What Drives Global Capital Flows?: Myth, Speculation and Currency Diplomacy

What Drives Global Capital Flows? Myth, Speculation, and Currency Diplomacy

Brendan Brown

What Drives Global Capital Flows?

Also by Brendan Brown EURO ON TRIAL THE YO-YO YEN ECONOMISTS AND THE FINANCIAL MARKETS THE FLIGHT OF INTERNATIONAL CAPITAL (1931–1986) MONETARY CHAOS IN EUROPE (1914–1931) THE DOLLAR-MARK AXIS MONEY HARD AND SOFT

What Drives Global Capital Flows? Myth, Speculation, and Currency Diplomacy Brendan Brown

© Brendan Brown 2006 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–1–4039–4757–4 hardback ISBN-10: 1–4039–4757–0 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Brown, Brendan, 1951– What drives global capital flows? : myth, speculation, and currency diplomacy / by Brendan Brown. p. cm. Includes bibliographical references and index. ISBN 1–4039–4757–0 (cloth : alk. paper) 1. Capital movements. 2. International finance. I. Title. HG3891.B765 2006 332′.042–dc22

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Contents List of Tables List of Figures

viii ix

1 2 3 4 5 6 7 8

1 38 65 94 120 146 182 215

Main Currents Black Money Driving Forces Short Circuits Sustainability Currency Diplomacy Dysfunctional Union Currency Speculation

Bibliography

251

Index

256

vii

List of Tables 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13 1.14 2.1 2.2 2.3 8.1 8.2

World Current Account Balance, 1975–90 World Current Account Balance, 1995–2005 Euro-area Capital Account, 2001–5 UK Capital Flows, 2002–4 UK International Investment Position, 1993–2003 Yen External Flow of Funds, 2005–6 Chinese Yuan External Flow of Funds, 2005–6 Small Advanced Asian Economies – External Flow of Funds, 2005–6 Non-EU Savings Surplus Countries – External Flow of Funds, 2005–6 Mid-East Oil Exporters (High Savers) – External Flow of Funds, 2005–6 Tax Havens and Offshore Financial Centres – External Flow of Funds, 2005–6 Sterling Flow of Funds, 2005–6 Euro Flow of Funds, 2005–6 US Dollar Flow of Funds, 2005–6 Total Errors and Omissions, 2005–6 Analysis of the Global Current Account Gap, 2005–6 Tracing Trade Balance Divergences to Global Tax Havens, 2005–6 US Savings and Investments, 2001–5 Japan Savings and Investments, 2000–8

viii

4 5 10 10 12 13 14 30 30 31 31 32 34 35 48 54 55 227 229

List of Figures 1.1 3.1 3.2 3.3 3.4 3.5 4.1 4.2 4.3 4.4 4.5 5.1 5.2 5.3 5.4 7.1 7.2 7.3 7.4 7.5 7.6 8.1 8.2 8.3

Foreign holdings in Japanese equity markets US$ vs. Euro, 2-yr and 10-yr swap rate spreads China – foreign exchange reserves, 2002–5 Hong Kong, Taiwan and S. Korea – foreign exchange reserves, 2002–5 Switzerland – current account and net investment income, 1980–2004 Japan – current account and net investment income, 1980–2004 OPEC countries – current account balance, 1974–2004 Japan – JGB 10-yr yield vs. overnight rate, 1990–5 Exchange rates, US$ vs. yen and euro, 1999–2005 US Treasury Bonds – conventional vs. inflation linked yield US inflation vs. swap rates, 1999–2005 US current account and investment balances, 1980–2004 US exports and imports of goods and services, 1980–2004 US, Germany and France – imports from Asian developing countries, 1980–2004 Latin America and Asian developing countries – current account balances, 1980–2004 Germany – savings, construction and investment, 1995–2005 Germany and France – CPI levels, 1998–2005 Spain, Netherlands, Portugal and Greece – CPI levels, 1998–2005 Germany, France and Netherlands – current account balances, 1998–2004 Italy, Spain, Greece and Portugal – current account balances, 1998–2004 Germany, France and Spain – national indices for house prices, 1996–2005 Real effective exchange rates – US$, euro, yen and Swiss franc, 1971–2005 Swiss franc exchange rate, 1975–2005 Canadian dollar vs. oil price, 2003–5 ix

27 72 76 77 81 83 102 104 107 108 109 121 137 138 141 188 189 190 190 191 198 216 236 238

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1 Main Currents

The unprecedented force of capital inflows to the USA which built up in the early years of the 21 st century provoked awe, bewilderment, resentment, and intense anxiety. In order to understand the wide range of reaction amidst the universe of international investors, currency diplomats, international bureaucrats, and economic commentators, it is necessary to delve far into the subject of what drives the global flow of capital. That is the main theme of the present volume. Global capital flows have a power to fascinate. There are many reasons for this. Foremost is sheer size. According to Commerce Department estimates, the current of capital inflow into the US in 2005 registered a force of around $800bn p.a., near 6.5% of US GDP. Beyond size there is the whole imagery of what lies behind this gigantic flow – including teams of faceless officials pouring over their desks in the Japanese and Chinese Finance Ministries and managing the world’s largest foreign exchange reserves (each around $800bn at end-2005), a nebulous commonwealth of private investors operating in the secrecy provided by offshore tax havens, and bold gamblers in the hedge fund industry intermittently making huge gains or losses. Indeed it is the roller coaster waves in the currency markets, on which a few successful speculators surf with success for periods of variable length, that grab the international financial headlines. Editors realize that many readers (or listeners) are absorbed in the quest for high return. Extremely low transaction costs make foreign currency speculation the cheapest form of gambling. Some knowledge of what drives global capital flows combined with market-timing skills might actually tip the scales so that the player could expect over the long-run to make net gains at the expense of less talented or more constrained 1

