Thursday, December 24, 2009

Chinese growth

Continuing Chinese growth is a major concern for Australia. The fact that China grew at a rate of 7.7 % for the year to September had a beneficial impact on Australian growth. I have long been worried that Chinese spending is not sustainable and as a consequence Chinese growth may not be sustainable.

According to Stephen Roach (Morgan Stanley) [cited in Is China's Economy Speeding Off the Rails?]
Investment in fixed assets like factories and the rail network accounted for more than 95 percent of China’s 7.7 percent growth in the first three quarters of 2009 and made up 45 percent of gross domestic product, which is higher than any major economy in history, according to Stephen Roach, chairman of Morgan Stanley Asia.
Without a surge in consumer spending and with export growth stalled, investment must rise even further to stoke growth, he said in a Dec. 18 speech in Beijing.
“These are ridiculous, unsustainable numbers for any economy,” Mr. Roach said.
Ninety-five percent of growth is a very large component of growth and although China does have large reserves, eventually growth must come from elsewhere. While these assets will eventually produce benefits - one hopes - they will not be affordable for a large percentage of the population.
China may be hit with a slowdown next year as the impact of the investment-led expansion wears off and shipments to the United States, the traditional external source of growth, fail to pick up, Mr. Roach said in an October report. He did not specify how much he thought growth might slow.
Some economists say the high-speed network is symbolic of a stimulus program that places too much emphasis on infrastructure spending and not enough on raising living standards. The average urban Chinese worker made 28,898 renminbi last year, a tenth of the $39,653 average wage in the United States, according data from the U.S. and Chinese governments.
Most Chinese rail travelers will not pay the premium to ride on the fast trains, Zhao Jian, a professor of economics at Beijing Jiaotong University, said in a September interview on Chinese television.
A second-class one-way ticket for the half-hour Beijing-Tianjin trip costs 58 renminbi, about three-quarters of the workers’ average daily pay. A so-called hard-seat ticket on a slower train, which covers the distance in two hours, sells for 11 renminbi.
Passenger reluctance means revenue from the high-speed lines will not be enough to service the debt if railway expansion continues at its current pace, Mr. Zhao said in the TV interview. The Ministry of Railways has 383 billion renminbi in bonds outstanding
“If America had its subprime crisis, in China we have a railroad-debt crisis, or you could call it a government-debt crisis,” Mr. Zhao said in the TV interview.

Wednesday, December 16, 2009


McKinsey generally have the best coverage of global capital flows and their latest report shows just how significant the global financial crisis has been for financial globalisation.

In its latest report Global capital markets: Entering a new era McKinsey reports that:
World financial assets fell $16 trillion to $178 trillion in 2008, marking the largest setback on record and a break in the three-decade-long expansion of global capital markets. Looking ahead, mature financial markets may be headed for slower growth, while emerging markets will likely account for an increasing share of global asset growth.

Financial globalization reversed in the wake of the crisis. Capital flows fell 82 percent in 2008, to just $1.9 trillion from $10.5 trillion in 2007.

Declines in equity and real estate values wiped out $28.8 trillion of global wealth in 2008 and the first half of 2009.
Other pertinent points made:
Falling equities accounted for virtually all of the drop in global financial assets. The world's equities lost almost half their value in 2008, declining by $28 trillion. Markets have regained some ground in recent months, replacing $4.6 trillion in value between December 2008 and the end of July 2009. Global residential real estate values fell by $3.4 trillion in 2008 and nearly $2 trillion more in the first quarter of 2009. Combining these figures, we see that declines in equity and real estate wiped out $28.8 trillion of global wealth in 2008 and the first half of 2009.

Credit bubbles grew both in the United States and Europe before the crisis. Contrary to popular perceptions, credit in Europe grew larger as a percent of GDP than in the United States. Total US credit outstanding rose from 221 percent of GDP in 2000 to 291 percent in 2008, reaching $42 trillion. Eurozone indebtedness rose higher, to 304 percent of GDP by the end of 2008, while UK borrowing climbed even higher, to 320 percent.

Financial globalization has reversed, with cross-border capital flows falling by more than 80 percent. It is unclear how quickly capital flows will revive or whether financial markets will become less globally integrated.

Some global imbalances may be receding. The U.S. current account deficit—and the surpluses in China, Germany, and Japan that helped fund it—has narrowed. However, this may be a temporary effect of the crisis rather than a long-term structural shift.

Mature financial markets may be headed for slower growth in the years to come. Private debt and equity are likely to grow more slowly as households and businesses reduce their debt burdens and as corporate earnings fall back to long-term trends. In contrast, large fiscal deficits will cause government debt to soar.

For emerging markets, the current crisis is likely to be no more than a temporary interruption in their financial market development, because the underlying sources of growth remain strong. For investors and financial intermediaries alike, emerging markets will become more important as their share of global capital markets continues to expand.

The major issue in the short-term will be how quickly capital flows recover. Another key issue is how slower growth in mature markets will affect emerging markets' financial systems.

The severity of the also highlights just how amazing it is that Australia managed to avoid a downturn in growth over the 2008-09 financial year. For Tony Abbot to argue that the Rudd govt has achieved little in its first couple of years and for some economists to argue that the fiscal stimulus has been profoundly negative defies any logic. Instead it appears to be simple oppositional politics for the former and blind anti-govt rhetoric for the latter.

If it sounds unlikely, it probably is.

Monday, December 14, 2009

Financial Regulation

Financial regulation is in the news again this week with Obama criticising fat cat bankers for just not "getting it". The administration is frustrated by the opposition to regulation, the continuing payment of excessive bonuses, the spending of huge sums on lobbying and the failure to lend.

There's no doubt that they're not getting it because they don't have to. The problem goes a long way back, including during the Clinton administration, which gave to much credence to the financial sector's power and seemingly enjoyed its support. Indeed many in its economic team were integral players in the financial structure. At least Obama is trying to do something.

In Australia the view from Reserve Bank governor Glen Stevens is that the regulatory problem is related to just 30-40 "bad apple" banks and that regulators should be careful not to overdo the changes.
We should try to ensure, however, that the cost is no more than necessary. The most egregious behaviour was mainly that of 30 to 40 large, globally active banks. They have imposed very large costs on their own banking systems, economies and taxpayers, and on the global economy. But there are thousands of other banks in the world whose risk appetite did not get out of control, that have remained solvent, and that have not needed public capital injections. So it will be sensible to ensure, as far as we can, that the proposed measures act effectively to constrain the worst excesses of the former without unnecessarily shackling the latter.

The real question is why Australian banks did well during the crisis. Was it because of more effective regulation in Australia, the continuing growth of the Australian economy that kept borrowers solvent (compared to the situation in many other countries), the high level of investment in housing and mining that meant that there was less 'loose' money to invest in the types of schemes that brought the US and European banks undone, the lessons of the financial debacle of the late 1980s.

To my mind all of the above played a role, but imagine a slightly alternative scenario where Australia did go into a deep recession and unemployment rose significantly or one where the Rudd govt did not support consumption and housing. Given the significance of home lending for the big banks in Australia, the banks books might not have looked so good if bad debts and the housing market had been affected by rising unemployment.

There is still much that could go wrong and indeed part of the problem for the future might be the belief that Australia is invulnerable and that our policy-makers are omnipotent. There is still a lot of debt in the system and if that debt increases then it makes Australia more vulnerable rather than less.

But the RBA is not worried at all.

Maybe they're right, but is it possible to keep increasing debt?

Sunday, December 13, 2009

Climate Change

Climate change obviously is the issue of the week and I'm not going to add too much to the debate except to provide some notes mainly for myself on some key positions.

The best way to get round those skeptical about human-induced CC is to argue that there are benefits to reducing energy intensity and lowering emissions that go beyond whether they will have an impact on the climate.

More money needs to be provided by govts for research into renewables: a basic fact that needs to be reiterated over and over again. (Imagine if some of the costs of the govt's entourage could have been redirected to university research).

A carbon tax would be simpler than a trading scheme but it is unlikely to happen in Australia.

The European scheme and all similar schemes (including the Australian one) are (and will be) subject to manipulation. They risk putting energy supply and abatement at the mercy of speculators.

Going down the tax route would have avoided the complexity issue that makes people suspicious about govt motives. People don't like taxation, but it would have been easier to explain. A low initial tax on carbon emmissions (escalating over time) would have provided a clear incentive to polluters. Revenue raised could have gone into renewables research and to assist the poor to adjust to higher electricity prices.

Higher taxes on fuel would provide incentives to drive less polluting cars. Simple but unlikely in the extreme in Australia (without bipartisan support).

Major reform in Australia is more difficult without bipartisanship. The liberalisation of the Australian economy was made possible by bipartisanship. The GST is somewhat of an exception. Who now really considers the GST as a problem? (Perhaps some in small business, but once systems are set up, people adjust).

