Currencies
A Fundamental and Critical Reconsideration of EM
November 10, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

We remain concerned about downside risks to EM currencies.  Not only will the powerful prospective cyclical downturn in the global economy be a major shock to EM economies and currencies, but we also believe that there are structural reasons for investors to be less enthusiastic about many EM currencies beyond this impending global recession. 

In this note, we argue that the outsized US C/A deficits in recent years have helped flatter the C/A surpluses of many emerging economies, especially those in Asia.  At the same time, such an extraordinary boost to demand for Asian exports may have also contributed to the strong commodity cycle witnessed in the past two years. 

If, however, the reversal in the US credit cycle persists, the US C/A deficit should also decline, dragging down the C/A surpluses of many EM economies and their demand for commodities.  But since exports and commodities have been two powerful engines of growth for EM, we suspect that potential growth for many EM economies, in the new ‘steady state’, should be lower than it was before the financial turmoil. 

Thus, while some investors may see the current sell-off in EM assets, including currencies, as a temporary shock, and that EM currencies and economies will eventually return to ‘normal’, we argue that the new ‘norm’ – while it may still be impressive – will likely be more tempered than the old ‘norm’.

US Private Savings Rate Is Rising Sharply

In a note we issued on November 15, 2007 (To Gisele and Jay-Z: US ‘Twin Deficits’ Are Shrinking), we pointed out that the dominant driver of the US C/A deficits has been the US personal savings rate.  Until recently, it had been in a secular decline since the mid-1980s.  In trying to determine the key drivers of this variable, we found that three factors – (i) US net housing wealth, as a percentage of disposable income, (ii) US net equity wealth, as a percentage of disposable income and (iii) the long bond interest rate – explain 83% of the movements in the US private savings rate.  Of these three variables, the most powerful driver is US net housing wealth, which had been in sharp decline for four quarters. 

After remaining close to zero from 2005-07, the US private savings rate surged sharply from 0.1% in 1Q08 to 2.7% in 2Q08 – a level last seen six years ago in 2Q02. 

This sharp recovery in the US private savings rate was predicted by our three-variable model.  In fact, based on what we know about the determinant variables, the US savings rate could rise to 5.7% by end-2009 – a level last seen more than a decade ago, in 1997. 

Implications for the Global Economy

We believe that the US C/A cycle has powered several trends in the global economy in the past years.  Normalisation of the US C/A balance will also have important implications for the world, in our view. 

•           Implication 1.  Smaller US C/A deficits will lead to lower C/A surpluses in EM.  Since 2000, the NPV of the cumulative C/A deficits of the US totaled some US$6.0 trillion.  This figure is on the same order magnitude of the total world’s official reserves of US$7.2 trillion.  While we are not arguing that all of the world’s official reserves have resulted from the US net external deficits, we believe that the rest of the world’s (RoW) official reserve positions would not have been nearly as large as they are had it not been for the US C/A deficits.  But if the US C/A deficits have been a result of the low private savings rates, which in turn was related to the housing bubble, then it is reasonable to ask what the RoW’s official reserves and export growth would have looked like in the absence of this US housing bubble.  Alternatively, instead of thinking about this ‘counterfactual’ of what would have happened in the absence of the US housing bubble, the possibility that the US private savings rate could be moving back to 5.7%, from close to zero in 2007, should have major implications for the outlook of the RoW’s C/A surpluses.  Investors should, in our view, seriously consider the scenario of a sharp compression of the trade and C/A surpluses of Asian countries in the years ahead.  This compression could be as high as 30-50% of GDP over the coming years.  Such a development is not positive for the currencies of export-oriented EM economies, unless EM economies succeed in developing their domestic demand as the new engine of growth.  We illustrate how dependent the C/A surpluses of some EM economies have been on the US C/A deficits. 