2 What Drives Global Capital Flows?

competitors (for whom limits might apply, for example, to the time over which they can maintain positions). Money equals power, not just at the micro level of the fortunate speculator but also at the macro level populated by governments. Global capital flows bestow influence on both the borrower and lender. For example, the US, as a massive global borrower, would be at risk from any sudden loss of momentum by capital inflows. Hence maintaining the strength of flow, or preventing any abrupt shut-off, has become a potential objective of US foreign policy – akin to securing sources of essential mineral wealth. In practice, as we shall see in Chapter 6, Washington has shown only scant and intermittent concern about this issue, perhaps persuaded of its own more than countervailing powers as the world’s largest and most eligible debtor. Borrowers can inflict large losses on the lender (in the US case most plausibly via the unleashing of unanticipated inflation). The whole subject of global capital flow is intimately connected with that of international relations between sovereign states. At the level of the individual citizen, global capital flows are an expression and condition of personal liberty. The option of putting some wealth outside the political jurisdiction in which one lives or in foreign currency assets expands the scope for individuals to reduce their exposure to various shocks – whether emitted by government or by nature. The constraints are tighter on the power of sovereign governments to impose penal tax regimes or inequitable laws. None of this is to deny that there might be losers as well as gainers from an increase in capital mobility across the globe. Nor are the gains equally spread.

Arithmetic and geography of net capital flow As a general principle, capital flows out of countries where there is a surplus of saving over domestic investment opportunity into countries where there is a deficit (savings less than investment). Through most of the past three decades, for example, Japan has been a large exporter of capital and the US a large importer (see Tables 1.1 and 1.2). That is consistent with the observation that in Japan the savings rate is high whilst in the US it has been low. And for most of the time (with the main exception of the late 1980s), apparent investment opportunity (measured by expected rate of profitability) has been relatively thin in Japan. It is an identity of national income accounting that the difference between saving and investment equals the balance on the current

Main Currents 3

account of the balance of payments. (More exactly, the surplus of savings over investment spending equals the surplus on the current account of the balance of payments, or the deficit of savings below investment equals the current account deficit). And if measurements are correct, the current account balance should be equal and of opposite sign to the capital account balance. (A current account surplus is matched by net capital exports of the same amount, a current account deficit by equal net capital imports). Hence in principle a surplus of savings over investment should equal net capital exports. By contrast a deficit of savings below investment should equal net capital imports. At a global level, current account balances should add up to zero. Equivalently, savings surpluses and deficits, added up across all countries, should sum to zero. (All net lending internationally must be matched by net borrowing). In practice there are large errors in measurement which mean that equality is not observed in the actual data. The savings-investment balance registered in the national income data is typically somewhat different from the current account balance found in the balance of payments statistics. (In turn, that difference equals exactly the residual error in the national income accounts, as discussed further in the next chapter – see p. 56). And as we shall see, when we add up the current account balances across all countries the result is a huge negative amount rather than zero. If measurement techniques were perfect, and all the relevant economic transactions were traceable by the official statisticians, there would be no errors. It is important to realize, however, that these saving and current account surpluses, even perfectly measured, would be quite different for much of the time from the equilibrium concepts in which economists are interested. There is no mechanism which ensures perpetual general equilibrium characterized by the level of economic output equal to productive potential in each country and the difference between intended savings and investment equal to actual net capital exports (or to the actually realized savings balance) and subject to the constraint that for all countries together these must add up to zero. That is an equilibrium outcome, dependent on the operation of a complex array of forces which operate over usually lengthy periods. Much of the time, disequilibrium rather than equilibrium pertains (where equilibrium in its fullest sense embraces all markets, including labour and capital). Households and corporations, for example, might have budgeted to save a given amount (for corporations, target savings means expected

4 What Drives Global Capital Flows? Table 1.1

World Current Account Balance, 1975–90

(US$ bn)

1975

1980

1985

1990

North America USA Canada

18 –5

2 –6

–118 –6

–79 –20

Europe ERM* Switzerland Norway UK Sweden

5 1 –3 –4 0

–35 0 1 4 –4

24 4 3 –1 –1

13 9 3 –40 –7

Japan

–1

–11

51

43

Asian Tigers**

–2

–8

11

17

Australasia

–2

–4

–8

–16

Total Advanced

7

–61

–41

–77

0 –7 27 –13 –10

0 –5 60 –20 0

–11 –8 –8 –5 –5

10 –25 –5 0 –10

Total Developing

–3

35

–37

–30

URSS & E. Europe

–18

–2

–4

–18

Developing China Other Asia Middle East/Turkey Western Hemisphere Africa

Aggregate Global Gap Memo: US GDP ($ bn)

