Global
Liquidity and the Real Economy – Are Derivatives a Sideshow?
July 16, 2007

By David Miles | London

The stock of derivatives outstanding has grown enormously in recent years. Is this of fundamental importance to real economic conditions, to liquidity, monetary policy and inflation? Or is the growth in derivatives really secondary to economic outcomes?

Do financial derivatives really reduce risk, as many people think? 

Finance theory says that derivatives are a sideshow — in fact the most widely used (still) model of option pricing (Black and Scholes) — is really based on the assumption that derivatives are redundant in the sense that their existence adds nothing. Yet fluctuations in the prices of derivatives and in the total stock of outstanding claims get a huge amount of attention, particularly in the turbulent conditions of the past few weeks.

So is what happens in the derivative markets a key driver of trends in the markets for the underlying assets and in the wider economy? The answer to that question has a bearing on how one sees the fallout from re-pricing in the credit and fixed income derivatives markets to the wider economy — so it matters.

Reflecting on this issue generated a lively discussion among Morgan Stanley's economists and credit market experts across the globe. The following is an edited version of that debate which aims to bring out the main points. 

Serhan Cevik: Financial liberalisation and innovation have led to explosive growth in derivatives and structured securities. The volume of derivative contracts on a variety of assets increased from US$5.7 trillion in 1990 to US$415.2 trillion last year. Put differently, the total amount of exchange-traded and over-the-counter derivatives snowballed from 26% of global GDP to an astonishing 789% (see Deriving Liquidity, June 4, 2007). As a result, the proliferation of these complex instruments — with abbreviated names like CDO, CDS, CLO, CPDO, CDS of CDOs, CPPI and LCDS — has become a major source of credit expansion and decoupled market liquidity from monetary tightening. Indeed, derivatives and securitised debt instruments account for almost 90% of global liquidity, while ‘traditional’ monetary aggregates represent a mere 10%. This explosive expansion is not just a result of financial innovation, but also reflects the emergence of new players with greater appetite for leverage and ‘positive feedback’ from the moderation of volatility in recent years. For example, the number of hedge funds increased from 300 in 1990 to more than 10,000 today, with an unlevered asset pool of about US$2 trillion under management and accounting for 60% of the trades in derivatives.

The disaggregation of risk through derivatives and structured products brings efficiency gains and makes financial markets more flexible. However, these new channels of risk intermediation also increase the degree of leverage and risk-taking and thereby set the stage for future shocks (see Richard Berner’s report, Credit Derivatives: Benefits and Risks, May 18, 2007). For instance, even though subprime mortgages in the US and structured securities based on such loans represent a small segment of the global financial system, recent developments highlight potential fragilities that may deepen and have contagious effects on other markets. Given the feedback loop between market liquidity and capital flows, a correction in risk appetite could create herding behaviour in financial markets. Indeed, we have already witnessed such sudden swings in investor sentiment and the unwinding of leveraged positions.

David Miles: That is interesting and the numbers are striking. But it raises a lot of issues. I have no desire to resurrect the old debate about what ‘liquidity’ means. But let me just ask something:

Suppose a bunch of us go to the race track and punt a load of money on a horse race. We bet different ways, and the odds on the horses adjust so that the book runner (in the UK we call them bookies, essentially they are market makers) feel comfortable with the risks. The contracts we then have are derivatives, which in the UK we call the betting slips. Before the horse race starts there are lots of these derivatives around, and we could measure the money value of the outstanding stock of them. After the race the dust settles, and the payouts are made. There are no net gains; it is a zero-sum game. The horses don’t care much who among the humans wins and who loses.

Question 1: Is the stock of betting slips ‘liquidity’ — I think the logic of your argument Serhan is that the answer is yes.

Question 2: Should anyone get excited about the stock of betting slips outstanding?

Question 3: Has it got anything to do with monetary policy, credit conditions, inflation, and macroeconomic outcomes?

I guess my answers would be:

1. ‘probably no’;

2. ‘depends what gets you excited — personally ‘no’;

3. ‘quite probably no’.

Maybe this horse racing story is a lousy analogy for what you are describing Serhan about the real world financial markets. But maybe there is an element of truth to it and that in some sense the derivatives markets are secondary.

Stephen Jen: I agree with David’s point and like his analogy. 