•           Implication 2.  EM’s potential growth could be slower than many may think.  Many EM economies have continued to be export-oriented, with domestic demand not being nearly as robust and reliable an engine of growth as many would like it to be.  More than a cyclical shock, if the compression in their C/A surpluses is as much structural as it is cyclical – as we suggest above, the potential growth rate of EM economies may be lower than many may believe, based on the recent growth performance, and assuming under-developed domestic demand.  We do not know what this new potential growth rate might be, but we suspect that it is lower than the average growth rate since 2000. 

•           Implication 3.  The global commodity cycle probably would not have been so powerful had it not been for the US credit/housing cycle.   To the extent that the commodity super-cycle we’ve witnessed in the recent years was propelled primarily by the outsized demand growth in some EM economies, pushing supply to its capacity, investors’ expectations of commodity prices should also be tempered. 

•           Implication 4.  The US C/A deficit could be compressed more sharply than some may think.  ‘Completing the circle’, with risks to US growth biased to the downside, and the private savings rate on the rise, two opposing forces will impinge on the dollar in the quarters ahead.  On the negative side, while the US may be ‘first-in-first-out’ – if it leads the world’s recovery in terms of timing – two or three quarters from now, the US recovery is unlikely to show too much vigour, in our view, because of the rising private savings rate.  We do not expect fiscal stimulus to fully offset the structural change in US private savings behaviour.  A tepid US economic recovery could put the dollar back onto the back-foot when the RoW starts to recover.  On the other hand, the sharply lower US C/A deficit – if it materialises – should be positive for the dollar.  Our own guess is that, in assessing these two opposing forces, investors are likely to emphasise relative growth, in the recovery phase, rather than rewarding the USD for its shrinking C/A deficit.  This notion underpins our view that the prospective further USD rally will be ‘front-loaded’ in that the dollar is likely to appreciate as the world falls into a deep recession (up high on the left side of the ‘Dollar Smile’).  However, when the world recovers several quarters from now, the US will likely lag behind other countries and the USD will give back some of the gains (the world slides into the trough of the Dollar Smile). 

The Past Seven Years, and the Coming Seven Years…

It is important to think about how the ‘general equilibrium’ of the global economy will change, as the US credit cycle reverses.  The powerful trends witnessed in the past seven years – (i) extraordinary global growth, (ii) outsized US C/A deficits, (iii) large C/A surpluses of some EM economies, (iv) rapid official reserve growth, (v) the rapid rise of EM, (vi) commodity super-cycle and (vii) the weak dollar – will likely not be repeated in the coming seven months, possibly seven years.  The key point for EM is that, while the structural EM story remains broadly compelling, it may have been grossly exaggerated in parts, and that some EM economies have prospered on the back of the US housing/credit cycle, and not on policy efforts of their own.  Financial markets are in the process of sorting out the ‘good’ from the ‘bad’ within EM. 

Bottom Line

The world is inter-connected, not just cyclically but also structurally.  We believe that the outsized US C/A deficits in recent years (totaling US$6.0 trillion since 2000) have powered a good part of the rise of EM.  There are signs that the US C/A deficit may shrink sharply as its private savings rate rises in the coming years.  This will reverse many of the trends we’ve witnessed in the past seven years, and expose the EM economies that rose more on the back of the US credit/housing/current account cycle than on efforts of their own.  More than a cyclical shock, investors may want to have a fundamental, comprehensive and critical reconsideration of their structural thesis on EM, if we indeed see structural changes in the US.

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Currencies
SWFs: Growth Tempered – US$10 Trillion by 2015
November 10, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

A lot has happened this year; even some SWFs may have been adversely affected by the market developments.  Many of the SWFs may have sustained paper losses on their investments, just like most private institutional funds.  In addition, with the US financial turmoil having infected most EM economies, there are now rising domestic needs for SWFs to help deal with.  Thus, lower oil prices, lower export growth rates, capital flight that has drained official reserves and new domestic fiscal needs may lead to a less rapid pace of asset accumulation for SWFs. 