–14 1638

28 2790

82

125

4220

5803

* Germany, France, Italy, Spain, Netherlands, Belgium ** Hong Kong, Singapore, South Korea, Taiwan

retained profits less intended capital expenditure including planned inventory building) in a given year. But the actual result is often very different from budget. In particular, realized income, corporate or household, (out of which investment spending and savings occurs) can turn out very different from anticipated income. One factor responsible could be a dip in output below full potential level, perhaps due to an exogenous shock. Another factor could be the economy unexpectedly hitting capacity constraints. On top there are the whole range of possible shocks from the side of the government’s budget (which is an important part of the overall savings-investment balance). As illustration of a disequlibrium outcome, take the case of the given economy beginning to overheat (as would happen if cyclical slack dis-

Main Currents 5 Table 1.2

World Current Account Balance, 1995–2005

(US$ bn)

1995

2000

2005

North America USA Canada

–105 –4

–414 20

–810 35

Europe Euro-area Switzerland Norway UK Sweden

40 21 5 –14 8

–20 31 26 –27 10

10 45 50 –60 20

Japan

111

125

170

Other Asia

0

42

65

Australasia

–22

–18

–45

Total Advanced

40

–225

–520

Developing China Other Asia Middle East/Turkey Western Hemisphere Africa

0 –40 0 –30 –15

20 26 45 –45 –5

105 20 215 10 0

Total Developing

–85

41

350

Transition economies of which Russia

–5 (n/a)

Aggregate Global Gap Memo: US GDP ($ bn)

10 (44)

20 (80)

50

174

150

7398

9817

12300

appears whilst aggregate demand growth continues unabated). Real income growth – profits and wage incomes – might suddenly slow because capacity limits have been reached. Productivity growth decelerates. It takes time for businesses and households to realize the new situation. Investment spending runs ahead. As consumer spending expands on the basis of anticipated rather than actual income growth, savings slows and savings relative to income falls. Inflation picks up unexpectedly. The current account deficit and savings deficit widens. But this is a disequilibrium outcome. By the same token actual spending, whether by households or business, can differ considerably from budgeted spending. This is most obvious in the case of inventory-building, which to a large extent

6 What Drives Global Capital Flows?

reflects unanticipated fluctuations in sales volumes or the hitting of capacity limits.. But it also applies to spending which is constrained by, for example, lengthening delivery periods (leading to so-called “forced” saving or dissaving). The observed current account balance equals the difference between realized savings and investment, not between the planned savings and investment totals which would coincide with the economy operating at (but not above) its full potential (defined as consistent with no inflationary pressure). There is equilibrium only when planned outcomes, based on income levels equivalent to full productive potential, turn out to be actual outcomes. And for global equilibrium to hold, that condition must hold in each economy (or currency areas). In addition, savings deficits and surpluses, so defined, must sum to zero across the globe. A possible example of disequilibrium at the global level where nonetheless one large economy is in equilibrium (with respect to planned savings and investment being in line with actual outcomes and with the given economy operating at full potential – but not above) was the US situation in late 2004. At that point the gap of US savings below investment (the savings deficit) and the current account deficit were estimated at around 6% of GDP. But also at that time, the second and third largest economies (Japan and Germany respectively) slipped unexpectedly into a growth cycle downturn. Slowed US export growth was the obvious immediate factor behind the widening of the US current account deficit. Slower exports coincided with a strong upswing in (US) business investment. In turn, there was a corresponding shift in the realized US savings deficit which moves in continuous identity (subject to measurement error) with the current account deficit. The weakened export demand (in the US) meant that interest rates there (US) remained lower than otherwise, helping to underpin asset values and contributing to a further fall in the US household savings rate (to near zero in net terms). By contrast the German and Japanese downturns went along with some rise in their savings rates. The internal disequilibrium in Japan and Germany (below-potential level of economic output) had a corollary in the US savings deficit being greater than what it would be if global equilibrium held. Economists and market analysts (they may be the same people!) are usually more interested in finding out the global equilibrium path rather than simply monitoring observed most-of-the time disequilibrium outcomes. The actually observed current account balances (and in

Main Currents 7

principle equal net capital flow balances) and their direction of change might provide clues to the equilibrium path (determined by the difference between planned savings and investment). If that path is far distant from present observations, then large corrective forces are surely operating. These are most likely going to have serious consequences for the course of economic growth and of financial market prices over time. Plotting an equilibrium path involves making estimates of the given balances both now and at various points (for which forecasts are available) sequentially into the future. In the jargon of analysts, such flow charting can be re-cast in stock terms. Instead of seeking to estimated planned savings and capital spending rates over given discrete time intervals the focus could be on the level of wealth and physical capital which various economic agents intend to hold at given dates in the future. Typically a country with a persistently large savings surplus would be characterized by a resident public which is seeking to accumulate wealth (measured net of government debt) at a faster pace (in absolute terms) than the expansion of the domestic capital stock. By implication, the amount of net external assets (measured after deducting liabilities to foreigners whether in the form of debt or equity) in the international balance sheet of the given country would be increasing. By the same token, a country with a persistently large savings deficit would be characterized by a domestic capital stock growing faster than wealth of domestic residents. The total of net external assets of the given country would be decreasing. In practice, the rate of net foreign asset accumulation is not determined simply as a residual as in the simplified description above but can stem from definite portfolio preferences on the part of domestic and foreign investors. That becomes clear as soon as we introduce the real world assumptions of currency risks and political (or credit) risks. Suppose, for example, resident investors in country A have a long run target of increasing the amount of wealth which they hold abroad, perhaps so as to reduce their exposure to various domestic political (including taxation) risks. This requires either the generation of a domestic savings (and current account) surplus to match, or a coincidental emergence of a foreign demand for assets in country A. The same conclusion applies in the case of foreign investors in A deciding to run down their net assets there. Either country A’s savings surplus must increase or residents of country A decide simultaneously to run down their foreign asset holdings.

