Day and Knight
August 21, 2007
By
Serhan Cevik and Katerina Kalcheva | London
The days of abundant liquidity turned into a Knightian uncertainty for financial markets. Frank Knight knew in 1921 what the world’s most sophisticated mathematical models could not capture today. That is, there is a fine line between risk with mathematical probabilities and uncertainty that cannot be measured. Although investors have no difficulty in pricing all sorts of risks, the “immeasurable” uncertainty and information asymmetries make them shy away from all forms of risk, especially in times of global anxiety. In our view, this is exactly what has happened in the past couple of weeks in financial markets, as credit risks linked to the US subprime-mortgage market spread out (through highly leveraged derivatives and structured instruments) and triggered a volatility wave across the world. Facing such an immeasurable uncertainty about underlying credit quality and counterparty risks, investors stopped lending to each other and started reducing risk in an indiscriminate fashion. The question is whether greater uncertainty and higher volatility in the financial sphere will spread into the global economy. The US Federal Reserve certainly seems to think so, cutting the discount rate by 50 bp in an attempt to restore order in money markets and limit the fallout on real economic activity.
Downside risks to growth in the US economy could threaten the rest of the world. The correction in the housing market has brought a gradual slowdown in America’s real GDP growth, from 3.1% in 2005 to 2.9% in 2006 and, according to our estimates, to 1.9% this year. However, the liquidity squeeze and financial de-leveraging could prolong the housing slump and become a drag on overall economic growth. Our chief US economist, Richard Berner, thinks that higher borrowing costs and tighter credit conditions could potentially lower growth from an annualised rate of 2.6% over the next five quarters to about 1.75% this year and 2% in 2008. What would be the implications for the rest of the global economy? The US slowdown has had little effect so far on growth in other parts of the world. But this is not because other countries are less dependent on the US economy. If anything, global business cycles have become more synchronised in recent years. In our view, there are two key reasons behind the muted, almost immaterial effect on the world economy. First, the US slowdown has been limited to the housing market and related sectors. Second, market liquidity remained abundant, thanks to financial innovation and the recycling of current account surpluses. However, the turmoil in financial markets now threatens these support channels as well as a broader spectrum of economic sectors. Therefore, even though domestic and intra-regional factors should minimise the knock-on effects on the global economy, the deepening of economic troubles in America could still have unexpected spillovers.
The indirect effects of greater uncertainty and higher volatility are more important in today’s world. Tracking the transmission of economic shocks from one country to others used to be straightforward when trade linkages were the main channel of contagion. For example, countries with greater trade exposure to the US and/or commodity markets tend to have highly synchronized business cycles. However, with increasing globalisation, cross-border financial links have also become an important source of transmission across the world. As a result, although direct effects of the liquidity squeeze may remain small, we should not ignore the indirect effects of greater uncertainty and higher volatility in global financial markets. In other words, market dislocations and growth fluctuations can now spread through an intertwined set of financial and economic channels that could magnify the shock. Let us start with the synchronisation of business cycles. Our calculations show that countries in the Middle East and North Africa have experienced a significant increase in bilateral growth correlation with the US. This partly reflects the global boom that pushed oil prices from $25 in 2002 to $65.8 this year. But the trade channel is just a part of the story. With the windfall reaching over $1.5 trillion, oil-exporting economies have embarked on a global ‘shopping spree’ and accumulated foreign assets at an average rate of 2% of global GDP a year since 2000 (see Pumping Money, May 22, 2007). In turn, the recycling of current account surpluses supported the expansion of market liquidity and limited the net burden of higher oil prices on the global economy. However, greater interdependence makes this ‘virtuous’ cycle susceptible to a synchronised slowdown in the global economy.
