Paul Donovan, London
Whenever economists gather together, sooner or later the conversation will inevitably turn to what is politely referred to as the problem of "global imbalances". This is the fact that the United States is running an extraordinarily large current account deficit, and the rest of the world is (by definition) running an extraordinarily large current account surplus.
It is a fact of economics (one of the very few incontrovertible facts) that a balance of payments position must balance out -- so the U.S. current account deficit requires an equivalent capital inflow to finance it. Today that flow amounts to something in excess of US$1.5 million dollars every minute, every day (including weekends).
The scale of the imbalance, and the stresses that it places on the global economy, are well known. America is spending more than it can afford to spend in the long run, and the rest of the world is denying itself the better standard of living it could otherwise enjoy.
Eventually, the imbalance will resolve (and economists hope that it will be resolved in a relatively smooth manner). In the meantime, the weight of the current account deficit means -- whatever the new U.S. Treasury Secretary may protest to the contrary -- that the U.S. dollar is a structurally weak currency.
For the last few years, the principle creditor in the balance sheet of global imbalances has been Asia. Thus the task of funding the U.S. current account deficit has fallen to Asian investors.
Asia has obliged by funding the U.S. current account deficit through foreign exchange market intervention (including that intervention conducted by Indonesia) -- and, indeed, around 40 percent of the U.S. current account deficit (or approximately $553,000 per minute) has been financed through Asian central bank action in the foreign exchange markets.
This year, Asia is unlikely to stay the largest creditor bloc. Asia's replacement as the principle creditor is, inevitably, the oil exporters of the world. With oil prices pushed up by a combination of political risk, supply constraints and strong demand, oil revenue (petrodollars) have been accumulated by oil exporters at a far faster pace than they can spend them. Their current account surpluses have grown, and (partly because of oil imports) the current account surpluses of Asia have moved off their recent peaks.
Why does this geographic shift matter? The geography itself is not that important, but this is about more than location; it is also about the institutions that move money around the world economy. While Asian current account surpluses have effectively been managed by the actions of central banks, this is not the case with the oil exporters.
OPEC countries' central banks intervention in the foreign exchange markets has accounted for less than 10 percent of the U.S. current account surplus in the immediate past. Oil exporters' current account surpluses are far more likely to be recycled by the private sector than has been the case with the current accounts of Asia.
Thus, the change in the current account creditor countries that we have seen emerge this year means that we are also witnessing a shift in the institutional management of money around the world -- away from (Asian) central banks and towards (oil exporters') private investors.
Generally speaking, central banks are more constrained in their investment choices than are private individuals. The (very strong) bias of central banks is to invest foreign exchange reserves into government fixed income assets -- and in the current environment that means U.S. Treasuries.
Private investors, of course, can invest wherever they chose. Thus, as Asian central bank's surrender their role to private sector investors, we are likely to see an asset allocation shift away from fixed income and towards other asset classes like equities and real estate.
The damage for U.S. fixed income markets may be mitigated -- particularly if the Federal Reserve cuts rates more aggressively in 2007 than investors currently expect. The problem for investors is trying to balance the different forces that are at work.
Certainly if current international investment trends continue, it suggests that the drop in U.S. Treasury bond yields will be less aggressive than the Federal Reserve's easing cycle might otherwise suggest. In a risk case scenario, if oil prices rise significantly the shift away from central banks and towards private investors would accelerate, and U.S. bond yields could even rise.
Large global shifts like the move from Asian to oil exporter funding of the U.S. current account position are difficult to interpret at a local economic level. Certainly, the move suggests further dollar weakness lies ahead.
This general dollar weakness is likely to offset the effects on the Rupiah of rising Indonesian import demand and a shifting interest rate differential (if, as I expect, Indonesian interest rates fall earlier and faster than those of the United States).
For fixed income markets the position is more unclear. U.S. Treasury yields should still fall as investors anticipate Federal Reserve easing -- but they are unlikely to decline to the low levels that we saw a few years ago, as shifts in international investment flows limit the decline. Indonesia's bond yields remain sensitive to oil prices, (because of concerns about local inflation pressures and government subsidies).
Thus a significant increase in the oil price could produce a double pressure for Indonesian bonds -- rising rates on domestic concerns, against an international backdrop where asset allocation shifts are exaggerated and Treasury yields fall less than is currently anticipated.
The writer is Deputy Head of Global Economics, UBS Investment Bank. He can be reached at paul.donovan@ubs.com.
