Perspectives on the Current International Financial and Macroeconomic Situation

Celebrity Speakers Ltd., London, May 14, 2007

Jeffrey FrankelHarpel Professor of Capital Formation and Growth

Harvard University

2

Four points to be covered

• Emerging markets are now in the boom phase of the 3rd consecutive 15-yearemerging-market cycle. “Is this time different?”

• China: the miracle is real but the RMB is wrong

• Commodities and carry trade• Twin deficits:

Is US losing economic hegemony?

3

We are now in the 3rd big consecutive cycle of

capital inflows to developing countries

It’s the biblical rule:

7 fat years followed by 7 lean years

1) Recycling petrodollars: 1975-81– 1982 international debt crisis,

then 7 lean years: -1989

2) Emerging market boom: 1990-96 – 1997 East Asia crisis,

then 7 lean years: -2003

3) Current boom, 2003-

4

The cycles show up in capital flow quantities

Capital Inflows to Developing Countries as percent of Total GDP (Low and Middle Income)

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

5.00

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

Net Total Private Capital Flows

Net Foreign Direct Investment Flows

Source: World Development Indicators

2nd boom1st boom

3rd

5

They also show up in prices: sovereign spreads.

EMBI was up in 1995 & 98; down in 2003-07

Calvo, BIS, 2006 The Economist 2/22/07

6

Is “this time different”?

• Ken Rogoff* says “no.”• Some things are different this time:

– Current accounts are stronger (esp. Asia)– Reserve holdings are much higher.– Exchange rates are more flexible.– More countries issue debt in domestic currency,

vs.$ (in part due to exchange rate volatility)– More debt carries Collective Action Clauses– More openness to trade and FDI.

* ”This Time It’s Not Different,” Newsweek International, Feb.16, 2004

7

Most large emerging markets are not usingthe capital inflows to finance CA deficits

as much as they did in the 1990s

-10

-8

-6

-4

-2

0

2

4

6

8

10

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0

Average CA/GDP (%): 1990-99

Ave

rage

CA

/GD

P(%

): 20

00-0

4

Mexico

EcuadorBrazil

Turkey

SSouth Africa

Argentina

Indonesia

Malaysia

CAD 2000-04 < in 90s

CAD 2000-04 > in 90s

8

Instead, countries are using the inflows to build up forex reserves

Flows to Developing Countries (Low- & middle-income), Current Account, Capital Account and Change in Reserves as a % of Total GDP

1982-2004

(3.00)

(2.00)

(1.00)

-

1.00

2.00

3.00

4.00

5.00

6.00

19

82

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84

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86

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88

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90

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92

19

94

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96

19

98

20

00

20

02

20

04

Source: World Development Indicators

Net Total Private Capital Flows

Net Trade in Goods & Services

Change in Total Reserves (Including Gold)

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Export/GDP ratios 2000-04 > than in 1990s

0

5

10

15

20

25

30

35

40

0 5 10 15 20 25 30 35

Average Export/GDP (%): 1990-99

Ave

rag

e E

xpo

rt/G

DP

(%):

200

0-04

Brazil

Argentina

Turkey

Mexico

South Africa

Ecuador

IndonesiaMoreopen

Lessopen

10

New emerging market crises will come; but

• they won’t necessarily take currency crisis form

(vs., e.g., crashes in land & securities markets).

• they won’t necessarily be soon: – Emerging markets not yet ripe for a new crisis round

• Memories are still fresh. • Traders’ jobs have not yet turned over.

– Global monetary policy has been easy (as in the boom phases of the late 1970s & early 1990s).

– Commodity prices are still near historic peaks

11

China

• China, in its own interest, should let the RMB appreciate.• Despite July 2006, the regime has not genuinely changed.• A global cooperative deal would simultaneously appreciate

the RMB & other currencies among Asian and oil-exporters, while the US raised national saving. – IMF could broker the deal. But it won’t happen.

• The Chinese growth miracle will probably encounter a crash somewhere along the road – the banking system, real estate, or stock market.

• Every new economic power goes through a rite of passage: financial bubble and crash.