European success in meeting its Kyoto targets has a lot to do with the collapse of communism and the creation of carbon credits from Eastern Europe.

Much of the action taken by developed countries to meet targets has little to do with cutting emissions at home (i.e planting trees, cuts in land clearing etc)

For current renewables to be viable requires a high carbon price - estimates range from $US20 to $150.

Tuesday, December 8, 2009

Between Luck and Vulnerability

I've just published an article on Australian Policy Online.  APO is probably the best source of academic research in Australia - well worth subscribing to for access to new research etc.

The piece is called Between Luck and Vulnerability: Australia in the Global Economy.

It contains an update of some of the stuff in my book and for those nerds who like graphs and tables, there's quite a few of those as well.

Its argument:

As Australians contemplate the lessons of boom and gloom and consider vulnerabilities it is worth thinking about why policy-makers thought we were doomed in the 1980s, according to this paper, because many of the problems of the 1980s remain. While the economy has been more productive, more efficient and, perhaps most important, less inflation-prone, the trade balance, current account deficit, foreign debt and inequality remain as markers of vulnerability.
This paper argues that Australians should be aware of the lessons of Australia’s economic history, that booms are often followed by periods of gloom. Booms do not solve the fundamental recurring problem of Australian economic history: vulnerability to changes in international demand and international financial sentiment. An over-reliance on resource wealth is still a precarious path for Australia’s future, just as it has been throughout Australian economic history.
This is especially the case if growth is supported through high levels of unproductive debt. Australia is more indebted than it has ever been in its history. Australia will remain vulnerable even if China continues to grow into the indefinite future. And it continues to be vulnerable in a world where financial markets continue to be unsettled. With rising concern about global warming it is perhaps more urgent than ever to increase the diversity of Australia’s productive capacity and export profile. If the more dire consequences of warming occur, Australia needs to be prepared to adapt.
To these well-known vulnerabilities we can add a third, vulnerability to rising inequality. Australia cannot control what happens in the rest of the world – we are a minor player in the global economy – but we can control the way we adapt to global events and developments. A fairer society is more likely to continue down the path of economic dynamism and continuous adaptation and less likely to see globalisation as a byword for rising inequality and a process that needs to be resisted.

Sunday, December 6, 2009

Government Spending, Deficits and Debt

There's been a lot of spurious stuff written recently about the dangers of deficit financing during the Great Recession. Reading some of the more alarmist stuff one would be forgiven for thinking that the world didn't just dodge a huge bullet - a major systemic financial collapse and a serious depression in the developed world, which would have eventually engulfed the whole world. The negative feedback possibilities were extremely scary. Massive fiscal stimulus made a big difference. As growth returns money will need to be paid back. My major concern is with indebtedness across the system, rather than in the govt sector.

The more alarmist writers always refer to govt debt in gross terms rather than in net terms.
Those interested in the detail can read the earlier post "Public Debt (for Nerds)". What really matters is net debt or more to the point net financial worth and net worth.

There is no doubt that govts cannot keep borrowing indefinitely, just like households and corporations.
One of the main differences between public andf private, however, is the capacity to fix finances through taxation. In the US in the 1990s, Clinton shifted the US debt position relatively easily and then Bush messed it up again.

For an excellent counter-intuitive account of these issues see Robert Frank's article "How to Run Up a Deficit, Without Fear

Frank drily notes that:
there are really only three basic truths that policy makers need to know about deficits: First, it’s actually good to run them during deep economic downturns. Second, whether deficits are bad in the long run depends on how borrowed money is spent. And third, eliminating deficits entirely would not require any painful sacrifices.

What! You ask, surely this can't be true? The first point comes directly from Keynes who correctly argued that in times of recession govts should do what they can to bolster spending.
Consumers won’t lead the way, because even those who still have jobs are fearful they might lose them. And most businesses won’t invest, since they already have more capacity than they need. Only government, Mr. Keynes concluded, has both the motive and opportunity to increase spending significantly during deep downturns.
Of course, if the government borrows to do so, the debt must eventually be repaid (or the interest on it must be paid forever). That fact has provoked strident protests about government “bankrupting our grandchildren.”
It’s an absurd complaint. Failure to stimulate the economy would mean a longer downturn. That, in turn, would mean longer stretches of reduced tax receipts, increased unemployment insurance payouts, and depressed private investment. The net result? Higher total public borrowing and a permanent decline in productivity compared with what we would have had under effective economic stimulus.
But govts do have to pay the debt back as the economy recovers.
At full employment, extra borrowing often compromises future prosperity, just as critics say. On President George W. Bush’s watch, for example, the national debt rose from $5 trillion to $10 trillion. Some of that borrowing paid for an expansion of Medicare prescription coverage and a financial bailout a year ago, but most went for a war in Iraq and tax cuts that largely just allowed for additional consumption. Our grandchildren will be forever poorer as a result.
What matters is what govt borrowing is used for - govts can usefully make productive investments that will benefit future generations.
After decades of neglect of the nation’s infrastructure, attractive public investment opportunities abound. It’s been estimated, for example, that eliminating bottlenecks on the Northeast rail corridor would generate $12 billion in benefits at a cost of only $6 billion. These are present value estimates. When government undertakes such investments, our grandchildren become richer, not poorer.
Frank then suggests correctly that in normal times, govts should pay for productive investment with savings rather than borrowings.
But they’d be richer in the long run if we paid for those investments with our own savings rather than with borrowed money, for that would allow our grandchildren to benefit from the miracle of compound interest. Many fiscal hawks insist that the only way to eliminate deficits and pay for additional investment is by cutting government spending. But as California’s experience suggests, that approach often backfires. Government programs have constituents. Those that get the ax are often not the least valuable ones, but those whose supporters have the least influence. California’s schools, once among the nation’s best, are now among the worst.
The solution, of course, is taxation. A dirty word for many, but essential for not only a civilized society but a productive one as well.
To eliminate deficits, we need additional revenue. The encouraging news is that we could raise more than enough to balance government budgets by replacing our existing tax system with one that taxes activities that cause harm to others. Called Pigovian taxes by economists — after the English economist Arthur Cecil Pigou — such levies create a burden that is more than offset by the reductions they cause in costly side effects of everyday activities.
When producers emit sulfur dioxide into the atmosphere, for example, the resulting acid rain harms others. As the 1990 amendments to the Clean Air Act demonstrated, the most efficient and least intrusive remedy was to tax sulfur dioxide emissions. Doing so entailed no net sacrifice, because solving the same problem by prescriptive regulation would have been much more costly.
Similarly, when motorists enter congested roadways, they impose additional delays on others. Here, too, taxation is the best remedy. The time that congestion fees save is more valuable than the fees are burdensome.
When the transactions of financial speculators fuel asset bubbles, they increase the risk of financial meltdowns. A small tax on those transactions would reduce this risk.
When drivers buy heavier vehicles, they increase others’ risk of dying in accidents. This risk would be lower if we taxed vehicles by weight. Carbon dioxide emissions contribute to global warming. Here as well, taxation offers the most efficient and least intrusive remedy.
Anti-tax zealots denounce all taxation as theft, as depriving citizens of their right to spend their hard-earned incomes as they see fit. Yet nowhere does the Constitution grant us the right not to be taxed. Nor does it grant us the right to harm others with impunity. No one is permitted to steal our cars or vandalize our homes. Why should opponents of taxation be allowed to harm us in less direct ways?
Taxes on harmful activities would be justified quite apart from any need to balance government budgets. But such taxes would also generate ample revenue for the public services we demand, quieting the ill-considered commentary about deficits.
In the meantime, however, such commentary continues to render intelligent political decisions about deficits less likely. For example, 58 percent of respondents in a recent NBC News-Wall Street Journal poll said the president and Congress should worry less about bolstering the economy than keeping the deficit down, while only 35 percent said economic recovery was a higher priority.
If we really want to bankrupt our grandchildren, that poll charts a promising course.


Sunday, November 29, 2009

China and America: Global Imbalances and Decoupling Yet Again

An interesting point made by Tyler Cowen (Dangers of an Overheated China) about the US-China economic relationship.
PRESIDENT OBAMA’S recent trip to China reflects a symbiotic relationship at the heart of the global economy: China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector. Yet this arrangement may unravel in a dangerous way, and if it does, the most likely culprit will be Chinese economic overcapacity.
This captures in a neat way the substance of the current relationships and the dangers as well. The US economy is still in a bad way. If you're in any doubt about this have a read of Gretchen Morgenson (Get Ready for Half a Recovery). Once again the issue comes back to the global imbalances (Chinese current account surpluses versus US deficits) and decoupling (or not).