8 What Drives Global Capital Flows?

The point here is that in the equating of savings surpluses and capital flows, there is a two-way causality possible. Excess savings (relative to domestic investment opportunity) tend to drive a current of capital outflow. But also an increasing net demand for foreign assets or a long-run reduction in foreign net demand for domestic assets (in the given country) can be the driving force behind an emerging or actual savings surplus.

Turn-tables Indeed without introducing some real world facts such as currency risk, political risk, and other heterogeneous factors, we would have a hard job in explaining a salient feature of global capital flows – the turntable. In a world where all assets were identical in characteristic across national boundaries, net and gross capital flows would be identical. Why would residents of country A invest in country B simultaneously with residents of country B investing in country C or A? A considerable amount of two-way capital flows can be explained by the simple arithmetic of diversification. If there were no home biases (preference to hold domestic rather than foreign assets) investors in any country would tend to hold the same portfolio of assets drawn from all over the world. That would mean large inflows and outflows of capital being the norm for each country as part of the process of wealth accumulation. Relative to national income these would be greater for small countries (whose assets formed only a small part of the world portfolio) than for large. The concept of a turntable in the global flow of funds refers to something different from simultaneous inflow and outflow of capital attributable to investors accumulating wealth in the global portfolio of assets. Rather a turntable describes the phenomenon of a country (or group of countries forming a currency area) importing capital on a net basis from one region of the world and exporting it (net) to another. Typically the turntable would import capital from the savings surplus countries and re-export (capital) to the savings deficit countries. But turntables can also have relationships with each other. For example, turntable A could import large amounts of capital from the savings surplus countries and turntable B and re-export this (capital) in large part to a huge savings deficit country and also to turntable C. Moreover the roles of turntable and savings deficit or surplus country are not mutually exclusive. A country can be in large savings surplus and also perform a turntable role.

Main Currents 9

Some illustrations help demonstrate these points. First, in 2003–4, huge Asian savings surpluses (mainly concentrated in Japan and the small advanced economies in East/South East Asia) and mid-East savings surpluses (in the oil exporting countries) coincided with a huge US savings deficit. But the Asian and mid-East investors were set on accumulating not just US but also a substantial amount of euro-assets. And some euro-area residents (whether corporations or hedge funds, for example) were keen to borrow low or zero rate yen to finance euro-assets. (In so far as euro-area residents borrowed yen to finance non-euro-assets, mainly US dollar, they were not generating any turntable role for the euro-area, but adding power to the main current of global capital flow – out of the savings surplus countries in Asia – especially Japan – into the biggest savings deficit economy, the US.) The euro-area was itself in small savings surplus. And so the inflow of Asian funds (whether powered by Asian investors or euro-area borrowers) was in fact matched by outflows of capital from the euro-area. These included in particular borrowing in euros by non-residents of the euro-area (whether in the form of loans by banks in the euro-area or issuing bonds to euro-area residents). Of some importance here were borrowers in the UK and in Eastern Europe – both areas of savings deficit. But the UK was itself a turntable, drawing in capital to finance its large direct investment in the US (see below). Second, in 1999–2000, European portfolio and corporate investors became very enthusiastic about US equities and companies (more so than did investors in other parts of the world). If that had occurred in isolation and had been sustained, euro rates would have risen and the euro fallen to a level such as in the medium term a savings and current account surplus would have been generated in the euro-area equal to the ongoing rate of accumulation of US assets. And it is arguable that to some extent this process got under way. This was the period of the cheap euro. Anecdotal evidence however suggested that there was also a simultaneous emergence of global investor demand (from outside the euro-area) for euro money and fixed-rate assets (ignited by the birth of the new European currency and the emergence of new deep money and capital markets in it). In effect inflows into euros from the savings surplus countries (including Asia, the mid-East, and Switzerland) played a large role in financing euro-area outflows of capital into the US which in turn filled the shortfall of US domestic savings below boom-time levels of investment spending.

10 What Drives Global Capital Flows? Table 1.3

Euro-area Capital Account, 2001–5

(€ bn)

2001

2002

2003

2004

2005H1*

Direct Investment equity out equity in intercompany

–103 –235 149 –17

0 –180 125 55

5 –113 124 –6

–78 –164 75 10

–68 –84 34 –16

Portfolio Investment

68

128

43

76

238

Equities –EURO out –foreign in

–128 –105 233

48 –38 86

52 –65 117

50 –73 123

62 –82 144

Debt Instruments –EURO out –foreign in

–61 –184 123

82 –135 217

–10 –213 203

26 –206 232

176 –324 500

Credits & Loans

–15

–170

–78

–32

–40

3 –18

–143 –27

–18 –60

–15 –17

4 –44

32 18

–30 –2

–28 30

–59 12

–132 15

Banks Other Errors/Omissions Official transactions * annualized rate

Table 1.4

UK Capital Flows, 2002–4

(£ bn) Direct Investment equity outwards equity inwards

2002

2003

2004

–18 –34 17

–28 –41 13

3 –25 27

Portfolio Investment

50

58

–13

Equities out Equities in Bonds out Bonds in

3 3 –4 48

–19 10 –17 84

–65 10 –60 102

1

–5

–13

–24

–11

64

Financial Derivatives Other Investments Reserve Assets

1

2

1

Errors/Omissions

6

3

4

Third, in the early and mid-1990s, investment opportunity in the Asian developing countries blossomed. One important element was the (post-bubble) depression of rates of return to business capital in Japan partly as a result of the sky-high yen and the related scope for firms in