The ‘liquidity’ in the credit derivatives market is a zero-sum game, with profit and losses and risks being shared by different players.  In the Wall Street Journal one day this week, we have an article on the problems with the sub-prime market and its derivatives, but we also have an article reporting the massive gains enjoyed by some hedge funds who betted against the sub-prime market.

Unless this problem turns into a default risk for brokers, some of which are banks, I just don’t see this being something that will lead to systemic problems, or something that fundamentally alters monetary policy or the inflation outlook. 

This is why I think it might be useful to think about different types of liquidity:

1.  Market liquidity, which includes the type that you, Serhan, mention: it divides and slices up risk but does not act like other types of ‘liquidity’.

2.  Monetary liquidity.

3.  Real liquidity.  This is determined by the world’s saving-investment balances and affects the real interest rates. 

Serhan Cevik: The data show increase in net risk taking to be around US$12 trillion with almost all investment banks taking part. Clearly this is not as large as the gross figures, but it is nevertheless not a zero-sum game.

As Stephen has been arguing for some time, there is a difference between monetary liquidity and market liquidity. Thanks to innovative products, financial markets are less sensitive to changes in monetary liquidity, and that affects lending/risk appetite and economic behaviour as well, in my view.

Laurence Mutkin: Coming back to David’s analogy: why isn’t the following something to worry about?  If a seller of a derivative cannot deliver (goes bust), the buyer of the derivative cannot realise his paper gain. In aggregate there may be no systematic ‘loss’, in principle, because the gain the buyer expected to make, and doesn’t, is offset by the loss the seller should suffer, but doesn’t suffer, by going under.

But in practice the two are not symmetrical. The seller’s gain is capped by his value going to zero; but that is not true for the buyer. Let’s come back to the horse racing story. Suppose the bookie whose market cap is US$10 bets against a horse which wins and so owes the better US$100. He can’t pay, so goes bust. The better gets the US$10, but loses US$90. But the bookie doesn’t ‘make’ the £90 he didn’t pay: he’s bust.

This is why Stephen Jen says “Unless this problem turns into a default risk for brokers, some of which are banks...”. 

And that’s why the value of collateral on derivatives is so important. Collateral can become inadequate, causing economic loss. That’s why the phrase ‘margin call’ means something.

But isn’t there systemic economic loss before broker default? If a bookie has offsetting bets versus a horse and the horse wins but the seller of the horse winning can’t honour his obligation, the bookie still has to pay the successful punter. The bookie doesn’t go bust, but takes a hit to his capital. Isn’t that an economic loss?

Perhaps I have the wrong end of the stick here: I don't know much about horse racing. By the way, I believe Will Rogers said that he knew horses were cleverer than people because horses never lose money betting on people races. Or did he mean ‘on derivatives?’

David Miles: Let me play devil’s advocate. The bookie going bust — with limited liability — is just another derivative coming into the money. It is one sold (implicitly) by the person who bet, and won, and does not get paid. So at one level it is all a zero-sum game, which does not mean it does not cause disruption when someone goes under of course.

By the way, how do we know horses don’t bet on what people do? Why not interpret some of their actions as the settling of bets?

Oliver Weeks: Just to (over) extend the racing analogy — that industry only exists because of the betting. The horses might run as hard but there’d be less of them if the betting collapses because bookies or punters have been misjudging the odds.  Isn’t it similarly the case that some of the loans and mortgages have been made mainly because of the appetite to put them into structured products?  And that is a horse race without a clear ending, so the betters can all mark up their winnings optimistically for some time before the dust settles, and spend accordingly.

David Miles: I guess your point Oliver is about the pricing of credit, whereas my simplistic point was that the quantity of derivatives per se was not obviously an indication of looseness of credit conditions (in fact it is not obviously an indication of anything).

Jim Caron: I think we also need to account for leverage and the ease at which it is created. I consider the low level of interest rates a few years ago as a key culprit.

David has a nice analogy. However, there is a part that is missing. And that is the part where someone shows up to the track and buys US$10 worth of contracts with US$1.

I view liquidity and leverage as commodities. They can simply be mined and manufactured. This leads to asset inflation. Now the bookies (we use that term in the US too) really have a problem. The odds will get further skewed.

I agree with Stephen Jen in that today’s repricing of risk is so far contained and not yet a systemic problem. The problem isn’t that Bear Stearns has a hedge fund that lost money. The problem arises when the lenders of capital stop lending (or charge higher rates) and then place margin calls on borrowers.