Cowen might be alarmist in his concerns about overcapacity but it seems that there is substantial evidence to back the overcapacity case up. Chinese banks have kept on lending and Chinese companies have kept on producing but who's buying this extended production?
China has been building factories and production capacity in virtually every sector of its economy, but it’s not clear that the latest round of investments will be profitable anytime soon. Automobiles, steel, semiconductors, cement, aluminum and real estate all show signs of too much capacity. In Shanghai, the central business district appears to have high vacancy rates, yet building continues.
Chinese planners now talk of the need to restrict investment in sectors that are overflowing with unsold products. The global market is no longer strong, and domestic demand was never enough in the first place.
Regional officials have an incentive to prop up local enterprises and production statistics, even if that means supporting projects or accounting practices that are not sustainable. For an individual business, the standard way to get more capital resources is to put forward a plan for growth. Because few sectors are mature, and growth has been so widespread, everyone can promise to be profitable in the future.

Can China keep on growing without final demand, particularly from the US? There's a lot at stake for Australia as well. China has kept on buying those resources throughout the global recession but eventually it has to sell things to keep buying our resources.

Chinese production is now helping to fund US deficits, which in turn is keeping the US economy afloat. The hope is that the US fiscal stimulus kick starts the US economy, which keeps Chinese factories rolling over, which allows Australian miners to keep selling minerals to China.

It could all work out, but then again it might not.

Cowen outlines perhaps the worst contingency:
China has had a 30-year run of stellar economic growth. But it’s only human nature for such expansion to breed too much optimism, overextending an entire economy. Americans have found this out the hard way in their own financial crisis.
History has shown that no major economy has grown into maturity without bubbles, crises and possibly even civil strife or civil wars along the way. Is China exempt from this broader pattern?
The notions of excess capacity and malinvestment were common in business-cycle theory of the 19th and early 20th centuries, when growing Western economies had frequent crashes of this kind. Numerous writers, from the Rev. Thomas Malthus to the Austrian economist Friedrich A. von Hayek, warned about the overextension of unprofitable capital deployments and the pain from the inevitable crashes. These writers may well end up being a guide for understanding China today.
What will the consequences be for the United States if and when the Chinese economic miracle encounters a major stumble? A lot of Chinese business ventures will stop being profitable, and layoffs and unrest will most likely rise. The Chinese government may crack down further on dissent. The Chinese public may wonder whether its future lies with capitalism after all, and foreign investors in China will become more nervous.
In economic terms, the prices of Chinese exports will probably fall, as overextended businesses compete to justify their capital investments and recoup their losses. American businesses will find it harder to compete with Chinese companies, and there will be deflationary pressures in both countries. And even if the Chinese are selling more at lower prices, they may be taking in less money over all, so they may have less to lend to the United States government.
In any case, China may end up using more of its reserve funds to address domestic problems or placate domestic interest groups. The United States will face higher borrowing costs, and its fiscal position may very quickly become unsustainable.







Friday, November 27, 2009

Tax burdens and the Role of Government

One of the major arguments of economic liberals in the 1990s was that globalisation would force a reduction in the size of the state. I was always sceptical about such claims given that the evidence seemed to go in the opposite direction when considering the fact that small trade exposed developed economies often had high taxation and extensive welfare states.

The latest OECD figures show that tax revenue declined (very) slightly in 2008 but this is not surprising given the economic downturn. Over the previous 30 years or so, as the world has become more globalised, tax revenue as a percentage of GDP has increased.

The figures for 2007 and 2008 make interesting reading showing that Australia is generally a low tax economy.

The welfare state has been remarkably resilient. This should not necessarily be surprising because the association of openness with the growth of the state has a long and varied intellectual pedigree. In a study of 18 capitalist economies in the 1970s, Cameron (1978) argued that “a high degree of trade dependence is conducive to a relatively large expansion of the public economy” and, further, that “a strong positive correlation … exists between the size of the increase in the public economy and a measure of economic equality”. In the mid-1980s, Katzenstein (1985) pointed out that in the ‘neo-corporatist’ countries of Western Europe strong social democratic parties and powerful union movements had led to a strategy of social compensation and had underpinned openness and competitiveness. Openness did not lead to, nor did it require, a small state or increased inequality. Indeed, in the late 1980s, Castles argued that “democratic capitalism is necessarily and unavoidably the progenitor of big government”.

Into the 1990s, many argued that while these views may have once been relevant, globalisation had made them redundant. This pessimistic view, however, has increasingly come up against the evidence. Garrett pointed out that partisanship continued to shape public spending, sound macroeconomic outcomes and higher levels of equality through the 1980s and early 1990s. Weiss argued that the idea of the powerless state was “a myth” and Rodrik reconfirmed and extended Cameron’s thesis, with a study of more than a 100 countries, contending that there is “a robust association between an economy’s exposure to foreign trade and the size of its government”. He concluded, “government expenditures have been and continue to be essential to provide social insurance against external risk”. Garrett criticised the static correlations of Cameron, Rodrik and others, arguing that it was necessary to consider changes in the level of globalisation over time and to analyse the impact of financial globalisation as well as trade. He found that increased trade globalisation over time had led to slower growth in government spending, but that higher levels of capital mobility had no effect on government spending. Responding to the need for a dynamic analysis of changes in the level of globalisation, Cameron and Kim considered changes in a country’s level of trade. They found that the total level of trade was insignificant for year-to-year changes in the relative size of government. Large increases in the volume of trade were associated with only small increases in the level of government taxing and spending, but large and deteriorating trade deficits “exerted a significant expansionary impulse on government spending across the advanced capitalist world”. Dreher, Sturm and Ursprung investigated globalisation’s impact on the composition of government spending in a sample of 60 countries between 1971 and 2001 and the OECD since 1990. They conclude rather prosaically, “our results indicate that none of the investigated expenditure categories has been robustly affected by any of our globalisation indicators”. This, they argue, is because governments match the disciplining effects of globalisation with compensatory spending, or “the effects of globalisation might be exaggerated in the popular discussion and might simply not exist”.

Colin Clark predicted in 1945 “that about 25 per cent of the national income, or possibly rather less” was “the critical limit of taxation”. Subsequent developments proved Clark wrong as some countries in Europe went well over 50 per cent of GDP. Whether there is an upper limit for capitalism around the levels reached by Scandinavian countries in the 1990s remains to be seen. While the ever-expanding state may have been slowed or even halted in some cases and while welfare institutions have been reshaped to bolster productivity, social spending remains pivotal in the first decade of the twenty-first century. As Cameron and Kim summarise, “the fiscal role of the government remains significant in all [countries] and continues to increase in some”. What is considered to be the appropriate limit of state spending continues to vary throughout the world, based on a combination of partisanship, political institutions, historical legacies, culture and ideology. Changes to outcomes and the composition of spending need to be analysed on a comparative or individual basis to understand how states have adapted to the pressures from the international and domestic domains. Although there are subtle but important differences in the various studies of the relationship between globalisation, taxing and spending, their broad thrust is that the retrenchment predicted has not happened. This is particularly the case in the advanced capitalist countries and is true for both welfare and general government spending. Leibfried and Rieger turn traditional arguments about the limits of the welfare state by arguing that there are limits to globalisation. They contend, “Just as government freedom of action is dependent on ‘globalisation’, the fate of globalisation itself is decided by government action”. Although it was not planned, the welfare state was a vital precondition for post-war globalisation. Instead, it was “an ironic twist of world history”. On this basis, it is possible to surmise that into the future liberal democratic support for globalisation may depend on redistribution.

Globalisation does not mean the end for the state as the financial crisis has made clear; rather, states have developed new ways to govern and generate economic growth. The coming years will provide new challenges for the state as it attempts to deal with a changing set of pressures from the world economy, interest groups and the electoral process. Gourevitch’s prescient plea for the continuing importance of politics, during the turmoil of the 1970s, is just as relevant today:

However compelling external pressures may be, they are unlikely to be fully determining, save for the case of outright occupation. Some leeway of response to pressure is always possible, at least conceptually. The choice of response therefore requires explanation. Such an explanation necessarily entails an examination of politics; the struggle among competing responses. The interpenetrated quality of international relations and domestic politics seems as old as the existence of states.
Constraints on states are now as intense as they have ever been, but not in the sense that state declinists would argue. Instead, the interaction of global and domestic pressures squeezes governments ever more intensely. Anyone trying to understand the role of government in the 2000s must come to grips with this more elaborate structure of constraints and opportunities and move beyond banal assertions that globalisation weakens the state.


David Cameron (1978) “The Expansion of the Public Economy”, American Political Science Review, 72(4), pp. 1253 & 1258.

Peter Katzenstein (1985) Small States in World Markets.

Francis Castles (1988) Australian Public Policy and Economic Vulnerability, Sydney, Allen & Unwin, 1988, p 2.
William Greider (1997) One World, Ready or Not: The Manic Logic of Global Capitalism, New York, Simon and Schuster.

