Wednesday 20 January 2016

Only Course left to FOMC- Reverse Stance Sooner rather than Later


All that was feared and written about on 24th August 2015 in "Rescuing a Deflationary World"(http://ageofdeflation.blogspot.in/2015/08/rescuing-deflationary-world.html) has ominously come to pass with the US Fed inexplicably raising rates in a haste in December accompanied with a simultaneous JPY carry trade unwind along with the breakage of the USD->CNY carry trade and as illustrated earlier in this blog the world economy is now truly on its knees.

The moot question is did the US Fed really see the ghost of inflation in December when the entire world actually stood perilously on the brink of deflation? And now that it is clear that the world is indeed in THE AGE OF DEFLATION what, pray, does the FOMC plan to do in the next two months? Study the data? Analyze? What analysis do we expect the captain of the sinking Titanic to do and indeed what analysis is on offer? No, please also do not expect the economic situation to revert back to square one to status quo prior to the December hike, if this hike is reversed - only that the route and fallout of the blunder will be slightly bearable to manage and implement a fix.

Why does the US Fed have to be answerable for China, Japan, ex-Asia et al? Because post the SE Asian crisis in 1998, most Emerging Economies' Central Banks have been maintaining a quasi dirty floating peg with the US$ using their respective FX reserves as the cushion to avert a repeat of the 1998 crisis and the result of this stratagem has been that post the 2008 crisis in the US when the US Fed slashed rates to almost zero, most Emerging Nations' Central Banks obediently* cut their REAL RATES to ZERO as well. In some cases , without naming individual Central Banks, the real rates were maintained at fairly high negative levels for much of 2009-2011 fuelling a rather huge credit binge driven asset price rally.
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* The reason is fairly obvious- If an Emerging economy were to maintain a higher real rate of interest higher than that of the US, the export driven economy(most Emerging economies are modelled on this in order to extract the purchasing power arbitrage or in other words the wage differential arbitrage between the Emerging economy worker and the American worker) would suffer as capital flows would make the exchange rate move adversely and make its exports uncompetitive. The saving grace was and is the FX reserves which would be expanded to keep the currency from appreciating too much against the greenback and thereby keeping the export driven model intact. The immediate 'obedient' fallout is that if due to any reason the US Fed has to reduce its real rates to 0, the hapless Emerging economy Central Bank has to follow suit and adjust its real rates at or below that 0 level which is what happened in the aftermath of the 2008 credit crisis. 

During the "taper tantrum" in 2013, when market was trying to price in the probability of the US Fed hiking rates, some emerging economies with weak current account and low FX Reserves were faced with the prospect of either higher domestic interest rates to attract foreign fund flows or a depreciating currency to maintain the export growth led model or deplete their FX reserves or a mix of these mechanisms. 

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In December 2015 when the US FOMC hiked rates in the absence of inflationary dangers, real US$ interest  rates started progressively moving higher as deflationary dangers manifested itself strongly. True to script, economies having weak current accounts or low FX reserves have had to face a brunt either through depreciation of the exchange rate or by raising the domestic interest rates or by depletion of their FX reserves(not an option for most emerging economy Central Banks though) or by a combination of either of these mechanisms.

Now add China and the Commodities complex in an overleveraged# setting to the above and the global economic growth model ignites to the mess we see today- a mega tragedy unfolding.
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#Not that you do not know this simple fact that we live in an era of over-leverage.... but the recent chain of events should not leave any doubt on the matter. Will not venture into a name and shame exercise as to who or what caused this sorry state of affairs, which is an exercise best left for another time or to another person (*a HISTORIAN?). China is a classic basket case of people trying to game the economic model of the state using leverage as an instrument and creating vast misallocation of capital into unproductive or wasteful activity.Take copper for example- in China with its ample land bank, inventory holding costs were low. US$ funding cost was cheap and because the PBOC created an artificial band between which the Renminbi could appreciate/depreciate, you could misuse this to import huge amounts of copper using borrowed dollars and inventory it for a short time while more leveraged buying of the commodity raised international prices- and then you sell it off in the domestic market at a profit because the RMB would not be allowed to :

(a) appreciate against the US$ beyond the band ensuring higher international prices always resulting in higher domestic prices,

(b)depreciate against the US$ beyond the band ensuring savings in hedging cost on the US$ Liability(referred to as USD->CNY carry trade) resulting in assured bumper profits attracting higher participation in a self fulfilling cycle as copper prices in particular and commodity prices in general kept rising -funded by leverage. 


This type of leveraged buying of commodities could not continue for ever as you ultimately need a willing and liquid buyer at the other end- which was ultimately found wanting because sooner someone realized that there was only so much requirement of wires to be extruded from the copper, and the rest had to be inventoried due to the limitation of actual end use.
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While we allow deleveraging to work its way through the system, what is required is a semblance of order and stability which can be used to gain time to resolve the rebalancing issues at hand. Had always maintained that the US Fed was mounted on a rather wild and fast horse in its quest to "normalise" rates and it has erred by a big margin and the time has come to either bailout of the Titanic by reversing course or if it still sticks to the "hike" bandwagon the boat will sink from hereon alongwith the entire bandwagon. 

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