Main Currents 11

the Asian developing countries to replace Japanese production, whether aimed at export sales to the US and Europe or at domestic consumers. The fall in investment opportunity in Japan and rise in Asia could have led simply to a corresponding direct investment flow (from Japan to Asia), which would have largely matched the rise in Japan’s overall saving surplus and the shift of developing Asia into deficit. And there was indeed a big increase in direct investment flows as described. But in some part Japan’s raised savings surplus flowed into portfolio-type assets (mainly bonds) in Europe and the US, whilst companies there joined in taking advantage of the new opportunities for direct investment in the Asian developing countries. Thus the US and Europe performed a (modest) turntable role between Japan and the other East or South East Asian economies. Fourth, in various episodes through the past three decades there have been huge outflows of flight capital from Latin America mainly into the US. The financing of the capital flight has largely taken the form of Latin American governments borrowing in Europe, Asia and the US. In so far as the borrowing was in the US, the phenomenon can be described as a round-trip rather than a turntable. The incentive behind the turntable flows was usually that yen and Deutsche mark interest rates were well below US rates, and governments (in Latin America) sought to keep down their current debt servicing costs.

Round-trips Round-tripping is a pervasive feature of the global flow of funds. This describes where a country or currency area imports capital in one form and exports it in another form – both flows occurring with the same group of countries. Round-tripping depends on various forms of asymmetry, whether between assets in different countries or between risk preferences of investors (or borrowers) across countries. Again, some examples help to demonstrate the concept. First, equity markets are more highly developed in say the UK or Switzerland (relative to size of GDP) than in other European countries. Correspondingly, companies in the UK or Switzerland become conduits of capital flow. Global investors buy shares in UK or Swiss companies which themselves make large direct investments in the world outside. In effect the UK or Switzerland become equity intermediation centres – some direct investment outside the UK or Switzerland that first passes through a British or Swiss multinational has ultimate equity owners also outside. In practice, Switzerland and the UK both have large net international liabilities in the form of equity (foreigners

12 What Drives Global Capital Flows? Table 1.5

UK International Investment Position, 1993–2003

(£ bn)

1993

1998

2003

Direct Investment abroad Direct Investment in Net Direct Investment

172 136 36

299 214 85

632 377 254

Portfolio Investment abroad

469

704

969

194 275

304 400

420 549

306

692

1054

133 173

402 290

490 564

(Equity) (Bonds) Portfolio Investment in (Equity) (Bonds) Net Portfolio Other Investments Reserve Assets

163

11

–75

–198

–253

–256

30

23

23

hold more equities in these countries than residents there hold outside) matched by net assets in the form of direct investment. A further factor in the importance of direct investment outflows from the UK is the comparative advantage (based largely in language) enjoyed by UK corporate managers in undertaking and administering business in the English-speaking world outside (especially the US). A naturally high level of direct investment outflow from the UK could in itself put some upward pressure on UK interest rates and that would play a part in bolstering the UK savings rate so as to match the capital exports. In turn higher-than-otherwise UK rates would attract global capital into Sterling money market and fixed-rate assets. In effect, the UK could have a turntable role (in addition to the round-tripping role already described). Net business assets abroad – largely in the US and other English-speaking countries – would be matched in part by net liabilities in the form of money and bonds held by investors in Asia and Continental Europe. Alternatively, if global investors are keen to buy equities in UK companies which have this comparative advantage in making direct investments in the US, the UK’s turntable role would take the form of running up equity liabilities (to foreigners worldwide) matched by direct investment in the US. Then there might be no interest rate effect or influence on the savings rate. Fourth, an unusual amount of home bias by Japanese investors with respect to equity investment means that over time inflows of foreign

Main Currents 13

funds into Japanese equities far exceed outflows of Japanese funds into foreign equities (both these items are highly volatile!). But in turn foreign corporations are typically more reluctant to acquire Japanese assets – or constrained by structural factors – than are Japanese corporations to acquire foreign assets. One such structural factor is the lack of a well-developed Japanese market in corporate control. (Its under-development is widely attributed in part to the still considerable amount of interlocking corporate shareholdings). And so a large net liability position in equities in Japan’s international balance sheet is matched by a net asset position in direct investment. Moreover some part of the Japanese demand for foreign bonds (the dominant form of external asset in Japan) might stem from the fact that Japanese equity yields have been depressed and the yen raised in value by worldwide investor demand (for Tokyo equities). Some of the foreign bond holdings of Japanese investors should be considered as part of the round-trip. Fifth, China has typically enjoyed large inflows of direct investment capital. Foreign companies have in some cases been better placed than domestic companies to take advantage of (and discover) emerging profit opportunities (whether from using cheap labour in export industries or for selling to the rapidly growing domestic market). China has been in modest (and now, 2005, large) savings surplus. So in practice the direct investment inflows have been matched by Chinese private

Table 1.6

Yen External Flow of Funds, 2005–6 (¥ 100 bn p.a.)