Philip G. Cerny (1997) “Paradoxes of the Competition State: The Dynamics of Political Globalization”, Government and Opposition, 32(2), pp. 251-74;

Susan Strange (1996) The Retreat of the State.

Robert O. Keohane and Helen V. Milner (eds) (1996) Internationalization and Domestic Politics, New York, Cambridge University Press.

Geoffrey Garrett (1998) Partisan Politics in the Global Economy, Cambridge, Cambridge University Press.

Linda Weiss (1998) The Myth of the Powerless State: Governing the Economy in a Global Era, Cambridge, Polity Press.

Dani Rodrik (1998) “Why Do More Open Economies Have Bigger Governments?”, The Journal of Political Economy, 106(5), p. 997.

Adrian Wood (1994) North-South Trade, Employment and Inequality, Oxford, Oxford University Press;

Dennis Quinn (1997) “The Correlates of Changes in International Financial Regulation”, American Political Science Review, 91(3), pp. 531-51.

Geoffrey Garrett (2001) “Globalization and Government Spending Around the World”, Studies in Comparative International Development, 35(4), pp. 3-29.

David R. Cameron and Soo Yeon Kim (2006) “Trade, Political Institutions and the Size of Government” in David R. Cameron et al (eds) Globalization and National Self-Determination: Is the Nation-State Under Siege?, London and New York, Routledge, p. 43.

Axel Dreher, Jan-Egbert Sturm, Heinrich W. Ursprung (2008) “The Impact of Globalization on the Composition of Government Expenditures: Evidence from Panel Data, Public Choice, 134(3-4), pp. 262-93.

Colin Clark (1945) “Public Finance and Changes in the Value of Money”, The Economic Journal, 55(220), p. 376.

Elmar Rieger and Stephan Liebfried (2003) Limits to Globalization, Cambridge, Polity Press, p. 4.

Michael Keating (2004) Who Rules: How Government Retains Control of a Privatised Economy, Sydney, Federation Press.

Peter Gourevitch (1978) “The Second Image Reversed: The International Sources of Domestic Politics”, International Organization, 32(4), p. 911.

Linda Weiss (2003) “Is the State Being ‘Transformed’ by Globalisation” in Linda Weiss (ed.) States in the Global Economy: Bringing Domestic Institutions Back In, Cambridge, Cambridge University Press.

Thursday, November 26, 2009

Foreign Investment

The big story of foreign investment in the last couple of years has been China.
Although Japanese investment has increased considerably over the past year as well, we stopped worrying about Japan in the 1990s.

Given these facts it is quite interesting that in the most recent release of 5352.0 - International Investment Position, Australia: Supplementary Statistics, 2008 shows that direct Chinese investment was still minimal up to the end of 2008 (the end of the period under review).

While Australia trades heavily with East Asia our investment links are poor.

When considering foreign investment statistics we need to distinguish between stocks and flows. Stocks are the accumulated investments over time measured at a particular point in time and flows (or transactions) register investment over a time period (in this case one year, 2008)

According to the ABS Australia’s net international investment position at the end of 2008 "was a liability of $713.8 billion, an increase of $58.7 billion on the previous year."
The level of foreign investment in Australia increased by $66.9 billion to reach $1,724.4 billion at 31 December 2008. Portfolio investment accounted for $921.2 billion (53%), direct investment for $392.9 billion (23%), other investment liabilities for $302.6 billion (18%) and financial derivatives for $107.8 billion (6%). Of the portfolio investment liabilities, debt securities accounted for $689.1 billion (40%) and equity securities for $232.1 billion (13%).
The leading investor countries at 31 December 2008 were:
United Kingdom ($427.1 billion or 25%)
United States of America ($418.4 billion or 24%)
Japan ($89.5 billion or 5%)
Hong Kong (SAR of China) ($56.3 billion or 3%)
Singapore ($43.1 billion or 2%)
Switzerland ($38.1 billion or 2%)
In addition, the level of borrowing raised on international capital markets (e.g. Eurobonds) was $145.3 billion or 8%.
It is clear that people who speak English like investing in each others' countries. Investing in countries like China is a difficult process and many restrictions remain. It's a bit of a joke really when people suggest that the Chinese will be offended if we don't get rid of the Foreign Investment Review Board. Instead, the Chinese well understand that strategic overview of investment is a worthwhile process regardless of what the economic liberal commentariat suggest.

The level of Australian investment abroad reached $1010.6 billion at 31 December 2008, an increase of $8.2 billion on the previous year. Portfolio investment abroad accounted for $373.1 billion (37%), direct investment for $281.1 billion (28%), other investment for $196.1 billion (19%), reserve assets for $47.5 billion (5%) and financial derivatives for $112.9 billion (11%).

The leading destination countries as at 31 December 2008 were:

United States of America ($394.6 billion or 39%)
United Kingdom ($158.1 billion or 16%)
New Zealand ($66.1 billion or 7%)
Canada ($38.8 billion or 4%
France ($35.4 billion or 4%).
Netherlands ($30.0 billion or 3%)
Transactions (flows) over the past year still don't record the huge growth of Chinese investment (although it is likely that they will in 2009. Remember that these transactions include all types of foreign investment not just foreign direct investment (FDI) which covers investment at a level of greater than 10 per cent in a particular company.

FOREIGN INVESTMENT IN AUSTRALIA "recorded a net inflow of $149.0 billion for the year ended 31 December 2008, a decrease of $11.0 billion on the net inflow of $160.0 billion for the previous year."
The leading investor countries were:

United State of America ($27.0 billion or 28%)
United Kingdom ($25.9 billion or 17%)
Japan ($20.3 billion or 14%)
Germany ($14.6 billion or 10%)
Hong Kong ($11.4 billion or 8%)
Switzerland ($8.8 billion or 6%).
AUSTRALIAN INVESTMENT ABROAD "recorded a net outflow of $100.8 billion for the year ended 31 December 2008, an increase of $6.6 billion on the net outflow of $94.1 billion for the previous year."
The leading destination countries were:

United States of America ($53.3 billion or 53%)
New Zealand ($14.5 billion or 14%)
Singapore ($8.0 billion or 8%)
United Kingdom ($7.4 billion or 7%)
Canada ($5.7 billion or 6%)
Luxembourg ($3.6 billion or 4%)
This set of statistics also show the amount of income paid out to foreigners and received by Australians from foreign investments.

Australia has a net income deficit (which is a vital component of our current account deficit) which is not surprising given that investment in Australia has long been greater than saving in Australia.
Income debits totalled $86.7 billion for the year ended 31 December 2008. This result is up $1.2 billion on the income debits in the previous year.
The main countries to which income accrued for the year ended 31 December 2008 were:

United States of America ($18.3 billion or 21%)
United Kingdom ($13.9 billion or 16%)
Japan ($7.4 billion or 9%)
Switzerland ($5.6 billion or 7%)
Netherlands ($3.2 billion or 4%)
Hong Kong ($1.7 billion or 2%)
One of the big changes in recent years has been the significant increase in Australian investment abroad.
Income credits totalled $41.8 billion for the year ended 31 December 2008. This result is up $3.5 billion on the income credits in the previous year. The main countries from which income accrued for the year ended 31 December 2008 were:

United States of America ($14.7 billion or 35%)
New Zealand ($4.4 billion or 10%)
United Kingdom ($4.1 billion or 10%)
Canada ($3.8 billion or 9%)
Netherlands ($1.5 billion or 4%).

For a more recent catch up on capital flows in and out of Australia see Australian Capital Flows and the Financial Crisis from the Reserve Bank Bulletin written by Patrick D’Arcy and Crystal Ossolinski of the International Department.

In this article they note that between 2000 and 2007 capital flows increased significantly compared to GDP and were relatively stable. The last 18 months or so have been more chaotic. Even though Australia has done well the global financial crisis they note that it still had a huge impact on capital flows.
Not only was it difficult for borrowers to obtain funding in international markets, but many international investors repatriated existing offshore investments. In essence the crisis induced a temporary bout of ‘home bias’ among global investors.
But the decline in foreign investment in Australia was partly covered by the repatriation of investment back to Australia.

Most of the volatility was related to credit markets (bank lending and asset-backed securities) and like in the Asian financial crisis before hand FDI was unaffected. Big investments can't be quickly withdrawn and generally direct investors are in for the long haul (unless it's investment by private equity companies - but that's another story).

This interruption to credit markets was significant for Australia given that before the crisis bank lending and asset-backed securities amounted to about 8 per cent of GDP per year between 2004 and 2006 - a huge amount.

It is clear in hindsight that govt action had a beneficial effect on supporting capital flows during the crisis. These include the setting up of US dollar swap lines between the US Federal Reserve and the RBA.
Reflecting the fact that the US dollar funds available under this facility were cheaper than available in the market, particularly in the December quarter, Australian banks replaced some of their short-term foreign funding with funding through this means.
According to D’Arcy and Ossolinski capital flows returned to "their pre-crisis configuration in the first half of 2009. Reflecting the improvement in global market conditions and the introduction of the government guarantee on bank debt, offshore debt issuance by Australian banks recovered solidly over the first half of 2009." This negated the need for the swap facilities.