12

Every new economic power goes through a rite of passage: financial bubble and crash

Hol-land

Great Britain

US Japan China

Take-off dates

16th century

17th century

19th century

1950s-1980s

Current

Change in GDP

X 3 (1500-1600)

X 6(1600-1820)

X6(1870-1913)

X8(1950-1973)

X10

Bubble Dutch tulip mania

South seas bubble

Roaring 20s (stocks & Fla. land)

Late 1980s (stocks & land)

2006-(stocks, real estate, & banks)

Crash 1637 1720 1929 1990s ?

13

Why did prices of oil & other commodities rise so much 2001-06?

• E.g., Copper, platinum, nickel & zinc all hit record highs in 2006

• Mankind has to live in the physical world after all !

• Many causes. One neglected cause is monetary policy: high real commodity prices can reflect low real interest rates.

• High interest rates reduce the demand for storable commodities, or increase the supply through a variety of channels:

1. By increasing incentives for extraction today rather than tomorrow2. By decreasing firms’ desire to carry inventories3. By encouraging speculators to shift from commodities to T bills

14

CRB Commodity Price Index vs. Real Interest Rate

Annual, 1950-2005

0.0

0.5

1.0

1.5

2.0

-7.5 -5.0 -2.5 0.0 2.5 5.0 7.5Real Interest Rate

Log R

eal C

om

modity P

rice I

ndex

Source: Global Financial Data Inc.

Statistical relationship 1950-2005.

15

Results of regressing $ real commodity prices against US real interest rates

• Statistically significant at 5% level for all 3 major price indices available since 1950-- from Dow Jones, Commodity Resources Board, & Moody’s -- and

significant for 1 of 2 with a shorter history (Goldman Sachs). • All are of hypothesized negative sign.

• The estimated coefficient for the CRB index, -.06, is typical. => when the real interest rate goes up 100 basis pts., real commodity price falls by .06, i.e., 6 %.

16

UK regression: real commodity prices in £ on real interest rates

Short Rates Long Rates

US r r differential US r r differential

Coeff. -0.053* -0.086* -0.106* -0.023*

s.e. 0.010 0.007 0.007 0.006

* indicates coefficient significant at 5%. (Robust s.e.s)

17

• Theory: Dornbusch overshooting model, with spot price of commodities replacing exchange rate, and convenience yield replacing foreign interest rate.

• Implication: beginning in 2001, easy monetary policy & low real interest rates among the FRB, BoJ, ECB & PBoC sent liquidity into commodity markets, pushing up real prices.

• Similar “carry-trade” arguments apply to other markets as well: has sent money not only into commodities, but also into housing, securities, and emerging markets.

• This phenomenon may start to reverse.

18

It is still puzzling that long-term interest rates remained so low, even as short-

term rates rose 2004-2006• spreads on high-income corporate debt in particular

have been inexplicably low.• Implied options price volatilities have been too low.• Private equity may also be overdone.• Part of a general pattern: private markets are

underestimating risk– a result of 5 years of low real interest rates & of

formulas that estimate volatility from lagged prices – which look calm – rather than from an intelligent assessment of the macro outlook & the odds of unexpected shocks.

• Private markets may in particular be under-estimating future budget deficits.

• In short, both risk curve & yield curve are too flat.

19

Medium-term global risks

• Bursting bubbles– Housing market downturns, underway– Bond market crash, not yet

• Possible new oil shocks, – e.g., from Russia, Venezuela, Nigeria, Iran…

• Possible new security setbacks– Big new terrorist attack, perhaps with WMD– Korea or Iran go nuclear/and or to war– Islamic radicals take over Pakistan, S.A. or Egypt

• Hard landing of the $: foreigners pull out =>$ ↓ & i ↑ => possible return of stagflation .

The US Current Account Deficit:Origins and Implications

Revsied version of Our Fiscal Future, 2006

21

Trade balance is deteriorating

U.S. Trade Balance and Current Account Balance, 1960-2004

-7.00

-6.00

-5.00

-4.00

-3.00

-2.00

-1.00

0.00

1.00

2.00

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

Balance on goods and services expressedas a share of GDP

Current account balance expressed as ashare of GDP

.