Inflows to Yen Current Account Surplus Net Foreign Inflows to Japanese Equities

Outflows from Yen 185 80

265

Official Intervention

40

Japanese Buying of Foreign Equities

30

Net Direct Investment from Japan (outflows less inflows)

25

Japanese Portfolio Outflows into Foreign Currencies (bonds or money market) on unhedged basis

125

Non-Japanese borrowing of Yen to finance non-Yen assets

45 265

14 What Drives Global Capital Flows?

portfolio and government investment in foreign currency assets (mainly in the form of dollar deposits with the local banking system). To a large extent this is round-tripping, but there may also be an element of turntable involved. The Chinese Diaspora throughout South and South East Asia is an important category of direct investor in mainland China. But Chinese resident foreign currency deposits are not as a rule lent back to the Asian surplus countries. (Rather they are lent into the euro-dollar money markets). Sixth, during 2003–5 there has been considerable speculation on an upward float of the Chinese yuan, which meanwhile (until July 2005) remained fixed to the US dollar. Exchange restrictions have meant that the main form of speculation has been local Chinese corporations reducing their borrowing in yuan and increasing their dollar loans. In turn the Bank of China has offset the speculative inflows by accumulating foreign exchange reserves. In so far as the process described creates an offsetting supply and demand for dollars in the Chinese currency market, this is a round-trip. It can be seen in all these examples that round-trips, as turntables, play an important part in the routing of capital out of the savings surplus countries into the savings deficit countries. But in themselves their operation cannot generate net global flows of capital unless they influence the equilibrium level of the savings surplus or deficit in the countries concerned. This is possible in the case of turntables but not round-trips. For example, if Europeans are keen to add to their holdings of US assets at the same time as Asian investors are seeking to deploy a raised share of their surpluses into euros, that helps to underpin the net flow of capital towards the US (financing its huge savings deficit).

Table 1.7

Chinese Yuan External Flow of Funds, 2005–6 (US$ bn p.a.)

Inflows Current Account Surplus

Outflows 110

Direct Investment Inflows

50

Speculative Borrowing in Foreign Currency by Chinese Companies

40

200

Chinese Reserves Portfolio Outflows Foreign Currency (Money and Bonds) Foreign Equity

170 20 (15) (5)

200

Main Currents 15

If by contrast Europeans have very small appetite for US assets, (or put more technically, a high degree of aversion to dollar risk), and global borrowers have little inclination (or a high degree of risk aversion) to switching their liabilities into euros (from dollars), then Asian savings surpluses seeping into euros (as Asian investors become more familiar with euro investment) would eventually have to be offset by an induced euro-area savings and current account deficit. (In the short run the Asian demand for euros can find accommodation in the form of speculators moving out in the expectation of buying back at cheaper levels later). The counterpart to that induced swing in the euro-area savings balance towards or into deficit (which could take place via a fall in euro interest rates and rise in the euro) would be a shrinking of the US savings deficit (under the influence of higher US rates). There could also be downward pressure on the Asian savings surplus (via lower yen interest rates) if the flow of capital from Asia to the euro-area were less elastic (with respect to interest rate differentials) than for flows between Japan and the US. Perhaps this divergence in interest rate elasticity could be due to the euro as yet still being under-represented in Asian portfolios, meaning considerable diversification benefits are still obtained (by Asian investors moving into euros). Or the Asian-dollar currency exchange rate (on average across all the currencies) might be less volatile than the Asian-euro exchange rate, meaning that small changes in interest rate spreads have a bigger impact on Asian capital outflows into dollars than into euros. Overall, the better the functioning of the euro-turntable, (betterfunctioning is defined in terms of willingness of European investors to switch into dollar assets in response to a widened rate spread in their favour and of global borrowers to similarly switch towards euro away from dollar liabilities) the more sustainable is likely to be a large net flow of capital out of Asia and into the US in the face of diversification by Asian investors away from the US dollar into euros.

How to measure? The main primary source of measurement on global net capital flows, turntables and round-tripping, is balance of payments data. Subsidiary sources include statements of external assets and liabilities produced at regular intervals by many advanced industrialized economies. In addition there is the data on savings and investment produced as part of the national income accounts.

16 What Drives Global Capital Flows?

All of this data is produced by national statistics offices. Some consolidation (across countries) occurs in euro-area capital account data but not so far current account data. (Various forms of capital export and import are measured net of intra-area flows). The guiding principle of balance of payments statisticians is to aggregate all transactions between residents and non-residents, broken down into the various categories of merchandise, services, invisibles, or capital. And the guiding identity which would hold if measurement were comprehensive and accurate is that net capital exports (imports) equal the current account surplus (deficit) (as discussed above, see p. 3). The capital flows measured by the statistician are between residents (of the country in question) and non-residents. These include a huge mass of flows between financial intermediaries (for example a US bank lending to a European bank). In principle, net capital exports over a given period add to a country’s net holding of foreign (external) assets by the same amount, adjusted for valuation changes. (In any given period – say a quarter or year – big valuation changes due to currency or capital market price fluctuations can bring changes in net asset positions which dwarf those attributable to net flows). Capital flow data as described should be distinguished from currency flow data. Here the aim is to measure fluctuations of international final demand and supply for assets in a given currency. “Final” means excluding the whole array of financial intermediaries. “Assets” include equities, bonds and money. “International” means the buyer is non-resident of the country issuing the currency. Net additional supply of assets in the given currency to international buyers (investors) can come only via the issuing country running a current account deficit, or residents there (in the issuing country) adding to their net position in foreign currency assets, or by non-residents (of the issuing country) issuing net debt in the given currency. The guiding principle is that final aggregate international supply (measured in flow terms over a given period) of and demand for assets in the given currency must be equal. As illustration of currency flow estimation, consider the global flow of funds in US dollars. International final demand for dollar assets includes not just foreign demand for US assets but also US dollardenominated assets throughout the world. That would include for example US dollar bonds issued by Brazil, or dollar deposits issued by banks in London or Singapore. Supply includes not just US net buying of foreign goods and services (as reflected in the current account deficit or savings deficit) but also US net buying of foreign equities and cor-

