 2003 and its trade surplus ballooned by more than 50% in February, compared with a year earlier. Manufacturers are brimming with a confidence they have not felt for nearly seven years, according to the quarterly Tankan survey released on Thursday, and some of that optimism is even spreading to the service sector, ending four years of negative thinking. It is easy to conclude, therefore, that Japan’s strengthening economy warrants a stronger yen. But that conclusion would be a little hasty. For Japan, a cheap yen is not just a way to conquer foreign markets; it is also a way to conquer deflation—and with the GDP deflator, a broad measure of the price level, still falling by 4.4%, that battle has yet to be won.

Inflation is often described as the result of too much money chasing too few goods. Japan’s deflationary dilemma is the converse of this: not enough money, chasing too many goods. The Bank of Japan is doing its best to fix the first part of this problem, flooding the banking system with reserves. But as Andrew Smithers, an independent financial analyst, points out, this policy is fraught with difficulty, because one never really knows how much money is enough. The right amount will vary as the economy grows, and as the demand for money fluctuates. This is precisely the reason why most central banks target the price of money, in the form of short-term interest rates, rather than its quantity.

Japan cannot do this, of course: its short-term interest rates, at zero, are already as low as they can go. But as an alternative, Mr Smithers points out, it can still target the exchange rate—the foreign price of money. The finance ministry sold ¥20 trillion last year trying to keep the exchange rate steady. But, Mr Smithers argues, this did not go far enough. In an ideal world, he says, the ministry would go on selling until the currency was thoroughly debauched and the economy decisively reflated.

However, the Americans, at the other end of the yen-dollar exchange rate, do not necessarily see things this way. “No one has devalued their way to prosperity,” asserted John Snow, America’s treasury secretary, earlier this month—ignoring the prominent example of President Franklin Roosevelt, who devalued his way out of America’s own deflationary trap in the 1930s. Alan Greenspan, the chairman of the Federal Reserve, echoed Mr Snow’s criticism: he recently said that the pace of Japan’s currency intervention was “unsustainable”. The scale of the dollar reserves that Japan has built up as a result of its intervention was “awesome”, he said.

Awesome these dollar purchases undoubtedly are, but shocking also is the supply of dollar assets coming to market. America’s federal government alone will need to issue over $500 billion-worth of Treasuries this fiscal year to cover the gaping hole in its budget. At the moment, foreign central banks are the star bidders every time these bonds are put up for auction. But if the Bank of Japan takes a back seat in future, other buyers will have to be tempted into the market by means of higher interest rates. The United States Treasury, in other words, will have to make its debt more attractive to hold and thus more costly to service. Japan may not be the only loser in the currency-intervention game.