If the borrowers of capital cannot make their margin calls, then they go bust. That is especially true if no one is willing to lend them money to make the margin call or their collateral has been marked down sufficiently that they can not raise enough money to make the margin call. Then you have thousands of mini Bear Stearns events taking place.

I think the risks are serious but so far they have not become systemic.

David Pais: Although I would tend to agree with Stephen and David that the growth in derivatives markets is merely the transfer of risk, I think the horse racing analogy is an incomplete one. Like Jim I think it’s important to consider where the individuals who are doing the betting get their money from. Also, the derivatives markets do not exist in isolation but are part of a broader financial system and as Bernanke recently reiterated, financial crises do have ‘real’ effects.  

As regards liquidity, I think it might be useful to use the definition provided by Shin and Tobias, a couple of finance economists, recently — liquidity is the rate of growth of aggregate balance sheets.

Manoj Pradhan: What matters in all this is the impact of what happens in derivative markets on systematic risk and the real economy. Can I take a step back and go back to fundamentals for a minute?

A financial asset is created every time a claim on a cash flow is securitised. Thus, the only way to create assets is to securitise more of the existing cash flows (e.g., by selling claims on a company or household’s future cash flows) or by creating new cash flows (which is what the process of economic investment is all about). A derivative has no claim on its underlying asset and the creation of tons of these derivatives therefore produces no new assets, according to our definition. Whether a derivative is a leveraged position is immaterial. I agree with David Miles that the creation of derivatives therefore has uncertain implications for liquidity from this perspective.

But consider systematic risk. One of the biggest questions that the derivatives markets have produced is: who holds the risk? Every single central bank and regulatory authority would like to know the answer to that because it can determine whether a deterioration in the real economy has a multiplied or a muted impact on the financial sector.

Richard Berner: As I see it, the credit derivatives market has been booming because it meets broad needs and carries well-known benefits. These innovations have improved market efficiency and financial stability. But that very stability may have increased risk-taking and leverage, creating the fuel for future shocks to menace financial stability.

While shocks may be less frequent, this new financial architecture may make them larger.

It may be sheer coincidence, but the explosion in credit derivatives has coincided with a boom in leverage. Corporate America is levering up with a record boom in privatisations, buyouts and buybacks. To be sure, CFOs are leveraging up the capital structure from a position of balance sheet strength, but many companies will emerge from this process with significantly higher leverage. For their part, investors are feeling exposed to the credit events represented by privatisation and the ‘covenant-light’ structure of today’s deals. That has distorted market pricing and disconnected credit ratings from credit risk. As result, investors are willing to move down the ratings spectrum but higher in seniority to get protection from LBO risk.

Turning to volatility, at issue is how much of the prior volatility compression was secular and how much was cyclical. Three secular factors reduced volatility for a couple of decades. The volatility of economic activity and inflation has steadily declined in what is called the ‘Great Moderation’; financial innovation has spread risk more broadly across market participants; the growth of the structured credit market suppressed volatility by enabling market participants to lay off risk ever more easily in liquid markets; and central banks have become more transparent about goals and their strategy to achieve them, while becoming more explicit about the likely path of interest rates consistent with their objectives. 

The secular factors won’t go away quickly, so a major reversal in volatility’s trend isn’t likely. However, two cyclical factors also depressed volatility over the recent past. Believing the secular story, and experiencing moderate but steady GDP growth over the past few years, investors increased their appetite for risk. And many market participants seeking to enhance yield expressed their volatility view by selling it in liquid markets.

Those cyclical factors are now changing quickly as uncertainty about the economic, credit and monetary policy outlooks increases. The interplay of weak economic data, fears of a credit crunch, lingering inflation risks and rising energy prices, combined with the reduction in liquidity, are producing rapid changes in asset prices. And I sense that those factors are promoting a watershed change in investor perceptions.

David Miles: Having possibly led us astray with my analogy to horse racing, maybe I can try to draw two conclusions where we might agree:

1. Fundamentals will still drive asset prices; but 2. financial innovation appears in the recent past to have increased risk-taking and leverage.  Thus, when real or financial shocks such as subprime defaults come, volatility and asset price swings may change abruptly. Investors take note.