% of GDP

Sources: Department of Commerce (Bureau of Economic Analysis) U.S. Economic Accounts

22

Trade deficit• Current account deficit for 2006 ≈ 6% GDP, a record.

– Would set off alarm bells in Argentina or Brazil

• Short-term danger: Protectionist legislation, such as Schumer-Graham bill scapegoating China

• Medium-term danger: – CA Deficit => We are borrowing from the rest of the world.– Dependence on foreign investors may => hard landing

• Long-term danger: – US net debt to RoW now ≈ $3 trillion. – Some day our children will have to pay it back

=> lower living standards.

– Dependence on foreign central banks may => loss of US global hegemony

23

The Bush Budget Bungle

24

Official forecast of US budget deficit vanishing by 2012 is fantasy

25

White House forecast of eliminating budget deficit by 2012 will not be met

under their policies• WH and CBO projections still do not allow for

– The full cost of Iraq and other “national security” spending– Fixing the Alternative Minimum Tax– Making permanent the tax cuts as it has asked for– More realistic forecasts of spending growth, e.g., in line

with population. (Actually spending growth since 2001 has far exceeded that.)

• More likely, deficits will not fall at all.

• Just as the budget forecasts were predictably overoptimistic throughout the first Bush term.– The surplus of $5 trillion+ forecasted in Jan. 2001 over 10

years became a 10-year deficit of $5 trillion.

26

Further, the much more serious deterioration will start after 2009.

• The 10-year window is no longer reported in White House projections

• Cost of tax cuts truly explodes in 2010 (if made permanent), as does the cost of fixing the AMT

• Baby boom generation starts to retire 2008• => soaring costs of social security and, • Especially, Medicare

27

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Appendix I: Origins of Current Account deficits

• Trade deficits are not primarily determined by trade policy (e.g., tariffs, NAFTA, WTO, etc.)

• Rather, by macroeconomics.

• Deficits are affected by exchange rates and growth rates.

• But these are just the “intermediating variables”

• More fundamentally, the US trade deficit reflects a shortfall in National Saving

29

The decline in US National Saving

• National Saving ≡

how much private saving is left over after financing the budget deficit.

• US CA deficit widened rapidly in early 1980s, & more so 2001-06, because of sharp falls in National Saving

30

National Savings, Investment & Current Account, as shares of GDP

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

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20

01

20

02

20

03

20

04

Net Natl Saving (% of GDP) Net Domestic Investment (% of GDP) Current Account (% of GDP)

31

Why did National Saving fall in early 1980s, and 2001-05?

• The federal budget balance fell abruptly both times– From deficit = 2% of GDP in1970s, to 5% in 1983.– From surplus = 2% GDP in 2000, to deficits >3% now.

• According to some theories, the pro-capitalist tax cuts were supposed to result in higher household saving.

• Both times, however, saving actually fell after the tax cuts.

• U.S. household saving is now < 0 !• So both components of US National Saving fell.

32

What gave rise to the record federal budget deficits?

• Bush Administration: Large tax cuts, together with rapid increases in government spending

• Parallels with Reagan & Johnson Administrations:– Big rise in defense spending– Rise in non-defense spending as well– Unwillingness of president to raise taxes to pay for it.– Leads to declining trade balance– Eventual decline in global role of the $.– They had ignored the advice of their CEA Chairmen.

33

34

Best precedent for fiscal expansion that began in 2001?

• Reagan’s 1980s fiscal expansion is a good precedent; it too came from a president raising defense spending without being willing to pay for it.– Weidenbaum quietly resigned over spending.– Feldstein popularized “Twin deficits.”

• But 1967-72 Vietnam-era expansion fits even better:– (1) Monetary policy was accommodating then, as

recently. – (2) The dollar’s international currency standing began a

trend decline in the 1970s, which the Iraq-era expansion is now restarting.

35

Appendix II: Ten Reasons Why Bush Budget Forecasts Are Too Optimistic

SPENDING

1. National security spending: • Iraq cost still not fully counted in defense budget. • Also, they want to build up the military to be able

to take on Iran & other countries. • New weapons systems (won’t enhance security). • Not to mention all the pork that is in the national

security budget.