The decline of the Aussie dollar also encouraged capital inflow (remember that an increase in the Aussie makes investment abroad more attractive to Australians and less attractive for foreigners).

Australians have also decreased their level of equity investment outside of Australia, which means that "the composition of net capital inflows has shifted towards sizeable equity inflows. In the decade prior to the crisis there was net equity outflow."

Another impact of the crisis has been the increase in public debt (see my earlier blog for an analysis of public debt in Australia), part of which has been funded by foreigners.
Federal government debt increased by $33 billion in net terms over the first half of 2009, and around $5 billion of this was recorded as being purchased by foreign investors. However, partly offsetting this is the ongoing investment in foreign equity assets by the public sector, mainly through the Future Fund, which amounted to $2 billion over the first half of 2009.

Monday, November 23, 2009

Krugman on Stimulus, Debt and Hysteria etc

Paul Krugman has long been the most accessible economic commentator on the US scene. I've been reading his work from the early 1990s when his contrarian views were aimed at those centre-left commentators like Lester Thurow, Robert Reich and Robert Kuttner who he argued were over-estimating the impact of globalisation.

His book Pop Internationalism was a fairly savage attack on what he implied was an economically illiterate position. In those days I saw him as a bit of smarty, who set up straw man constructions of his opponents' arguments (and he really did see the debate in these oppositional terms).

But in the main, I soon realised he was largely correct about globalisation and indeed his scepticism was needed. The belief of the Clinton Liberals that they were "held hostage by a bunch of f...king bond traders" was indicative of the overblown (financial) globalisation thesis that effectively argued that finance ruled and needed to be obeyed. (Susan Strange and Philip Cerny also argued this position).

This was always crappola, especially in the US, but the lobbies were extremely powerful and US policy-makers saw a more free-wheeling approach to financial regulation as in the US's interests. Unfortunately, the fact that the Clinton admin gave so much ground to financial interests is a fundamental antecedent of the global financial crisis.

No doubt Krugman has shifted to the left since those days and perhaps today he is the most influential liberal (in the American sense) economic commentator in the US, writing regularly for the New York Times.  His blog The Conscience of a Liberal is definitely worth following if you're interested in the US or world economy.

His latest crusade is against the fear mongering about US public debt. Now US debt is extremely high at $12 trillion, but Krugman argues that the crisis was and is still so bad that this debt is worthwhile and needs to be extended.

The NYT itself ran a story on the front page about the debt quoting Bill Gross of Pimco, who argues that
What a good country or a good squirrel should be doing is stashing away nuts for the winter ... The United States is not only not saving nuts, it’s eating the ones left over from the last winter.
You got to love folksy parables about government debt. Not.

But government debt makes good copy. It is, after all, the tax payers' money. And, you'll be pleased to know that the financial sector has the taxpayers' interests at heart!

Krugman's most recent target in "The Phantom Menace" is Obama, whom he argues is losing his nerve and rationality.
In December 2008 Lawrence Summers, soon to become the administration’s highest-ranking economist, called for decisive action. “Many experts,” he warned, “believe that unemployment could reach 10 percent by the end of next year.” In the face of that prospect, he continued, “doing too little poses a greater threat than doing too much.”
Ten months later unemployment reached 10.2 percent, suggesting that despite his warning the administration hadn’t done enough to create jobs. You might have expected, then, a determination to do more.
But in a recent interview with Fox News, the president sounded diffident and nervous about his economic policy. He spoke vaguely about possible tax incentives for job creation. But “it is important though to recognize,” he went on, “that if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession.
What? Huh?
Most economists I talk to believe that the big risk to recovery comes from the inadequacy of government efforts: the stimulus was too small, and it will fade out next year, while high unemployment is undermining both consumer and business confidence
Now, it’s politically difficult for the Obama administration to enact a full-scale second stimulus. Still, he should be trying to push through as much aid to the economy as possible. And remember, Mr. Obama has the bully pulpit; it’s his job to persuade America to do what needs to be done.
Obama, according to Krugman is getting the wrong advice from Wall Street. One wonders how much credibility is left on the Street, but I guess that money (especially when buttressed by the tax payer) can buy a lot of influence.
Ever since the Great Recession began economic analysts at some (not all) major Wall Street firms have warned that efforts to fight the slump will produce even worse economic evils. In particular, they say, never mind the current ability of the U.S. government to borrow long term at remarkably low interest rates — any day now, budget deficits will lead to a collapse in investor confidence, and rates will soar.
And shouldn’t we consider the source? As far as I can tell, the analysts now warning about soaring interest rates tend to be the same people who insisted, months after the Great Recession began, that the biggest threat facing the economy was inflation. And let’s not forget that Wall Street — which somehow failed to recognize the biggest housing bubble in history — has a less than stellar record at predicting market behavior.

Still, let’s grant that there is some risk that doing more about double-digit unemployment would undermine confidence in the bond markets. This risk must be set against the certainty of mass suffering if we don’t do more — and the possibility, as I said, of a collapse of confidence among ordinary workers and businesses.
And Mr. Summers was right the first time: in the face of the greatest economic catastrophe since the Great Depression, it’s much riskier to do too little than it is to do too much. It’s sad, and unfortunate, that the administration appears to have lost sight of that truth.
 Let's hope that Obama doesn't take too much advice from Wall Street or the Pentagon (but that's another story).

Wednesday, November 18, 2009

Growth in Asia and its Effect on Australia

Asia will be a long-term benefactor of Australian prosperity according to virtually all Australian economic policy-makers and commentators. Some like RBA governor Glenn Stevens and Treasury Secretary Ken Henry argue that there will be some problem associated with this ‘politics of prosperity’ but generally they do not consider it possible that either growth in Asia could slow or that demand for Australian resources could be negatively affected by increases in supply from elsewhere or technological changes. So-called ‘black swan’ events – war, terrorism, political unrest, environmental or natural catastrophe are not considered at all and I suppose that’s fair enough at one level. We can’t spend our entire lives preparing for the worst of all cases.

Probably the best coverage of the assumption that ‘Asian non-drama’ will be beneficial for Australia comes from Philip Lowe Assistant Governor (Economic) with the RBA. (See Philip Lowe (2009) “The Growth of Asia and Some Implications for Australia”, Talk to Citi Australia Inaugural Australian Investment Conference, Sydney, 19 October <>.)

Lowe begins by pointing out that Australia has done better than virtually any other developed country in the world, noting that Australia is the only country to not record a decline in exports. This good performance he argues was shaped by prescient monetary and fiscal policy, the “healthy state of the banking system” and “Australia’s trade links with Asia”.

His main concern he argues is with “medium-term structural issues”.

My central theme is that there are reasonable grounds for optimism about the prospects for the Australian economy over the decade ahead. There are a number of reasons for this, but the one that I would like to discuss today is our growing trade links with Asia.
Economic weight has shifted to Asia and because much of Asia is in a developmental mode it will require considerable resource development. When starting from a low base growth can be very rapid indeed.

Asia’s share of world GDP was only 7 per cent of GDP in 1990 (at market exchange rates, more if we use purchasing power parity – see my book Chapter 3 for explanation). This increased to around 15 per cent by 2008. Growth in East Asia has averaged 7 per cent a year during this period compared to 2 per cent for the developed world.

As far as industrial production goes Asia has done even better, especially China. In 1990 China’s share of industrial production was 2 per cent, in 2008 the figure was 13 per cent.

Lowe summarises the situation thus:

The general picture here is pretty clear: there has been very strong growth in Asia, with the economies of the region now accounting for a significant share of world output. And looking forward, there is a high probability that this will continue over the years ahead. As an illustration of the ongoing shift, recent growth projections from the IMF suggest that by 2014, the total amount of fixed asset investment in the developing world – much of which will occur in Asia – will be the same as that in the advanced economies (Graph 4). This would be a remarkable change from the situation just a decade ago when the level of investment in the developing world was only one third of that in the developed world. The change that is going on here reflects the subdued prospects for many of the advanced economies, the high pace of growth in Asia, and the current high rates of investment in many Asian countries.
Note that the assumption here is that what has happened over the past few years is expected to continue and the graph below is an estimate beyond 2008.