Important Disclosure Information at the end of this Forum

Euroland
Inflation Made by Governments
July 16, 2007

By Elga Bartsch | London

Euro area governments exert an important influence on consumer price inflation in the euro area. Of course, many government policies, such as the fiscal policy stance or labour market regulation, have an indirect impact on medium-term inflation trends. But by setting indirect taxes, fees and administrative prices, government decisions also have a direct bearing on near-term inflation dynamics. We estimate that on average governments have added 0.22 percentage points to HICP inflation over the last ten years. This is equivalent to 10% of inflation being directly down to government-controlled prices. Note that the magnitude of our top-down estimates on the impact of indirect taxes and administrative prices is very similar to the bottom-up calculations of the ECB. In the coming years, we expect the contribution from government-created inflation to rise, for several reasons.

First, budget deficits will likely deteriorate again in the future. After a smart cyclical improvement in budget balances on the back of past consolidation, one-off measures and, more importantly, a sharp rise in tax revenues, structural issues will likely resurface. Over the last three years, the tax elasticity in the euro area temporarily surged to 1.5%, implying that a 1% increase in nominal GDP raises tax revenues one-and-a-half times as much, led by a sharp rise in volatile corporate tax takings. Such a high elasticity is not sustainable in the long run, and a return to a value of around 1% thus seems likely. In addition, in many countries the structural issues of rising age-related pension and healthcare spending have not yet been adequately addressed, and are likely to weigh on budget deficits over the longer haul. As a result, ageing populations will likely have a significant negative impact on government budgets. Historically, there has been a close correlation between the aggregate budget deficit in the euro area and the government-created inflation in the following year. Hence, renewed budgetary pressures will likely add to the inflationary pressure created by governments.

Second, the tax burden will likely continue to shift from direct to indirect taxes. In a world of rising cross-border capital mobility and increasing competition from low labour costs countries, euro area governments are increasingly forced to shift the tax burden from direct taxes, such as corporate, income or payroll taxes, to indirect taxes, such as value-added or sales taxes. As a result, the implicit tax on consumption has been on a steep uptrend since the beginning of this decade. In addition, ageing societies need to enhance the incentives to work to make up, at least partly, for the demographic demise. We would therefore expect this trend to continue, and the tax burden to gradually shift from workers to consumers in the years to come.

Third, taxation will likely become greener in the coming years.  Given the substantial commitments European governments have made to combat climate change and to reduce greenhouse gas emissions, clear price signals to consumers will be needed to reduce energy consumption. We would therefore not be surprised if we were to see a bout of ‘green taxes’ being introduced. Such taxes and charges are increasingly used by Member States as a cost-effective instrument to implement the ‘polluter pays’ principle. Hence their use is likely to spread in the coming years. These could be energy taxes to induce more efficient energy-use, as envisaged in the EU Commission’s Green Paper on Energy Efficiency. These could be climate change levies, as are reportedly being considered in Germany at the moment. Or current fuel subsidies could be removed. In addition, there could be higher fees for waste generation, such as landfill charges or waste-water fees. Many, if not most, of these changes would be relevant for measured HICP inflation. 

Fourth, user fees and charges will become more important. While many areas see further deregulation of previously regulated prices, say for utilities, where the EU electricity sector has become fully liberalised since the beginning of this month, governments will likely increasingly charge individual consumers for certain services, such as university education, healthcare or road use. In the face of more and more government services being farmed out to the private sector via public-private partnerships, this trend is likely to continue, we think. In this context, we will be watching road-pricing trends, such as congestion charges and road tolls, in particular.

Fifth, new ‘sin taxes’ will likely be introduced. In order to deal with the rising costs of providing adequate healthcare and in order to strengthen incentives for people to look after their personal health and avoid unhealthy lifestyles, it also seems conceivable to us that so-called ‘sin-taxes’, which already exist for alcohol and tobacco, could be extended to certain foods that are perceived to be unhealthy. With obesity fast becoming one of the major budget busters in many developed countries around the world, the introduction of so-called ‘fat taxes’ seems not only possible but also probable.