A marked drop in oil prices would lead to slower growth in the Middle East. According to our computations, Middle Eastern economies have become more integrated with the US business cycle. For example, growth correlation coefficients of Saudi Arabia and the United Arab Emirates vis-à-vis the US economy increased from -0.66 and -0.01, respectively, in the 1990s to 0.68 and 0.76 in the past six years. Globalisation may have played a role, but the most important factor is still oil dependency, in our view. Export revenues in the Gulf region soared from $154 billion a year between 1998 and 2002 to $507 billion last year. However, since commodity markets are levered to global growth, the recent turmoil already lowered oil prices from $75.4 in July to below $70 last week. With further downside risks, we think that oil prices could fall to an average of $57.2 in 2008. Albeit still above the breakeven price of around $38 in the Gulf, that would lead to a slowdown in output growth from 6.5% this year to around 5% in 2008. Furthermore, a prolonged correction in financial markets would also have a negative wealth effect on oil-rich countries, given the size of their foreign holdings. But is this enough to result in a dramatic slowdown in the Middle East? We certainly do not think so. The accumulated savings and the pipeline of investment projects provide a cushion against temporary setbacks in the global economy. However, we should note that possible changes in the behaviour of petrodollar liquidity would also have repercussions for asset markets.
Israel is the most vulnerable country to a major slowdown in the US. With almost 40% of exports going to America, the Israeli economy is highly exposed to what happens in the US. Indeed, its growth correlation with the US economy increased from -0.15 in the 1990s to 0.76 between 2001 and last year. For the time being, our projections point to real GDP growth at about 6% this year and 5.5% in 2008. However, a significant weakening in the US would lower growth in Israel through the trade channel, limited access to capital markets for start-up companies and the negative wealth effect. Given our US economics team’s alternative scenario, we would expect real GDP growth in Israel to be 5.6% in 2007 and about 4.5% next year. The limited fallout on the rest of the world and the strength of domestic demand should prevent a more dramatic deterioration in growth outlook. In such a scenario, the Bank of Israel would limit its tightening campaign to 4.50-4.75%, keeping inflation within the target range. Since we think the shekel is fundamentally undervalued, we see no reason for sustained depreciation.
Turkey’s vulnerability comes from its exposure to liquidity-driven capital flows. Exports to the US account for less than 5% of the total and therefore Turkey has negligible direct exposure to a slowdown in the US economy. Nevertheless, its growth correlation with the US showed a curious increase from -0.16 in the 1990s to 0.71 in the last six years. In our view, this is a reflection of Turkey’s greater integration with the global economy and exposure to liquidity-driven capital flows. Therefore, although the Turkish economy would not suffer much from a temporary slowdown, the unwinding of carry trades would hit it through the financial channel. In turn, we would expect real GDP growth to stay around 5.5% (instead of surging to above 8%) next year, as tighter credit conditions slow the pace of recovery in domestic demand. On a positive note, that would help narrowing the current account deficit and keeping disinflation on track.
A Theoretically Bold Move Toward ‘Managed Capital Account Liberalization’
August 21, 2007
By
Qing Wang | Hong Kong
China’s SAFE announced on Monday, August 20, that retail investors will be allowed to invest in the Hong Kong market directly through brokerage accounts opened with the Bank of China (BOC). The openings will be managed by the BOC branch in Tianjin, a coastal city in northern China chosen to run several pilot programs for financial liberalization. BOC branches across the country can participate after signing agreements with the Tianjin branch. Retail investors who invest through this particular program are not subject to the $50,000 annual cap that is currently imposed on individual Chinese residents.
This is a theoretically bold move by the authorities to move toward ‘managed capital account liberalization’. The main purpose is to facilitate FX outflows to ease domestic excess liquidity and the pressures on Renminbi appreciation. In practice, while we do not expect this policy initiative will be able to induce a sufficiently large amount of FX outflows as to help achieve these objectives in the foreseeable future, the ‘forced Hong Kong-bias’ under this new policy will have a significant and positive impact on the HK market, especially the H-share stocks. It will also help perpetuate the excess liquidity situation in Hong Kong, as represented by the wide Libor-Hibor spread, and thus should be positive for interest-rate sensitive sectors (e.g. property), in my view. The impact on the domestic A-share market should, ceteris paribus, be negative.