But the real issue here is the extent to which growth and investment in Asia is dependent on growth in the developed world. As Lowe notes demand in developed economies is likely to be weak over coming years because of the high level of indebtedness among households. (This is also true of Australia, where the debt to disposable income ratios is about 160 per cent. This is the highest ever by a long shot.). But it is not just households that are indebted, now because of the global recession governments are increasingly indebted as well. Lowe notes that: “net public-sector debt to GDP for the G7 countries is likely to exceed 90 per cent within a few years, an outcome that has not previously been seen outside of periods of war”. (See the previous post on public debt)

This takes us back to the debate about ‘decoupling’ that was seemingly won by the anti-decouplers during the financial crisis and the early stages of the global recession. Basically, the de-coupling thesis argued that Asia and Europe (but particularly China) would be less affected by events in the US economy and financial system. The anti-decouplers correctly pointed out that Asia was negatively affected by the greatest collapse of trade since the Great Depression. Indeed for a time, there seemed to be some suggestion that the export-led model was dead. European financial markets were devastated by the flow on effects of US developments (particularly the UK) and exporters like Germany were severely affected by the collapse of world trade as well. The de-couplers, however, now claim some vindication given China’s amazing growth performance built on the back of one of the biggest government stimulus packages of all time. As they say, the jury is still out. But the major question is what will happen when governments remove monetary and fiscal stimulus.

These are short-to-medium-term concerns, Lowe's main concerns are the medium-to-long-term implications of developments in Asia. He tries to navigate a middle-way in the de-coupling debate:

Slower growth in the advanced economies will inevitably weigh on growth in Asia. The business cycles of the major regions of the world are clearly interconnected, and the ups and downs in one part of the world have an effect in other parts of the world.

But importantly this is not the end of the story. These interconnections do not mean that Asia must inevitably experience a marked reduction in its medium-term growth trajectory. As we have seen recently, the region has the capability to grow strongly through domestic, not external, demand. This really should not come as a surprise.

After all, the US economy, with a few hundred million people, has grown for many decades largely on the back of domestic, rather than foreign, demand. There is no reason that the approximately 3½ billion people in Asia cannot do the same. It ultimately comes down to the policy choices that are made.
The last paragraph is a big call and consumption in Asia (China) is unlikely to match that of the West, particularly the United States, anytime soon. A chart presented by David Gruen from Treasury in a presentation entitled “Global Imbalances: How much adjustment will we see?” (at the In the Zone Conference at the University of Western Australia on 9 November 2009), shows why this is a problematic assumption.

US consumption accounts for about 18 per cent of global GDP, Chinese consumption is less than 3 per cent at market exchange rates.

Lowe acknowledges that there are long-term structural issues that need to be addressed in China and the rest of Asia for sustained increases in domestic demand to occur.

Here, there is a reasonably broad consensus as to the types of policy steps that could be made over the medium term, although the specifics clearly differ from country to country. One possibility is continuing liberalisation of the services sector, which has the potential to grow strongly in many countries in the region. Another is reform of retirement incomes policies to give people more confidence that they will have sufficient income in their old age. A third possibility is further development of the financial sector so that savings can be most efficiently allocated to those who can make best use of them.

These are all rather long-term structural issues but gradual progress on these fronts can help form the basis for sustainable growth in domestic demand over the medium term in many of the countries of the region. There is also considerable scope for high levels of infrastructure investment in many of these countries, and the process of technology convergence has much further to run. And many of the countries of Asia are devoting increasing resources to education to improve the average productivity of their workforces.
Lowe then turns to the impact on Australia and notes that our 4 biggest merchandise export markets (i.e. not including services exports such as education and travel services – the third and fifth biggest exports) are all in Asia. The graphic is particularly revealing about the rise of China’s share.

The shift towards Asia has undoubtedly been a benefit during the global recession. As Lowe acknowledges:
Despite global trade falling by nearly 20 per cent over the past year, the volume of Australian exports stayed broadly flat over this period. The strong recovery in China saw demand for raw materials rebound strongly, and Australian producers were able to respond quickly. A number of other commodity exporting countries whose major customers are in Europe and North America have, until very recently, had less favourable experiences.
Growth in Asia has helped commodity prices to stay high despite the worst global economic downturn since the Great Depression. Many commentators including myself thought that commodity prices would have collapsed further (and they still might) but the fact that they haven’t has been a bonus for Australia. Most commentators, including those in the mining sector itself, now believe that the boom will continue onwards and upwards, making a mockery of historical precedents for collapses in prices.

Lowe then turns to investment pointing out, as have Henry and Stevens in recent times, that Australia is a high investment country. In the past year, investment has reached 17 per cent of GDP – the highest on record. Almost a third of it has, not surprisingly, been in the resources sector. Australia’s growing capital stock during a global recession is a remarkable performance.

According to estimates based on ABS data, mining investment was the equivalent of almost 5 per cent of GDP over the past year, a record by a large margin. While we had booms in the mining sector in the late 1960s and the early 1980s, these look relatively small compared with the current one. Over the past couple of years, we have had particularly high rates of investment in both the iron ore and coal industries and this is now starting to show up in export volumes. For example, the volume of iron ore exports has risen by around a third over the past two years, as new mine and port capacity has come on stream, and further increases are likely.

Lowe argues that this high level of investment will continue, given the huge deals on LNG made recently for long-term supply contracts for China, Japan and India.
Such developments make the sort of shrill commentary from some business journalists that Australia needs to alter the discretionary elements of its foreign investment review process or suffer the consequences seem rather ridiculous. Australia should continue to review large-scale investments in its resource assets to make sure that they produce the greatest gain for the Australian people.

Australia’s prospects are undoubtedly better than virtually all other developed countries at the moment. But we still need to think about how to reduce our vulnerability to a downturn in commodities.

Tuesday, November 10, 2009

The Carry Trade Explained

Want to know one of the reasons why the movements of exchange rates can be so pronounced at times?

There are many reasons why exchange rates move.

The first thing to remember is that there are two sides to any currency story.

For example the current strength of the Australian dollar (the Aussie) is a product of Aussie strength and greenback weakness.

Now Aussie strength has a lot to do with the price of commodities, with the Aussie traditionally seen as a commodity currency.

The Aussie is also important as a trading currency because of its position in Asia, that is between the North American close and European opening. It's also important as an 'Asian' currency.

But another vital factor is the carry trade.

Despite being at so-called 'emergency' levels, Australian interest rates are actually high by international standards.
Japan 0.10%
Canada 0.25%

United States 0.25%
Switzerland 0.25%
Sweden 0.25%
UK 0.50%
Europe 1.00%
Taiwan 1.25%
Norway 1.50%
Korea 2.00%
New Zealand 2.50%
Australia 3.50%
Poland 3.50%

So if you borrow money in Japan at low rates of interest and then invest it in Australia at high rates of interest and the Yen-Aussie exchange rate either stays constant or the Aussie appreciates against the Yen, you end up making a truck load of cash.

But ...

If the Aussie falls against the yen as it did from late last year then you're stuffed and everyone runs for the door at the same time. This adds to what is often called 'momentum' in currency trades. Right now the 'momentum' is for a higher Aussie.

Anyway the following graphic from the Financial Times explains it much more neatly than I can do.

See also Nouriel Roubini (2009) "Mother of all carry trades faces an inevitable bust", Financial Times, 1 November <>

Roubini outlines what he calls 'the mother of all carry trades' involving US interest and exchange rates. The major financial issue at the moment is the growing financial bubble that has been reignited by low interest rates.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.
Now short dollar positions mean that investors are borrowing greenbacks to sell now ('going short') and pay back later when the greenback is (hopefully) lower. Of course the more that investors short the greenback the more likely it is to be lower. So what is the effect of low interest rates, quantitative easing and massive purchases of long-term debt instruments (the metaphorical printing of money)? According to Roubini it is
seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.
But like all bubbles eventually they get pricked.
But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
The question for risk-takers is how long should you stay in the market and what will cause the reversal.
Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
The thing for investors to weigh up is timing.
This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

Monday, November 9, 2009

Bubble Trouble

As I've long said I may just be a negative vibe merchant but everywhere I look I see bubbles - in China and in Australia, and the US stock market. While a few months ago it appeared that many had learned the lessons of boom times - that they don't last forever and that they nearly always end badly - we are back in boom time territory and the phrase 'this time it's different' (TTID) has truly made a comeback. The TTID mentality extends right across the spectrum from the property spruikers to the governor of the Reserve Bank and the Head of Treasury.

Latest figures from the ABS on Housing Finance show a seasonally adjusted rise of 4.8% for the month (that's an annualised rate 57.6%). Now it's obvious that govt grants to house buyers (really a grant to venders) have bolstered these figures and many people who believed (like me) that house prices would have fallen by now are thinking "I better get in the market now" or "I'll be paying even more soon". One truly wonders how high house prices can go.

Now there is one intervention that govts could do to restrict house price growth and that's increase supply. One of the original aims of public housing was to keep a lid on the private market, particularly for rentals.
But govts and much of the population associate rapidly rising house prices with prosperity when really they are drag on prosperity both present and future. Firstly they make one of the most significant costs in our lives more expensive and they divert investment away from potentially productive endeavours.