Main Currents 17

porate assets (direct investment) and also foreign countries running up net liabilities in dollars as a counterpart to their own current account deficits or accumulation of non-dollar assets. Currency flow data are not estimated or published by official statisticians. But they can be put together as “guesstimates” from primary source data. They bring two important advantages compared with the traditional balance of payments data. First, their focus is on the ultimate sources of new international demand and supply of assets in a given currency rather than on where precisely the flow of capital crosses the frontier of the country (or area) of issue. For example, take the accumulation by Japanese investors of international dollar bonds issued by non-US borrowers. The latter may in turn be reducing their borrowing of dollars from US banks (replacing bank loans with bond issuance). In the US balance of payments it is the reduction in US bank lending to foreigners which is registered – not the transactions in dollars between non-US residents (Japanese buying of foreign dollar bonds). Yet the bank is only acting as a passive intermediary with respect to final foreign demand for US dollar assets. Another example relates to foreign exchange intervention by non-US central banks. Suppose the Bank of Japan buys massive quantities of dollars (so increasing the reserves held by the Government of Japan) and deposits these with Japanese banks both in Tokyo and London (foreign subsidiaries and branches of Japanese banks). In the US balance of payments what becomes registered as a result of this original demand is an inflow into the US via the banking system. But this tells us nothing about the ultimate final demand (for dollars). The second advantage of currency flow data (following on from its focus on currency demand and supply) is its potential use in the analysis of forces operating in the exchange markets. Several of the main theories of exchange rate determination are built on demand and supply for assets denominated in the various currencies. Issuance of dollar liabilities by non-US borrowers add to the supply of dollar assets in global markets as much as does US excess demand for goods and services (the current account deficit) or US demand for foreign assets. Evidently foreign dollar and domestic US assets are not perfect substitutes for each other, but neither are the various types of US domestic assets. In principle there is much to be gained towards the understanding of exchange rate dynamics by focusing on final demand and supply for dollar assets wherever located rather than on data about capital flows

18 What Drives Global Capital Flows?

across the US coastline (in a transaction between resident and nonresident). The latter include a large blur of intermediary transactions and also matched external borrowing and lending by the US non-bank sector. (For example, large net purchases by US investors of dollar paper issued by foreigners would be registered as a capital outflow from the US and there would be a corresponding inflow of funds somewhere in the US balance of payments to finance this. But in reality the two are offsetting and the US outflow of funds into foreign dollar paper does not add to its net international supply). Insights can also be gained from currency flow analysis into the socalled US current account sustainability issue (see Mann, 1999). A common cry of the dollar pessimists has been the huge size of the US current account deficit as if this could ultimately exhaust the global appetite for US dollar assets. As we shall see in a later chapter (5) that is a phantom danger, when account is taken for example of the fact that in various periods there have been huge supplies of dollar assets from non-US borrowers, whereas in the period of mega US current account deficits these foreign supplies have all but dried up.

Net capital flow – present and past A table of the world current account balances provides the main insight into net global capital flows. The table shows the current account balance for each country or selected group of countries. In principle these add up to zero. In practice, there is a large and variable global gap – with the total of all current account balances adding up to a large negative number. The economic significance of this is discussed fully in the next chapter. For now it suffices to note that the global gap matches to a considerable extent investment income accumulating in offshore tax havens. This income is not treated as a credit in any of the IMF reporting countries. Yet the interest and dividend payments by the respective debtors are in general registered in national balance of payments. If there were 100% accurate measurement, and national savings surpluses or deficits as revealed in the national income data were exactly equal to the current account balances which in turn were exactly equal to net capital flows, then we could describe the world current account as a statement of the net flow of savings from (savings) surplus countries to deficit countries. In practice there are errors, and so the table of world current account balances provides only an approximation to the underlying savings flows. (In Chapter 2 it is shown how the various

Main Currents 19

types of error including the aggregate global gap can yield indirect estimates of grey and black capital flows. In Tables 1.1 and 1.2 (pp. 4–5) we show the world balance of payments in 2005 and at five-yearly intervals back to 1975. The dominant feature of present net global capital flows as revealed is the huge current towards the US. US net inflows of capital (approximately equal to the current account deficit) are estimated at around $800bn. That corresponds to a huge savings deficit in the US economy – a reflection mainly of a large household sector savings deficit (stemming from a low level of personal savings compared to Europe or Japan and booming residential construction). There was a considerable structural budget deficit in the US, but budget woes plagued also several of the surplus countries, including most prominently Japan. The main ultimate sources of net capital outflows are the advanced economies in East/South East Asia (Japan, South Korea, Taiwan, Hong Kong, and Singapore), with an estimated surplus of $230bn, Middle East oil exporters, $220bn, Western Europe excluding the UK (euro-area, Switzerland, Norway, and Sweden), $120bn, and Asian developing countries (China, India, and others) $130bn. The UK is the largest net importer of capital outside the US, at around $60bn p.a. Australasia and the transition economies in Central and Eastern Europe (excluding Russia) are each – considered as a group – not far behind. The underlying story (behind the deficit) includes some combination of low household savings, strong investment, or large budget deficits. The aggregate global gap amounts to around $150bn (equivalent to 1.3% of US GDP). A more detailed geographical breakdown on Europe would show the surplus in Western Europe excluding the UK and Mediterranean areas (Spain, Portugal, Greece and Italy) at around $200bn, broadly the same as for the advanced economies in East Asia. But there is a flow of capital within the euro area – from Germany and the Benelux countries towards the South. Currents of capital flow within a currency area are one subject of Chapter 7. Here the subject is the capital flows between currency areas or countries with their own sovereign money. Amongst the savings surplus countries there are two groups of small countries with extraordinarily high surpluses relative to their economic size – one in East Asia and one in Western Europe. The Asian group includes Taiwan, Hong Kong and Singapore, for which savings surpluses range from 10 to 20% of GDP. There is a similar range for the European group including Switzerland, Sweden and Norway. In absolute terms the aggregate surplus of each group is around $70–110bn (Asian group towards the lower end of the range in 2005