36

2. Domestic discretionary spending

• Government forecast assumes spending rises only with inflation,

• but in fact it started rising at ≈ 8 % /year when Bush came to office, far higher than under Clinton with caps & PAYGO

– e.g., agricultural & energy subsidies– prescription drug benefit– manned space program...

• Likely to continue [1]

[1] Non-partisan Concord Coalition: if spending were to stay constant as % of GDP, it would add $1.1 trillion. (Or $1.3 trillion, including interest on the additional debt.)

37

2 quotes from economic advisorsto Reagan & McCain

– Bartlett (2005): “In light of Bush's big-spending ways, Bill Clinton now looks almost like another Calvin Coolidge.”

– Hassett (2005): “spending growth under George W. Bush has been almost four times as high as it was during the same period of Bill Clinton's presidency.”

38

3. Now that the congressional Democrats are in the majority…

• they may have some priorities of their own to spend money on, like health & education.

• In the 1990s, they were persuaded by President Clinton and the PAYGO rules to hold back, in order to get a budget surplus, having passed the 1993 budget act without a single Republican vote.

• Since Bush blew the surplus, and paid no price for it, it may be more difficult to put together the same Democratic support for budget discipline achieved in the 1990s.

39

ECONOMIC FORECASTS

4. Some economic & technical assumptions in CBO & OMB forecasts have been overoptimistic,

• e.g., early growth forecast at 3.3% & high labor share of income.

• Currently, if real interest rates rise to more normal levels, debt service costs will rise sharply.

40

TAX CUTS

5. White House proposes extending tax cuts passed in 2001and 2003, and

6. permanently ending estate tax in 2010.7. Had also proposed privatizing social

security and expanding IRAs/401(k)s; all of which would have lost revenue esp.

outside the 5-year budget window.8. Eliminate Alternative Minimum Tax [1]

[1] Estimated cost $0.7 trillion .

41

ENTITLEMENTS

9. Social Security [1]

10. Medicare

[1] Official forecasts count $2 1/2 trillion in payroll tax revenues that are in fact supposed to go to Social Security; even that is far from enough to pay for promised benefits.

42

What about the “Starve the Beast” hypothesis (“tax revenue↓ => spending↓”) ?

• History shows that the Starve the Beast claim does not describe actual spending behavior.

• Spending is only cut under a regime of “shared sacrifice” that simultaneously raises tax revenue (the regime of caps & PAYGO in effect throughout the 1990s)

• Spending is not cut under a tax-cutting regime (1980s & current decade).

• See Figure 2.

43

Fig. 2: US Federal Budget Deficit and Spending as % of GDP.

16.0%

17.0%

18.0%

19.0%

20.0%

21.0%

22.0%

23.0%

24.0%

25.0%

26.0%

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99

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00

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01

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02

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03

20

04

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

Spending/GDP (left) Budget Deficit/GDP (right)

J.

Ca

rte

r

R.

Re

ag

an

G.H

.W.

Bu

sh

W.J

. C

lin

ton

G.W

. B

us

h

44

Further, even if the Starve the Beast hypothesis did describe actual behavior…

• It would contradict the original rationale for the tax cuts: the Lafferite hypothesis that “tax rate cuts produce more tax revenue.”

• “Starve the Beast” would then predict more government spending not less.

• Is Laffer a straw man?– President George W. Bush, July 24, 2003

– OMB Director Joshua Bolten, press conference July 2003; & WSJ, Dec. 10, 2003

– Treasury Secy.John Snow, Congr. testimony, Feb. 7, 2006: “Lower tax rates are good for the economy and a growing economy is good for Treasury receipts.”

45

Appendix III: Many economists have come up with

ingenious counter-arguments to the twin deficit concerns.

• But I don’t buy them.• I.e., the twin deficits that face us now and

in the future should indeed be a source of concern

• Low US national saving is roughly a “sufficient statistic” for the problem.

46

7 alternate views that purport to challenge the “twin deficits” worry

• The siblings are not twins

• Alleged Investment boom

• Low US private savings

• Global savings glut

• It’s a big world

• Valuation effects will pay for it

• China’s development strategy entails accumulating unlimited $

47

Appendix IV: Possible loss of US economic hegemony.

• US can no longer necessarily rely on the support of foreign central banks, such as China.