The next bubble or set of bubbles that indirectly could concern Australia are in China. As Rowan Callick (one of the best writers from The Australian) observes today there are worrying signs in Hong Kong and the rest of China:
Last week a flat on Conduit Road in Hong Kong's mid-levels was bought for a world record of $51m - $135,626 per square metre.
The dominant element of Beijing's anti-GFC stimulus package has comprised the rampant return of the "policy loans" to state-owned enterprises, plus the opening of credit to individuals with privileged access, thanks to party or other connections, to the state banks.
Interest rates are not only paltry but notional. This is more than low-cost capital, or even no-cost capital. Hardly anyone's thinking about repaying the billions of bucks involved. Most of it has swiftly found its way into property and shares. Within China, house sales have surged 70 per cent this year.
This raises interesting questions about the fulsome praise that has been lavished on the Chinese stimulus package, in Australia as elsewhere. Some of the spending has doubtless found its way to useful projects where investment will be returned, in a socially and economically beneficial way, for some time to come.
But it's more difficult to see what's gained from printing heaps more money and telling the government's banks to shovel it out to mates.
I highlighted the worry that no thought is being given to repayment. Debt is serious and right now we've forgotten that much of the GFC was built on a cavalier attitude to debt.

Property and share markets can easily develop bubbles - as prices go up, investors pour more money in and prices go up further, attracting more investment and so on. But eventually everyone realises that the bubble is really just air and sentiment changes.

Just remember one phrase:
The unsustainable cannot be sustained ...
Actually another one is worthwhile as well:
This time it's not different ...

Saturday, November 7, 2009

Debate on the Current Account Deficit

The following article might be quite helpful for those wanting to understand the debate about the current account deficit in Australia.

Balance of power

October 24, 2009

IN THE wake of the global financial crisis, a crucial question confronting policymakers is why Australia seems to have got away with so little damage?

Was it a lucky escape, which should be a wake-up call for us to tackle our persistent current account deficit before it brings us down? Or was it, rather, evidence that the quality of our economic policies has made us invulnerable to the shocks dealt out by global financial markets?

This week, two of the economists Kevin Rudd listens to most carefully delivered sharply different readings of what has been dubbed "Australian exceptionalism", and its implications for the current account balance.
In one corner is Ross Garnaut, one of Australia's most influential economists since the 1980s, as economic adviser to then prime minister Bob Hawke, author of the 1989 report that led to the virtual demolition of the tariff wall, and more recently, the man Rudd commissioned to draft his policy on climate change — albeit, a draft he then rejected as too rigorous.

Garnaut, of course, also has a considerable sideline in corporate Australia, as long-time chairman of Lihir Gold and former chairman of what we now call Bankwest. Add in his time as ambassador to Beijing, where his staff included a young Mandarin-speaking workaholic who went on to achieve great things, and he brings an unusual range of experience to bear.

In the other corner is Ken Henry, secretary of Treasury since 2001, Rudd's main adviser on the Government's fiscal stimulus package, and a man now bearing a very heavy workload as chairman of its tax policy review at the same time as running a Treasury that now finds its work constantly in the spotlights of a bitter political debate.

On most issues, Garnaut and Henry see eye to eye. Both are mainstream economic liberals who believe that free markets are a powerful force for good. But both temper their faith in markets with a strong social and environmental conscience. They look to the long term, share a global perspective — and are men of subtle minds.

Yet now they are in sharp conflict over the question of whether Australia can afford to go on running the most persistently large current account deficit in the Western world: a deficit that has now averaged 4 to 4.5 per cent of our gross domestic product for the past 30 years, and driven our net foreign debt from $8 billion to $633 billion, or 53 per cent of our GDP.

It is a concern to Garnaut. With co-author David Llewellyn-Smith, he has just published an absorbing account of the crisis, The Great Crash of 2008 (MUP, $24.99), which is rich in reflections on its implications for global power relationships, for the future development of the financial system, and for key countries, not least Australia.

Garnaut sees the crisis as vindicating his warnings during recent years about "the great complacency" in Australian policymaking: the belief that the current account deficit and the associated build-up of foreign debt don't matter, but simply reflect the confidence with which foreign investors see us.
Australia's growth in recent years, he argues, has been unsustainable, because so much has been funded by increasing foreign debt — and you can't increase foreign debt forever. "Australians," he says, "were the spendthrifts of the commodities boom".

"If expenditure, both government and private, is allowed to expand too much when commodity prices are exceptionally high, there will be dreadful problems when it becomes necessary to adjust to lower living standards as prices fall to more normal levels.

"Australia has two strikes against it: its huge current account deficits before the crisis, and the deterioration in its terms of trade. They mean that Australia will have to reduce average consumption levels more than most countries if it is to restore full employment on a sustainable basis."

Henry strongly disagrees. In an unusually passionate speech in Brisbane on Thursday, the Treasury chief voiced strong confidence in Australia's economic future, along with equally strong fears about what it might mean for our environmental future, and for our wildlife, if Australia adds another 13 million people by 2049, as Treasury now projects.

Without naming Garnaut but clearly targeting his critique, Henry argued that Australia faced "a set of structural changes more profound than anything in its history": the ageing of its population, tackling global warming and adapting to it, the spread of the IT and communications revolution to the delivery of services — and the rapid growth of China and India, and their demand for Australian minerals.

"China and India are only in the early stages of catching up with the living standards of the developed world, and this process could have a very long way to run," Henry declared. "We should get used to the idea that we could have structurally higher terms of trade for quite some time — possibly for several decades."
We should also get used to the fact that Australia will keep borrowing and running current account deficits far into the future, Henry said. All the big changes we face will require higher investment. And our population is too small to be able to adequately fund "an abundance of investment opportunities".

"Australia's sustained high current account deficits reflect high national investment rather than low national saving," Henry declared, flashing a graph showing the national savings rate soaring between 1990 and 2008. "And national investment levels could remain elevated for several decades."

Let's pause for a word of explanation. Current account deficits can be viewed on two planes. The deficit measures the gap between what you sell the world and what you buy from it (the trade deficit), plus the gap between what you pay to foreign investors here and what you earn from your own foreign investments overseas.

For Australia, both gaps are substantial. Over the past decade, our trade deficit has averaged 1.3 per cent of GDP, or $16 billion a year in today's money. Since 1980, Australia has run 25 annual trade deficits and only four surpluses — in the slumps of 1991-92, 2000-02, and 2008-09. Our income deficit has averaged 3.4 per cent rising, as mining profits and interest bills on the foreign debt have swollen.
But in analytical terms, the deficit can also be seen as the gap between Australia's savings and investment — which is the way Treasury prefers to view it. Since mining is capital-intensive, and our population is growing rapidly, Australia invests more than other Western countries. But despite the spin in Henry's speech, we are mediocre savers, consistently in the bottom half of the OECD in national savings to GDP, and in the bottom third for household savings.

(His graph used one of the oldest tricks of speakers flashing graphs: start your graph in the bust, and end it in the boom. Had his graph begun in 1987 instead of 1990, and ended in 2009 rather than 2008, it would have looked very different. Even at its peak in 2008, Australia's national savings rate was less than 20 years earlier, and it has plunged in 2009.)

Whichever way you prefer to view it, the solutions are the same. There are four ways to reduce the current account deficit. Export more. Import less. Save more. Or invest less.

Garnaut, a mining industry veteran, sees the high prices of recent years more as a transient phase, in which miners worldwide were caught unawares by China's rapid growth in demand. He also argues that China and India are going through a growth phase that is particularly resource-intensive.

Back in 2005-06, he argued in vain for the Howard government to save the windfall revenues from higher commodity prices, rather than handing them back in tax cuts and new spending. His book does not expand on this, but one option, advocated recently by Saul Eslake of the Grattan Institute, is to establish a sovereign wealth fund where temporary surges in company tax revenue could be stored for use in harder times.
Henry denies that policymakers have been complacent about the deficit. He argues that compulsory superannuation and a tradition of budget surpluses were established to lift saving rates and make Australia "able to sustain a sizeable current account deficit". His tax review is also expected to propose new tax breaks for savings, especially in the banks.

But can we sustain deficits of this size? No one can live indefinitely by borrowing. As your debts rise, so does the cost of servicing them. Henry's deputy, David Gruen, has estimated that Australia's debt-GDP ratio could be stabilised if the trade balance shifts by about 2 percentage points of GDP, from consistent deficit to consistent surplus. But there is no sign of that.

Henry's speech dismisses fears that one day financial markets might decline to roll over Australian debt, leaving borrowers stranded. "It would be difficult, I suggest, to construct a more demanding stress test of this vulnerability than that posed by the global financial crisis," he said. "The fact of our having passed that test provides grounds for some confidence, though certainly not complacency, in the strength of our policy frameworks and decision-making."