Bottom line

Our estimate of the average euro area inflation created directly by governments of 0.22 percentage points should constitute the lower end of what we could see in the future. Like most forecasters, the ECB only includes tax changes and administrative price adjustments in its inflation projections once they have been decided on, thereby introducing a downward bias to its ‘projections’. However, in our view, the upside risks to the inflation outlook stemming from indirect taxes and administrative taxes go beyond these forecasting technicalities. The greater direct impact of government policies on euro area inflation is one of several factors adding to the inflation risks in the coming years. In our view, these risks are not yet fully priced into fixed income markets.  We therefore expect a further rise in 10-year Bund yields in the remainder of this year, led by higher break-even inflation rates. A sharp rise in actual HICP inflation to 2.7%Y by year-end, on our forecasts, could be the catalyst, we think.

 

Important Disclosure Information at the end of this Forum

Middle East/North Africa
Pegged Imbalances
July 16, 2007

By Serhan Cevik | from Ankara

Pegged exchange rate regimes in the Middle East are coming under greater pressure. It is a peculiar phenomenon to see currency depreciation in oil-exporting countries of the Middle East when their balance of payments and domestic economies actually justify the appreciation of exchange rates. Take, for example, the case of Saudi Arabia. As the world’s leading provider of crude oil, the Saudi economy has enjoyed an astonishing surge in its export earnings and current account surplus in the past five years. However, the value of its currency has kept depreciating in real terms by more than 24% since the beginning of 2002. In our view, currency misalignment in Saudi Arabia (as well as in other Gulf countries) is basically a result of the fixed exchange rate regime pegged to the US dollar. With the dollar’s sustained weakness, the riyal has become cheaper and cheaper, contributing to imbalances not just in Saudi Arabia but also throughout the global economy. And as the dollar fell to a record low against the euro and other currencies, pegged exchange rate regimes in the Middle East have led to even greater currency misalignments and therefore come under more pressure. This is why we have argued that the windfall from higher oil prices and widening domestic imbalances justify the realignment of Gulf currencies.

The rise in oil prices will expand the windfall gain for oil-exporting countries in the Middle East. We were expecting a period of consolidation in oil prices, but the latest figures point to the continuation of supply-demand imbalances around the world and so higher prices for a longer period of time. According to the International Energy Agency, global oil demand is likely to increase by 2.2% a year in the next five years, especially as developing countries keep increasing oil consumption from 42% of global demand to 46% by 2012. Therefore, given the limited — 1% a year — expansion in global oil supply, upward pressure on prices is expected to remain intact. Indeed, Morgan Stanley has recently revised up its baseline oil price estimate from an average of US$63 a barrel to US$67.6 this year and from US$58.6 to US$63.7 next year (see Eric Chaney and Richard Berner, Oil: Revisiting $80/bbl?, July 9, 2007). Of course, that will expand the size of the windfall enjoyed by oil-exporting economies. In the case of Gulf countries, exports revenues already soared from an average of US$154 billion between 1998 and 2002 to US$507 billion last year, raising the cumulative current account surplus from 5.4% of GDP to 24.6% over this period (see Pumping Money, May 22, 2007). Although such an unprecedented current account surplus is enough to justify a more flexible exchange rate, the case for currency revaluation goes beyond the ‘link’ between external accounts and exchange rates, in our view.

Liquidity-driven growth and the dollar’s weakness fuel inflationary pressures. Thanks to the abundance of petrodollar liquidity and accommodative policies, real GDP growth in the Gulf region accelerated from 3% a year between 1998 and 2002 to 7.3% in the last four years. Even though the burst of the regional equity bubble led to a moderation in credit growth and consumer spending, the latest figures indicate a renewed surge in domestic demand. Once again, favorable liquidity conditions and rising investment expenditures are driving domestic economies to a higher growth plateau. Needless to say, these economies have also experienced a sustained increase in inflation rates — from an average of 0.1% between 1998 and 2002 to 4.5% at the end of last year. The inflation problem, however, is not just a result of excessive growth in domestic demand. While the behavior of non-tradables (and especially housing prices) has dominated the policy debate, we believe that exchange rate regimes pegged to the US dollar are also responsible for the rise in inflation throughout the region (see Pegged Pains, February 20, 2007). Since imports from Europe account for approximately one-third of all imports, the dollar’s continuing weakness will only intensify the currency pass-through effect on domestic prices. This is particularly worrying when food prices are on the rise all around the world. All in all, pegged exchange rate regimes that were once considered to be the ‘anchor of stability’ have become a source of imbalances.