• China may allow appreciation of RMB.• Even if China keeps RMB undervalued, it can

diversify its currency basket out of $– There now exists a credible rival for international

reserve currency, the € .– Chinn & Frankel (2007): under certain scenarios, the

€ could pass the $ as leading international currency. – US would lose, not just seignorage, but the exorbitant

privilege of playing “banker to the world “

48

€ could surpass $ as leading international

reserve currency by 2022 – Chinn & Frankel (2007)

0.0

0.2

0.4

0.6

0.8

1.0

75 80 85 90 95 00 05 10 15 20 25 30 35 40

USD

DEM

EUR

49

Possible loss of US political hegemony.

• In the 1960s, foreign authorities supported $ in part on geopolitical grounds.

• Germany & Japan offset the expenses of stationing U.S. troops on bases there, so as to save the US from balance of payments deficit.

• In 1991, Saudi Arabia, Kuwait, and others paid for the financial cost of the war against Iraq.

• Repeatedly the Bank of Japan bought $ to prevent it from depreciating (e.g., late 80s)

• Next time will foreign governments be as willing to bail out the U.S.?

50

Historical precedent: £ (1914-1956)

• With a lag after US-UK reversal of ec. size & net debt, $ passed £ as #1 international currency.

• “Imperial over-reach:” the British Empire’s widening budget deficits and overly ambitious military adventures in the Muslim world.

• Suez crisis of 1956 is often recalled as occasion when US forced UK to abandon its remaining pretensions to an independent foreign policy;

• Important role played by simultaneous run on £.

51

Appendix V: Estimating

the Implicit Weights in the Chinese RMB Basket

(Frankel and Wei, 2007)

52

The new exchange rate regime announced July 2005:

• Minor initial appreciation of 2.1% appreciation.

• RMB to be set with reference to a currency basket,• allowing a movement of up to +/- .3% in bilateral

exchange rates within any given day – (in theory, daily band could cumulate to 6.4% /mo.).

• Governor Zhou revealed 11 currencies (Aug. 2005),• though numerical basket weights still unannounced.

53

The magnitude of daily movements vs. $ increased in the spring of 2006,

-.002

0.0

02

.004

ln(c

ny)-

ln(c

ny[_

n-1

])

01 Jul 05 01 Jan 06 01 Jul 06 01 Jan 07date

Changes in CNY per USD over Time: 07/22/05-1/8/2007

54

Estimating the weights

• A problem made-to-order for OLS regression.

• Regress % changes in value of RMB against % changes in values of candidate currencies.

• Δ log RMBt =

c + α Δlog $t + β1Δlog € t + β2 Δlog ¥t + …

• The coefficients are the basket weights.

• Can impose α + Σ β j = 1.

55

• If China is following a perfect basket peg,

the fit should be perfect, a rarity in econometrics ( s.e.r. = 0, & R2 = 100%).

• More likely, the basket peg is not perfect, but one can still estimate weights with fairly tight standard errors.

• The real questions: – How wide is the band? – How strong is the trend term (c), and– How great is the estimated weight on non-$

currencies?

56

In terms of what numeraireis “value” defined?

• It doesn’t matter, if basket peg holds well.

• Previous authors have chosen: the SDR, Swiss franc, dollar, purchasing power over a consumer basket of domestic goods, a GDP-weighted basket of major currencies, & Canadian dollar.

• We here use the SDR as numeraire, & the price of gold as a robustness check.

57

References for the technique

• “Pioneered” by Frankel (1993), Frankel & Wei (1994, 95).

• Used by others, including Benassy-Quere (1999), Ohno (1999), Frankel, Schmukler & Servén (2000), and Benassy-Quere, Coeure & Mignon (2004).

• Applied to RMB by Shah, Zeileis, & Patnaik (2005), Frankel & Wei (2006), Eichengreen (2006) and Yamazaki (2006)

58

Implicit weights in RMB basketTable 11 7/22/05-1/8/07 Estimate (standard error)

US Dollar 0.904** (0.021)

Euro -0.006 (0.014)

Japanese Yen 0.008 (0.006)

Korean Won 0.002 (0.009)

Singapore $ -0.018 (0.021)

British Pound -0.004 (0.011)

Malaysia Ringgit 0.053** (0.015)

Russia Ruble -0.018 (0.021)

Australian Dollar -0.003 (0.008)

Thailand Baht 0.006 (0.010)

Canadian Dollar 0.003 (0.008)

Trend .00009** (.00003)

** significant at 5%; Change in the log value of RMB (in terms of SDRs) is regressed on changes in log values of other currencies.