We still believe that SWFs will be a very powerful source of demand for risky assets in the coming years, but now believe that the expected growth rate of their assets under management (AUM) will need to be revised down. 

In How Big Could SWFs Be by 2015? May 3, 2007, we argued that AUM of SWFs could surpass the world’s total official reserves by 2011.  We now believe that this ‘cross-over’ date may be delayed by three years and that, by 2015, instead of US$11.9 trillion, total AUM of SWFs of US$9.7 trillion now looks like a more realistic target. 

Paper Losses That May Have Been Incurred by SWFs

We do not have specific information on SWFs’ AUM or their portfolio structure, either by assets or geography.  We certainly don’t have precise information on the portfolio structure of any specific SWF, with the exception of the NBIM.  But, in thinking about the entire category of SWFs, our guess is that the group may have incurred paper losses – in USD terms – on the order of 25% so far this year.  This means that, on a base of US$3.0 trillion in AUM at the beginning of the year, total AUM by SWFs may now be US$2.3 trillion.   (Between end-October 2007 and end-October 2008, the MSCI global equities index has declined by 41%, and the MSCI EM equities index has shed 57% in value.  We also computed the valuation changes in the various bond markets, and assumed that alternative investments (including hedge funds, real estate, commodities, infrastructure, etc.) registered a similar performance to equities.  We also considered the rally in the dollar, and how that might have further eroded the dollar value of the portfolios of the SWFs, most of whom consider the US dollar as the accounting currency.  The outcome of our calculation suggests that SWFs, with a portfolio structure having the 25:45:30 split over bonds, equities and alternative investments, may have suffered total paper losses of 23-35%.  Considering possible evasive action taken, total paper losses could, on average, be 20-30%.)   Some of these losses will be recovered if the prices of the underlying assets recover.  Also, part of the decline in asset value reflected the strong rally in the USD, which is a trend that could reverse (not our central case, but it is a legitimate possibility). 

Slower Incremental Growth of AUM of SWFs

There are several reasons to expect that the pace of the increase in the AUM of SWFs may decline somewhat in the coming years.  We highlight the following key trends:

1.         Lower oil prices.   The impact of lower global demand on oil prices, and in turn on oil-based SWFs, is clear.  The daily oil exports of GCC countries are around 18 million barrels.  At US$140 a barrel, this translates to US$2.5 billion in oil export revenues per day.  But at US$70 a barrel, this number falls to US$1.3 billion a day. 

2.         Lower EM export growth.   During 2007, the official reserves of Asian economies grew from US$3.1 trillion to US$3.8 trillion – implying an average growth rate of US$64 billion a month.  More modest C/A surpluses and capital inflows will undermine official reserve growth, and therefore the amount of foreign exchange that is diverted to the SWFs. 

3.         Need to replenish depleted official reserves.   Excluding Japan and China, Asia’s official reserves growth has slowed dramatically.  Without discussing the profile of official reserve growth for individual central banks, we note that interventions to counter capital outflows have had their logical impact on official reserves.  What had appeared to be overly abundant reserve holdings suddenly looked not that abundant in the face of significant currency pressure.  There is likely going to be a reconsideration of what constitutes adequate reserves.  (A related topic of discussion is the currency composition of reserves.  While some central banks may have diversified their reserve holdings, away from dollars, they have recently been reminded that having adequate liquidity in the intervention currency – the US dollar – is critical, i.e., not only the share of the reserves that is held in non-dollars but also the underlying USD asset holdings will likely be re-considered going forward.)  At a minimum, part of the reserves used for interventions may need to be replenished.

4.         Help fund domestic fiscal operations.  While it may still be unclear how large the fiscal operations will need to be in the SWF countries, it is clear that fiscal policy will play a critical role in this impending global recession.  Pressures could mount for governments to consider utilising some of the resources now managed by SWFs.  As the global financial turmoil has infected the economies of the SWFs, SWFs are now more likely to help deal with the problems in their own backyards, before looking overseas for opportunities.

