What happens when country A has a massive and growing current account surplus? The most natural thing to happen is that the people with responsibility for the surplus try to find reasonable rates of return for some of that surplus. If the surpluses are large, then, by definition, you have to find quite a deep, liquid pool of potential investment opportunities to bed that “hot money flow” down safely. The major industrialized countries, in particular the US, stand out as the obvious targets to explore.
In his speech to the G20, Federal Reserve Chairman Ben Bernanke explains his take on how capital inflows drove the crash:
“The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities. Remarkably, even though a large share of new U.S. mortgages during the housing boom were of weak credit quality, financial engineering resulted in the overwhelming share of private-label mortgage-related securities being rated AAA. The underlying contradiction was, of course, ultimately exposed, at great cost to financial stability and the global economy.”
Yes indeedy. It’s called the US subprime mortgage crisis and most of us know the main lines by heart, though I haven’t seen it phrased quite like this before – the helicopter view from helicopter Ben, perhaps. But Bernanke was not simply taking the G20 on a guided tour through well-known territory. He could have sent his audience to sleep in many other ways. This had a purpose. Bernanke’s key point was to highlight the fact that when one is talking about very substantial capital flows all searching for a better yield than can be offered by “safe” instruments such as long-dated US Treasuries, you may well run up against a systemic failure; i.e. that those you deal with will have insufficient expertise or ability to invest those flows with any degree of reliability or surety of touch.
The key part of Bernanke’s speech, it seems to me, is right there in his opening paragraph (you can’t accuse the man of not setting out his stall clearly!):
“...international capital flows have brought with them challenges for macroeconomic adjustment, financial stability, or both. Such challenges have tended to arise in two situations: first, when the "rules of the game" of the international monetary system - the policy responses that countries are expected to take to help foster a balanced global economy over time - are either poorly articulated or not observed by key countries; and second, when the financial systems of nations receiving strong capital inflows have not been up to the task of investing those inflows productively.”
What is actually being said here is pretty plain. China, though it is not mentioned, is clearly the target of the first part, as the country that is “not observing” the rules and not making the proper policy responses (i.e. allowing its currency to appreciate). The whole US financial services industry is the target of the second part. You messed up, guys. That too, of course, is pretty incontrovertible. As a major bank you can’t be in need of vast sums of taxpayer cash to bail you out and claim that you did OK.
One has to wonder though, whether any fund manager or set of fund managers has the capacity to absorb vast inflows successfully. The story of financial investment is full of tales of boutique funds who could do a stellar return on a fund size of $300 million but fell apart when their performance attracted much heavier funds inflows. The problem with scaling up is that it becomes harder and harder, and ultimately impossible, to outperform the market beta. And, of course, if the GDP of the country starts to tank, everything tanks. The resultant volatility even bombs out the short positions, and besides, there are very real limits to how much money any short position can handle (or would want to!).
Initially, Bernanke pointed out, as with the Asian Tiger economies, money pours into the country in a highly uncritical way, buoyed up on tides of investor optimism. But then over time a more careful and considered scrutiny of investment performance shows that those involved, for any of a variety of reasons, be it institutional weaknesses or inadequate regulation, have not managed to channel the surge of incoming funds into productive investments. And then the outflow begins, leaving carnage behind. “The Asian crisis imposed heavy costs in terms of financial and macroeconomic instability in the affected countries...” Bernanke noted.
Much of the rest of the speech was a restatement of Bernanke’s well known thesis, that the root cause of the 2008 smash was the global savings glut:
"... many emerging market economies have run large, sustained current account surpluses and thus have become exporters of capital to the advanced economies, especially the United States. These inflows exacerbated the US current account deficit [and drove down interest rates, prompting the mad hunt for higher yield, and preparing the ground for the subprime mortgage crisis]."
Bernanke goes to some trouble in his speech to outline “the portfolio preferences” of external investors, beginning with the obvious assumption that there will be a huge preference for “very safe and liquid US assets”, namely Treasury and agency securities. Again, however, this simply depressed yields still further and pushed yet more money off into the search for higher and more risky yields. With everyone chasing risk, the premium that could be demanded for investing in risk fell and fell, as did the reward, until in the end people were buying junk as if it was gold bars and inevitably, the roof fell in. How it happened goes back to US regulatory failures and “misaligned incentives” in underwriting and securitization, and so on. But what all this boils down to is that no one, anywhere, has the perfect formula for taking truly huge volumes of capital inflows and delivering alpha returns on such flows.
What is needed, Bernanke suggests, is “to reshape the international monetary system to foster strong sustainable growth and improve economic outcomes for all nations.” What does this mean, if it is not meant to be a recipe for unicorn pie (step one, catch your unicorn...)? It means China letting its currency float to the “natural” level against the dollar, he hints. Well, Ben, that is not going to happen any way other than very, very gradually, and guess what? Those capital surges are building up all over again and no one has got any closer to an answer as to how to invest them “safely”, while still generating an acceptable return.
Further information on the global economy and market crises:
- Dodd-Frank Act won't prevent future crises, by Ian Fraser
- Navigating a liquidity crisis effectively, by Klaus Kremers
- Banking Transparency and the Robustness of the Banking System, by Solomon Tadesse
- Understanding and Forecasting the Credit Cycle—Why the Mainstream Paradigm in Economics and Finance Collapsed, by Richard Werner
Tags: Asian crash , Asian economies , Ben Bernanke , capital flows , China , currency appreciation , Federal Reserve , sub prime fiasco , subprime mortgages