Whenever economists gather together, sooner or later the conversation will inevitably turn to what is politely referred to as the problem of "global imbalances". This is the fact that the United States is running an extraordinarily large current account deficit, and the rest of the world is (by definition) running an extraordinarily large current account surplus.
It is a fact of economics (one of the very few incontrovertible facts) that a balance of payments position must balance out -- so the U.S. current account deficit requires an equivalent capital inflow to finance it. Today that flow amounts to something in excess of US$1.5 million dollars every minute, every day (including weekends).
The scale of the imbalance, and the stresses that it places on the global economy, are well known. America is spending more than it can afford to spend in the long run, and the rest of the world is denying itself the better standard of living it could otherwise enjoy.
Eventually, the imbalance will resolve (and economists hope that it will be resolved in a relatively smooth manner). In the meantime, the weight of the current account deficit means -- whatever the new U.S. Treasury Secretary may protest to the contrary -- that the U.S. dollar is a structurally weak currency.
For the last few years, the principle creditor in the balance sheet of global imbalances has been Asia. Thus the task of funding the U.S. current account deficit has fallen to Asian investors.
Asia has obliged by funding the U.S. current account deficit through foreign exchange market intervention (including that intervention conducted by Indonesia) -- and, indeed, around 40 percent of the U.S. current account deficit (or approximately $553,000 per minute) has been financed through Asian central bank action in the foreign exchange markets.
This year, Asia is unlikely to stay the largest creditor bloc. Asia's replacement as the principle creditor is, inevitably, the oil exporters of the world. With oil prices pushed up by a combination of political risk, supply constraints and strong demand, oil revenue (petrodollars) have been accumulated by oil exporters at a far faster pace than they can spend them. Their current account surpluses have grown, and (partly because of oil imports) the current account surpluses of Asia have moved off their recent peaks.
Why does this geographic shift matter? The geography itself is not that important, but this is about more than location; it is also about the institutions that move money around the world economy. While Asian current account surpluses have effectively been managed by the actions of central banks, this is not the case with the oil exporters.
OPEC countries' central banks intervention in the foreign exchange markets has accounted for less than 10 percent of the U.S. current account surplus in the immediate past. Oil exporters' current account surpluses are far more likely to be recycled by the private sector than has been the case with the current accounts of Asia.
Thus, the change in the current account creditor countries that we have seen emerge this year means that we are also witnessing a shift in the institutional management of money around the world -- away from (Asian) central banks and towards (oil exporters') private investors.
Generally speaking, central banks are more constrained in their investment choices than are private individuals. The (very strong) bias of central banks is to invest foreign exchange reserves into government fixed income assets -- and in the current environment that means U.S. Treasuries.
Private investors, of course, can invest wherever they chose. Thus, as Asian central bank's surrender their role to private sector investors, we are likely to see an asset allocation shift away from fixed income and towards other asset classes like equities and real estate.
The damage for U.S. fixed income markets may be mitigated -- particularly if the Federal Reserve cuts rates more aggressively in 2007 than investors currently expect. The problem for investors is trying to balance the different forces that are at work.
Certainly if current international investment trends continue, it suggests that the drop in U.S. Treasury bond yields will be less aggressive than the Federal Reserve's easing cycle might otherwise suggest. In a risk case scenario, if oil prices rise significantly the shift away from central banks and towards private investors would accelerate, and U.S. bond yields could even rise.
Large global shifts like the move from Asian to oil exporter funding of the U.S. current account position are difficult to interpret at a local economic level. Certainly, the move suggests further dollar weakness lies ahead.
This general dollar weakness is likely to offset the effects on the Rupiah of rising Indonesian import demand and a shifting interest rate differential (if, as I expect, Indonesian interest rates fall earlier and faster than those of the United States).
For fixed income markets the position is more unclear. U.S. Treasury yields should still fall as investors anticipate Federal Reserve easing -- but they are unlikely to decline to the low levels that we saw a few years ago, as shifts in international investment flows limit the decline. Indonesia's bond yields remain sensitive to oil prices, (because of concerns about local inflation pressures and government subsidies).
Thus a significant increase in the oil price could produce a double pressure for Indonesian bonds -- rising rates on domestic concerns, against an international backdrop where asset allocation shifts are exaggerated and Treasury yields fall less than is currently anticipated.
The writer is Deputy Head of Global Economics, UBS Investment Bank. He can be reached at paul.donovan@ubs.com.
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