There is no valid justification for delaying currency revaluation, in our view. Kuwait has already abandoned its currency peg to the US dollar and revalued twice in marginal steps. This is an interesting development, since Kuwait has a relatively low inflation rate, standing at 5.2% in 1Q07, while other countries like Qatar and the United Arab Emirates have inflation rates running at 15% and 13.5%, respectively. Bearing in mind the underestimation of consumer price inflation, the rise in inflation has already become a significant threat to economic stability in the Gulf region. And given the state of domestic economies and an incredible pipeline of investment projects over the next five years, inflation pressures will likely intensify, in our view, not recede as many expect. Furthermore, the problem is not limited to domestic cycles, but will also affect the planned monetary union. With widening inflation differentials, Gulf countries risk the credibility and sustainability of a common currency (see Currency Union — Disunited They Stand, June 14, 2007). This is why we argue that a synchronized revaluation of exchange rates and the adoption of a flexible currency regime would support efforts to achieve sustainable economic growth and diversification.

 

Important Disclosure Information at the end of this Forum

Nigeria
Solid Food Crop Production Helps Cap Food Prices
July 16, 2007

By Michael Kafe | Johannesburg

Thankfully, weather conditions in Nigeria have not really been extreme, and the government’s success at revitalizing agricultural production as a means of reducing the country’s overdependence on oil has yielded positive dividends in food crop production. Hence, since 2H05, Nigeria has consistently reported decelerating (and occasionally, negative) food inflation readings, at a time when food price pressures were mounting almost everywhere else on the continent.

A key component of the economic diversification strategy was to encourage differentiated lending conditions to the non-oil sector — mainly the agricultural sector. Financial disbursements were stepped up under the national Agricultural Credit Guarantee Scheme, where guaranteed loans were granted at preferential rates to agrarian communities — particularly the northern states such as Adamawa, Jigawa and Zamfara, where more than 80% of the inhabitants are engaged in agricultural activities. This year’s Budget provided a further N38 billion (about US$300 million or 1.6% of government expenditure) to fund key agricultural projects and initiatives. Thanks to these efforts, fortuitous weather conditions and, more recently, a sustained appreciation in the currency that has helped to contain imported input costs, agricultural production has risen to average of some 7%Y in the last four years — a time when growth in the oil sector was broadly stagnant and occasionally negative. Naturally, the rising volumes of crop production helped to place a cap on food prices, to publicly embrace an anti-corruption regime.

Oil prices and food inflation in Nigeria

However, of more immediate relevance to the recent downtrend in Nigeria’s inflation profile is the sharp drop in oil prices between August 2006’s peak of US$79/bbl and a subsequent trough in 1Q07. As we have mentioned before (see Nigeria: Looking Up, June 15, 2007), the most important driver of food inflation in Nigeria is the oil price. A rise in fuel costs tends to raise the input costs of virtually the whole food production process, including the transportation of seeds/seedlings, running of seed-drills, powering of combined harvesters and the distribution of final produce from farmgate to shopshelf. And our econometric analysis suggests that, on average, a 10% increase in oil prices tends to raise food inflation by some 4.75% and vice versa. We also find out that the pass-through from oil prices to food inflation is quite rapid, and this could be explained by the huge size of the country’s  informal sector, as well as what appears to be the dominance of final distribution costs (transportation costs) in the food production cycle. Once fuel price adjustments are made, supply-side participants in informal markets tend to respond almost immediately. And the generally low level of inventories in these markets ensures quicker pass-through of changes in distribution costs.

In Nigeria, food accounts for some 64% of the CPI index, and farm produce accounts for more than 90% of the food basket. Hence, movements in the CPI index are often driven by the underlying trend in food prices, which are themselves driven by weather patterns, variable input costs such as oil prices and harvest patterns. Given the important role that oil prices play in the food price formation process, and the fact that oil prices have now risen by 50% from the lows seen in 1Q07, we think that it is only reasonable to expect a pick-up in both food inflation and the overall CPIX readings in the coming months. In particular, the 7.5% increase in the local pump price of petrol in May/June will hurt.