This policy announcement will likely attract more funds into the HK market, first from other offshore investors – who attempt to front run China-based investors – and then from China-based retail investors themselves. The implications for global markets will, however, be rather limited, because we believe China is not yet ready for genuine capital account liberalization until the soundness of the domestic banking system is fully secured
Opens H-shares to domestic retail investors
Retail investors who participate in this new program are not subject to the $50,000 annual cap that is currently imposed on individual Chinese residents who want to purchase FX with their Renminbi cash for other purposes (e.g., remittances, overseas travel, off shore investment through the QDII program). This is a theoretically quite bold move, in our view. For example, if a Chinese billionaire wants to invest RMB1 bn cash into the HK market, he/she can do it with no restrictions under this new program.
In practice, the requirement to only invest in the HK market will likely make this program less attractive to those investors who want to diversify their assets geographically on a global basis. On the other hand, for many domestic retail investors, this program provides an opportunity to buy H-share stocks that are not available in the domestic A-share market and/or are now traded at a significant discount to their A-share counterparts for those dual-listed companies. To be able to buy individual stocks in HK market directly should also make this program superior to collective investment programs such as the QDII, whose investment track record has yet to be proven.
SAFE considers this new policy as a pilot program “to help gain experiences to be prepared for further expansion of the individuals’ direct investment in offshore securities market in the future.”
Potentially large positive impact on Hong Kong market
The ‘forced Hong Kong-bias’ under this new policy will have significant and positive impact on HK market, especially the H-share stocks, in my view. For those ‘value investors’ in China, investing in the HK market – especially the H-share stocks – appears to offer an absolute advantage in view of the more reasonable valuation, better regulatory supervision, favourable dividend distribution practice, and hedge against Renminbi appreciation (if investing in H-shares). On the other hand, for those ‘speculative investors’, investing in the HK market is less attractive, because the excess liquidity and excess demand for investable financial assets play that has underpinned the extraordinary performance for some A-share stocks simply does not exist in HK market, which is fully integrated with the rest of the global markets.
For those ‘value investors’ in China, investing in the HK market-–-especially the H-share stocks – appears to offer an absolute advantage…On the other hand, for those ‘speculative investors’, investing in the HK market is less attractive… |
Another channel through which this new investment program will likely impact Hong Kong is market interest rates. As more funds from mainland China enter the HK market, the excess liquidity situation in Hong Kong – as represented by the wide Libor-Hibor spread – will likely persist. The low interest environment should be supportive to interest-rate sensitive sectors (e.g. property), in my view.
Moderately negative impact on A-share market
The impact of this new policy on the domestic A-share market should, ceteris paribus, be moderately negative. Funds outflows under this new individual investment program will help ease the excess liquidity and excess demand for investable financial assets. Some investors will likely choose to liquidate their holdings of A-share stocks to invest in H-share or other stocks in the HK market.
However, since the primary source of liquidity creation is FX supply from large trade surpluses, which average about $20bn per month, it is unlikely FX outflows under this new program would be large enough to offset FX inflows stemming from trade surpluses. This suggests that the excess liquidity situation – which underpins the strong A-share market performance — is unlikely to change. For the same reason, we do not expect appreciation pressures on the Renminbi to ease either, as a result of this policy change.
Limited impact on the global markets
If China lifts its capital account controls completely, the impact on global markets should be very significant, given the large amount of savings by Chinese investors, their pent-up demand for high-quality investable financial assets and the desire for geographical diversification of investment.
We, however, believe that liberalization of China’s capital account is bound to be gradual and that the pace will hinge on the improvement in the soundness of its domestic banking system. Until Chinese authorities can be sure that the banks operate on a truly commercial basis and exercise effective control over the new generation of non-performing loans, we do not believe China is ready for genuine (private sector-led) capital account liberalization.
This theoretically bold move is still a pilot program. If significant funds were to flow out of China under this program – which we do not envisage happening in the first place – so that it may threaten the stability of the banking system, the authorities may reintroduce restrictions to stem FX outflows. We therefore argue that high expectations for substantial relaxation in private sector-led capital outflows like under this new investment program are unjustified. The impact of this policy change on global markets will be rather limited, in my view. I suggest that investors should instead watch for more government-led initiatives for ‘capital outflows’, such as the planned establishment of China Investment Company.