59

Estimation in sub-periods• 6 sub-periods:

– (1) July 22-Oct.31, 2005, (2) Nov.1, 05 – Jan.31, 2006, (3) Feb.1 – Apr. 28, 2006, (4) May 1- July 31, 2006, (5) Aug.1-Oct.31, 2006, (6) Oct.1, 2006 – Jan.8, 2007.

– Tables 11 – 17 report results.

• In 1st 2 sub-samples, regime is a US $ peg. – Weight on $ & R2 virtually 1.0. As tight as Hong Kong $ !

• After Jan.2006, however, $ weight falls. – In Feb.-April, 2006, est. weight on $ only 0.7. – Ringgit, won, ruble, & baht receive positive weights. – Surprisingly, ¥ & € continue to receive no positive weight.

• Over last 8 months, $ weight ≈ .9– Significant trend appreciation = .0002 / day => 5.2 % /yr.

60

Extensions

• Basic results robust with respect to:– using another numeraire (gold price) Tbs.11A-17A

– constraining weights to sum to 1, • Table 20 => won estimate sharper

– Method of moments

• We allowed for accelerating trend, but found no sign of it.

61

Evolution during the course of the sample period

Downward trend in basket’s weight on $

• Highly significant if assumed linear - Table 18

– Trend in level still significant as well, but only .0001 appreciation/day, or 2.5 %/yr., against basket

• But we need to specify the time pattern of the weights non-linearly, so they won’t go <0 or >1.

62

Full specification of weights w(j)on currency values X(j)

• Δ log RMBt = f(t) + ∑ w(j) Δ X(j)t

• To impose the constraint ∑w(j) =1, – Let € = 1st currency: w(€) = 1- ∑w(j) =>

• [ΔlogRMBt - Δlog€t ] = f(t) + ∑ w(j)(ΔX(j)t - Δlog€t)– where 0<w(j)<1.

• Now let the weights w(j) depend on time, using exponential form.

• Specification 2 : let w(j) = b0(j) + b1(j)* [1- exp(-d t)], and f(t) = c0 + c1* t .

63

Estimation of nonlinear evolution of weights 7/22/05-1/8/07 in Table 22

• Confirms – in 2005, $ weight = .98 ≈ 1. – significant downward trend in $ weight– Of non-$ currencies, upward trend in the ringgit

weight is the strongest statistically.

• Strikingly, no more statistical significance to the trend of appreciation against the basket, – let alone to acceleration in that trend. – Rather, action comes from falling weight on $.

64

But the estimated shift away from $ is painfully slow:

starting at .98 in 2005, $ weight falls only to .87 over 5 yrs. Weight on the dollar

0.8

0.82

0.84

0.86

0.88

0.9

0.92

0.94

0.96

0.98

1

month-year

65

We also looked at intra-daily movements

• Some evidence that intra-daily pattern differs from inter-daily pattern, itself consistent with declared regime.

• On purely intra-daily data, there is less sign of a downward trend in the very high weight on the dollar.

66

Has US pressure pushed the pace of increased flexibility?

• We searched an electronic database of news reports (FACTIVA/NewsPlus) , recording the number of US news reports of US officials asking China to speed up RMB flexibility/revaluation.

• Two separate time series on the cumulative numbers of complaints – from US Treasury and – from officials of other government agencies (e.g. the

White House, Congress and Fed)

67

Complaints: Treasury & other US0

510

15

20

01 Jul 05 01 Jan 06 01 Jul 06 01 Jan 07date

cumulative non-treasury report cumulative treasury report

Time plots of cumulative US Treasury and Non-Treasury Complaints

68

We added # complaints as a regressor

There is evidence that cumulative complaints are associated with a reduction in the RMB’s weight on the US dollar.