Revised Medium-Term Trajectory of AUM for SWFs

In the note we issued in May 2007, we suggested that total AUM by SWFs could reach US$11.9 trillion by 2015.  Given the significant changes in the macroeconomic and financial market landscape, we have updated our calculations.  The most significant change is our assumption on how rapidly the US C/A deficit will be compressed over time.  We are also reducing the current AUM of SWFs by 12.5% to US$2.6 trillion to reflect half of the paper losses that SWFs may have incurred.  The implicit assumption is that, over time, SWFs could recuperate half of the paper losses.  For 2009, we are assuming a contraction in oil revenues and export surpluses of Asian countries.  There will be a recovery in both oil exports and merchandise exports by the SWF countries beyond 2010, albeit at a more tempered pace.  The rate of return on investments is trimmed to 3.5%, instead of 5.5%.  (Another source of change is that the world’s official reserves have grown dramatically since we wrote our first note on this subject in May 2007.  Thus, the starting point of our calculations is much higher for the world’s official reserves.)  

We illustrate how we have revised our view of the likely trajectory of AUM of SWFs in the coming years.  First, total AUM of SWFs is now expected to reach US$9.7 trillion by 2015, compared to US$11.9 trillion in our previous forecasts.  Second, the ‘cross-over’ point when the AUM of SWFs is expected to exceed the world’s total official reserve holdings is now 2014, compared to 2011 previously.  Third, the relative size of oil-based and non-oil based SWFs will now swing in favour of the former, relative to our previous forecasts.  This reflects our view that a sharp compression in the US C/A deficit will have logical consequences for export-oriented economies in the world.  (Our calculations assume more reserve losses in 2009, as EM central banks continue to defend their currencies.  As the world normalises in 2010, there will likely be a move to replenish official reserves, before funds are diverted to SWFs.) 

SWFs Will Still Be a Major Support for Risky Assets

We have not changed our view on this thesis that SWFs will remain a major source of support for risky assets.  Their preference for equities over bonds reflects their DNA make-up, since they were created to move out on the risk-return curve.  This part of the thesis will not change.  Further, SWFs’ greater capacity to express long-term views – due to their superior liquidity/lack of leverage characteristic – should continue to permit them to capitalise on opportunities that private institutional funds may find too illiquid.  Moreover, the structural conversion of wealth by oil-based SWFs from underground real wealth (oil) to above-growth financial wealth will certainly continue, for all the reasons we’ve put forward in the past. 

But New Questions Have Arisen Due to the Crisis

Without legal protection, the SWFs of some countries will remain prime sources for extraordinary fiscal operations.  Bailing out of banks and financial institutions and other ‘one-off’ but large fiscal operations could lead to SWFs being forced to slow down the pace of their investments, or, in extreme cases, liquidate parts of their portfolios.  Before the global financial turmoil, we had been of the view that SWFs would almost certainly be a source of support for risky assets.  But now that the financial turmoil has turned truly global, we can no longer rule out some SWFs becoming sellers of risky assets. 

There is also the question of the ‘model portfolio’ of SWFs.  Now that we have witnessed sharp breakages in the trends of all asset classes, it will be interesting to see if SWFs – and other institutional funds – will reconsider their long-term investment strategies. 

Bottom Line

Back in May 2007, we projected that total AUM of SWFs may grow to US$12 trillion by 2015.  We now believe that US$10 trillion may be a more reasonable target, in light of (i) the paper losses that SWFs may have suffered this year; (ii) lower oil prices and a possible compression in the US C/A deficit; (iii) the need to replenish official reserves; and (iv) meaningful risks of SWFs being called upon to finance extraordinary fiscal operations.  We still maintain the thesis that SWFs will be a source of support for risky assets.  However, we need to acknowledge that SWFs’ firepower may have been constrained somewhat.

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