Inflation has likely turned the corner

The Nigerian National Bureau of Statistics often publishes the country’s CPI data on the third Thursday of each month — albeit with some inconsistency. We expect the June reading to be published on July 19, 2007, ceteris paribus. As we mentioned a fortnight ago (see EM Economist, June 29, 2007), the reading will in all probability be higher than the 4.6%Y that was published for May. In fact, assuming full pass-through of the hike in petrol prices, rising food prices, as well as a low base off June 2006, the June 2007 reading could come in as high as 7%Y. We must point out, however, that the controversy and confusion surrounding the May/June petrol price hike raises the risk that we only see partial pass-through in the June reading. Even so, we still expect inflation to reach 8-10% by year-end.

 

Important Disclosure Information at the end of this Forum

China
All the Hype about the Return of Massive ‘Hot Money’
July 16, 2007

By Denise Yam, CFA & Qing Wang | Hong Kong

Return of massive ‘hot money’ in 1H07?
China’s reported US$131 billion increase in foreign exchange reserves in 2Q07 to reach US$1.33 trillion by the end of June again caught much attention.  It raised questions among observers with regard to the nature of China’s balance of payments (BoP) inflows in excess of the trade surplus and reported foreign direct investment (FDI) inflows.  It has been a commonly practiced approach among market observers to track the incremental month-on-month (or quarter-on-quarter) changes in the stock of official FX reserves, net it off the reported trade surplus and FDI, and interpret the remainder as a proxy for short-term capital, or ‘hot money’ flows. A simplistic breakdown suggests that after the US$73.3 billion of ‘hot money’ inflows in 1Q07, which was partly explained by the PBoC as the repatriation of IPO proceeds by Chinese banks and enterprises that raised funds abroad (primarily in the Hong Kong stock market in 2H06), China continued to experience significant inflows of US$48.4 billion in 2Q07.  From only 3% of the increase in reserves in 2006, the portion accounted for by ‘hot money’ inflows jumped to 46% in 1H07 (54% in 1Q, 37% in 2Q).

Many observers hence commented on this apparent return of massive ‘hot money’.  Specifically, questions have been raised about whether China is losing effective control over its capital account transactions, which carries implications for China’s objective of maintaining a stable exchange rate.  Moreover, there are doubts about whether monetary aggregate (e.g., M2) targeting by the PBoC will lose its meaning as the money supply becomes endogenous with a less effectively controlled capital account.  What follows is whether the massive ‘hot money’ inflows undermine the viability of China’s strategy of allowing gradual appreciation of the renminbi, and whether the authorities should consider a large ‘one-off’ revaluation to rid appreciation expectations once and for all.

The true picture: A closer look at the BoP flows
We attempt to take a more detailed look at the available data, to try to decipher the flows and, where possible, identify the drivers behind them.  China’s official BoP accounts are reported semi-annually and available up to 2H06 currently.  We have made our own estimates for 1Q07 and 2Q07.

China’s current account has demonstrated a steady expansion trend over the past few years on the back of surging exports, as the entry into the WTO accelerated the integration of China’s surplus labor pool and enormous manufacturing capacity created over years of rapid investment growth with the rest of the world.  The ballooning trade surplus has contributed to both the rapid accumulation of foreign reserves and frictions with China’s major trading partners. While gradual policy changes are being made to address the ‘trade imbalance’, including the downscaling and/or removal of export-promoting measures such as export VAT rebates, and import-hindering tariffs, these initiatives are fighting an uphill battle against the fundamental drivers behind China’s trade surplus (competitive production), and take time to show a meaningful impact.

Meanwhile, emerging investment opportunities from China’s rapid development, improving corporate profitability and prospective currency appreciation also added fuel to the balance of payments surplus and hence the growth in official reserves through the capital account.  In particular, Chinese companies’ attempts to raise equity capital from international capital markets had received enthusiastic response.  This further complicated or even undermined management of monetary conditions, and intensified international pressure on China to accelerate currency appreciation.  Since policies aimed at promoting a better balance in the trade account may take several years to bear fruit, the authorities saw more readily available means to influence the pace of capital inflows. 

While China’s current account surplus jumped from US$46 billion in 2003 to US$69 billion in 2004, US$161 billion in 2005 and US$250 billion in 2006, heightened attention over China’s overall BoP surplus in 2004 (US$206 billion) and the subsequent rise in overseas equity fund-raising caused the authorities to act on slowing capital inflows.  Net inflows to Chinese equity securities doubled from US$11 billion in 2005 to US$20 billion in 2005, and again to US$41 billion in 2006.