Yet as Garnaut points out in the book, it was precisely the refusal of foreign market to roll over bank debt in the panic of last October that led the Australian Government to guarantee the banks' wholesale borrowings. "Banks had become heavily reliant on foreign borrowing and suddenly they were unable to borrow abroad," he says. Had the Government not given the guarantee they sought, Australia would have faced an "enormously disruptive and costly" recession.

Was Henry's comment just a slip by an overworked public servant? Or did it imply that from now on, Australian banks' borrowings will carry an implied government guarantee, to be called on whenever needed?
As shadow trade minister in 2005-06, Rudd took up Garnaut's critique, advocating a higher priority for exports. Then as mineral prices surged and a trade surplus emerged, the issue faded from his priorities. But with export prices down 32 per cent this year, and trade now back in deficit by more than $1.5 billion a month, the current account deficit is back to haunt us.

Thursday, November 5, 2009

Public Debt (for Nerds)

Public debt is going to be a big issue in the coming years and the following is a summary of an excellent article from 3 economists at the Treasury, with some additions and updating with some recent statistics from the 2009-10 Budget and 2009-10 MYEFO.

From Treasury A History of Public Debt in Australia by Katrina Di Marco, Mitchell Pirie and Wilson Au-Yeung

The International Monetary Fund (IMF) Government Finance Statistics (GFS) manual defines gross debt as:

All liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future. Thus, all liabilities in the GFS system are debt except for shares and other equity and financial derivatives [paragraph 7.142].

The main component of gross debt on the Australian Government’s balance sheet is Commonwealth Government Securities (Treasury Bonds) outstanding.

Gross debt does not incorporate amounts that are owed to government by other parties. Also governments, like an individuals or businesses, hold assets which can be sold to meet their financial obligations. To capture the asset side of equation, net debt needs to be considered.

Broadly speaking, net debt is equal to gross debt less a related pool of financial assets.2 Table 1 gives a simple representation of the main components that are included and excluded from the Australian Government’s net debt calculation.

Table 1: Components of net debt

Source: The Australian Treasury

Compared with gross debt, net debt is a better measure of a government’s overall indebtedness as it also captures the amount of debt owed to the government. Still, like gross debt, net debt is only a partial indicator of the government’s financial strength, as not all government assets or liabilities are included. As an example, unfunded superannuation is not included in the calculation of net debt. On the other side of the ledger, the equity holdings of the Future Fund are also not included as an asset in the calculation of net debt.

Australia has had historically low levels of net debt over the past two decades compared with the G-7 economies (Chart 2). In the early 1990s, Australia, along with the major economies, experienced an increase in net debt largely because of the global downturn. But in contrast to other economies, after 1995, Australia experienced a significant fall in its net debt.

Other measures of financial position

Over time, the demand for greater public accountability has led governments to publish more comprehensive sets of fiscal data. This has resulted in a trend towards using accrual accounting measures. By introducing a balance sheet into the primary Budget documents from 1999-2000, the Australian Government has been able to measure net financial worth and net worth.

• Net financial worth is defined as total financial assets less total liabilities.

• Net worth is defined as total assets less total liabilities.

Both measures are conceptually better than gross debt and net debt at capturing the Australian Government’s financial strength, as they are more comprehensive.

From MYEFO 2009

Definitions from the 2009-10 Budget

Measurement of the Government's financial position

Net debt is the most commonly quoted and well known measure of a government's financial strength. One of the reasons is that it is part of everyday life for business and households. Another reason is that, historically, it was the only available stock measure for governments that were recording financial information in a cash based accounting system. Net debt provides a useful measure for international comparisons, given most OECD countries report on it.

Net worth provides a more comprehensive picture of the Government's overall financial position than net debt. However, the valuation of physical assets can be problematic as they are typically valued without consideration of their potential use. Also, the Government may not be in a position to sell certain non financial assets, and therefore these assets would not be available to meet the Government's financing requirements.

Net financial worth is used by the Government as the primary indicator of balance sheet sustainability, because it provides a more effective and intuitive indicator of the sustainability of the Government's finances. It is a broader measure than net debt as it includes government borrowing, superannuation and all financial assets, but is narrower than net worth since it excludes non financial assets. There are advantages to excluding non financial assets since they are often illiquid and cannot easily be drawn upon to meet the Government's financing needs.

The projected deterioration in net financial worth is largely driven by the sharp downward revisions to tax receipts over the forward estimates resulting from the deterioration in the global economic outlook.

From Treasury A History of Public Debt in Australia by Katrina Di Marco, Mitchell Pirie and Wilson Au-Yeung

The difference between the two measures is the inclusion of non-financial assets in net worth. Given concerns surrounding the valuation of non-financial assets and their liquidity in the face of adverse shocks, the Australian Government has decided to use net financial worth as its primary indicator of balance sheet sustainability.

During the First World War, gross Australian Government debt increased from around 2.2 per cent of GDP to around 50 per cent of GDP (Chart 5), with around one-third of this increase met through loans issued in London (AOFM 2003-04). By comparison with the First World War, the financing requirements of the Second World War were met largely through domestic borrowing. Gross Australian Government debt increased from around 40 per cent of GDP in 1939 to around 120 per cent of GDP in 1945. During both wars, War Savings Certificates, targeted at retail investors, were the primary instruments used to raise funds.

Australian Government debt was progressively reduced after the Second World War and largely eliminated by the beginning of the 1970s. In the decade following the Second World War, relatively tight fiscal policy halted the growth in gross debt, while high inflation underpinned the sharp reduction in gross debt as a share of GDP. By 1974, gross debt had declined to around 8 per cent of GDP from a peak of around 120 per cent of GDP in 1946.

There were two further episodes of debt accumulation, and subsequent reduction, during the 1980s and early 1990s driven by periods of weak economic growth and associated budget deficits. From the mid-1990s, as the Australian Government’s fiscal position improved, gross debt declined steadily as a share of GDP.

The Australian Government historically had a significant proportion of its debt denominated in foreign currencies, but foreign-denominated debt is now negligible (Chart A).

For the first 30 years after Federation, foreign currency debt made up around 35 per cent of total debt on issue. A large portion of this debt was financed from London. Between 1940 and 1950 the amount of foreign currency debt fell as domestic markets grew in size. After the Second World War, the value of foreign currency loans began to rise to finance balance of payment deficits (AOFM 2002-03).

The share of foreign currency borrowings of the Commonwealth Government Securities (CGS) portfolio remained around 30 per cent from 1970 until 1988. In 1988, the Government decided to concentrate debt issuance in domestic markets to maintain liquidity and efficiency.

Capital account liberalisation has underpinned an increase in foreign holdings of Australian dollar-denominated CGS since the early 1980s (Chart B).

Chart 6 shows that the Australian Government has historically had a positive net debt position — that is, the value of debt liabilities has exceeded the value of debt assets. Since 1970-71, net debt has averaged 5.7 per cent of GDP, reaching a peak of 18.5 per cent in 1995-96, and a low of -3.8 per cent of GDP in 2007-08. Changes in net debt have largely been driven by changes in the government’s budget position.7 Especially in the 1990s, asset sales have also been a significant contributing factor (Box 2).
During the early 1970s net debt was mainly negative and reached lows of -3.1 per cent of GDP. During the first half of the 1970s budget surpluses averaged 1.7 per cent of GDP, while in the second half, there were budget deficits averaging around — 1.6 per cent of GDP. By 1979-80, net debt was around 4.7 per cent of GDP.

During this same period, the current account deficit was on the rise and reducing the Government’s call on foreign capital was an important driver of fiscal policy (Kennedy, Luu, Morling and Yeaman 2004). As a result, in 1988, the government decided to concentrate its debt issuance in Australian dollars (Box 1). In 1987, 30 per cent of total borrowings were in foreign currencies. By 1990-91 it was around 21 per cent.

In the early 1990s recessions in many advanced economies caused a marked slowing in the world economy. The government implemented a more expansionary fiscal policy that was funded by borrowing. Net debt reached a peak of 18.5 per cent of GDP in 1995-96.

From 1995-96 onwards, the government undertook a program of fiscal consolidation (Kennedy, Luu, Morling and Yeaman 2004). The government also undertook significant sales of Public Trading Enterprises around this period (Box 2).

The combination of successive budget surpluses and asset sales led to the elimination of net debt. Net debt as a proportion of GDP gradually declined to its historical low of -3.8 per cent of GDP in 2007-08.


A government’s balance sheet comprises both assets and liabilities. This article has demonstrated that only considering gross debt can result in an incomplete picture of public finances. By taking into account assets the public sector owns, a more accurate view of a government’s ability to respond to economic conditions can be determined.

This article has shown that Australia has undergone several periods of debt accumulation, followed by periods of fiscal consolidation. Periods of strong economic growth following episodes of debt accumulation have helped support relatively quick improvements in the public sector’s net debt position. Australia has a low level of net debt both historically and when compared with G-7 economies.