It appears that Chinese financial institutions and enterprises had delayed the repatriation of their overseas IPO proceeds, and they had been also encouraged to park their foreign currency funds temporarily in the form of overseas debt securities through perhaps engaging in currency swaps with the central bank.  Almost all outflows (to the tune of US$110 billion) under the capital account in 2006 were actually caused by Chinese residents purchasing foreign debt securities instead of foreign speculators taking their money and leaving the country, as has been commonly perceived among market observers. We believe that a large majority of these Chinese residents are domestic financial institutions.  As a result of these transactions, the surplus in China’s capital and financial accounts of the BoP actually shrank from US$138 billion in 2004 to US$46 billion in 2005, and even turned into a small deficit of US$3 billion in 2006.

What took place in 1H07 appears to be a reversal of the ‘hot money outflows’ in 2H05-2006.  When the PBoC reported the FX reserves data for March in April, officials attributed the large chunk of capital inflows to the repatriation of IPO proceeds held offshore since 2H06.  We believe that more of the unwinding of the ‘outflows’ took place in 2Q07, though of a smaller magnitude than in 1Q07, in the form of greater repatriation, and possible unwinding of swaps.

A conscious change in policy in anticipation of the CIC?
As described in the previous section, we interpret the observations we made as an intentional or conscious change in the authorities’ policy stance towards capital flows over the past couple of years.  In other words, the swing in capital flows was not so much a phenomenon of ‘hot money’ flows, but in response to policy-led initiatives.  We believe that the upcoming establishment of the China investment Company (CIC) played a role in this seeming shift in policy stance.  As the CIC provides China with a more versatile but still effectively managed channel for recycling balance of payments inflows into outbound investments, the authorities appear to have found more comfort in reversing the directed outflows last year.

‘Hot money’ inflows to dwindle ahead
It appears that much of the policy-driven outflows over 2H05-2006 have been reversed.  Looking ahead, we expect that ‘hot money inflows’ observed in 1H07 would likely diminish, or even turn into outflows in late 2007 and 2008, as the CIC becomes fully functional and increases its outbound investments.

Policy-led capital flows still dominate, helping China to maintain some monetary policy independence
As we have argued in our previous reports (see Don’t Count on QDII to Affect Global Financial Markets, May 22, 2007), China is not yet ready for genuine capital account liberalization amid concerns over the soundness of its banking system, in our view.  We believe that policy-led capital flows will likely continue to play a significant role in the overall balance of payments, providing a cushion to the growing flows through the gradually relaxing private sector channels, such as overseas equity fund-raising, and outbound financial investments through the Qualified Domestic Institutional Investor (QDII) scheme.  The CIC is expected to be a key player in recycling inflows to outbound investments, and we believe that the government maintains the ultimate effective control over the pace of such recycling.

Having understood the role played by policy-led flows, we come to terms with the fact that despite the ongoing gradual liberalization of the capital account, Chinese authorities still maintain considerable influence over the overall BoP position, and hence monetary conditions.  In other words, the current system functions as though capital controls are still effective, helping to preserve a certain degree of monetary policy independence.  It follows that despite the relatively rigid exchange rate policy, China still enjoys some autonomy in setting interest rates for its currency.  In this context, the resistance towards faster currency appreciation should not be a hard constraint on lifting local interest rates, in our view. In fact, it is worth noting that the authorities have allowed both faster appreciation and some rise of domestic interest rates since this year.

To reiterate and conclude, we believe that the significant swings in capital flows observed in China’s balance of payments have been dominated by transactions by China’s residents, enterprises and financial institutions.  We disagree with the common view that foreign speculative capital plays a significant role in driving the domestic equity and property markets in China.  In the same vein, we do not subscribe to the notion that there has been a return of speculative ‘hot money’ inflows in 1H07, or that such flows could eventually force the Chinese authorities to give up their current strategy on the renminbi exchange rate.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in this report were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or JM Morgan Stanley Securities Private Limited and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

This research observes our conflict management policy, available at www.morganstanley.com/institutional/research/management_policies.html

Important Disclosures

This report does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, reports prepared by Morgan Stanley research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a company. Facts and views in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: This publication is distributed by Morgan Stanley & Co. International plc, Taipei Branch; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

This publication is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, this report, and any access to it, is intended only for "wholesale clients" within the meaning of the Australian Corporations Act.

Trademarks and service marks herein are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. This report or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities is available on request.