20 What Drives Global Capital Flows?

influenced by the surge in oil imports). There are some common themes and some individual factors behind these huge savings surpluses. A common theme is population ageing and state-sponsored pension provision at a high level involving high present mandatory contributions. Political risk and the associated efforts of the resident population to build up foreign asset portfolios (rather than plough savings into domestic fixed assets) are an important element in the case of Taiwan, Hong Kong, and even Singapore. In the case of Norway there is the explicit political decision to invest huge state oil revenues in a welfare fund for pension provision in the future and taking into account the long-term decline of oil production. Amongst the developing countries, there are no persistent savings and current account surpluses as of the mid-2000s except in the important case of China (where a large savings surplus is emerging most probably on a long-run basis). Amongst the Middle East oil exporters the tiny states with huge oil resources – Kuwait and the UAE – are always in surplus, but not always by a large amount. The Asian developing countries (principally Indonesia, Malaysia, Thailand, and Philippines, and India) are now (2005–6) in slight surplus and were in large surplus (around $50bn maximum) in the aftermath of the 1997 Asian debt crisis. But further back, especially during the mid-1990s boom, they were in large deficit. Some commentators and policymakers have suggested that the natural situation of the developing countries should be to be in large savings and current account deficit – as the counterpart to large inward flows of capital to take advantage of investment opportunities in rapidly growing economies. But domestic investment opportunity is only one part of the story. Savings rates are very high, reflecting a combination of population ageing and lack of confidence in pension provision. And a high level of political risk in most cases goes along with a considerable appetite for foreign assets (partly by way of unregistered capital flight). To complete the snapshot of present global net capital flows we need consider the situation of Eastern Europe, Australasia and Latin America. The so-called transition economies (in Eastern Europe) are in surplus by around $20bn, but that is a combination of a large surplus for Russia (around $80bn – reflecting a jump in oil revenues associated with the 2003–5 oil price shock) and large deficits (relative to economic size) for the other East European economies most of which are already in the EU or embarked on an entry program. The latter’s

Main Currents 21

deficits match a shortfall of domestic saving below investment – natural for economies in which savings rates are not especially high (in contrast to in East Asia) but where there is considerable investment opportunity as part of the process of long-run convergence with the more advanced economies in Western Europe and where budget deficits are large (relative to economic size). The Australasian current account deficits are accounted for mainly by Australia and are in part symptomatic of a consumer and real estate boom in the first half of the 2000s (already the real estate market had started to cool in 2004–5). Also in the long-run, Australia has been a large capital importer, related to the depth of investment opportunity in the commodity extraction industries (and the insufficiency of domestic saving for exploiting these). Finally, the developing countries in the Western Hemisphere (including Mexico) are in aggregate running an almost zero savings and current account deficit (in 2005). That should be considered an abnormal situation in the aftermath of debt crisis (Argentine default, Brazil crisis). These observed net capital flows (current account balances) as described may well be out of line with the global equilibrium solution where at least all the big economies were operating at around their productive potential and planned savings and investment spending were equal to actually realized amounts (as discussed in an earlier section). Equivalently, a contemporary snapshot of net capital flows could be of a transitional stage on a way to the equilibrium solution. In particular Germany had been in virtual recession during most of 2004 and personal savings had risen there as households responded to grown risks of unemployment and heralded cut-backs in social protection. Two stories, however, could be told about the path going forward. Perhaps forces would emerge to push up domestic spending in Germany (for example, new investment opportunity or a fall in the savings rate). And then the euro-area savings and current account surpluses would fall, and the euro-area might actually become a capital importer in the long-run. Alternatively, the source of German economic distress in the early 2000s might be that inside the observed large savings surplus is an even larger one seeking to emerge. (This would be the case if many Germans would ideally like to save at a greater pace but are constrained by income levels which reflect economic output below productive potential). Then as the German price level fell and the euro turned back down, the German savings and current account surpluses could rise from the present 5–6% of GDP to say 10% of GDP. Germany would return to economic health via the

22 What Drives Global Capital Flows?

emergence of mega capital exports and savings surplus matched by buoyant exports. Similarly in some degree it is an open question whether present net savings surpluses (and capital exports) in East Asia (including Japan and China) are below or above final equilibrium levels. If below, and the same in Europe, then the implication could be that the US savings and current account deficits would have to rise to even higher levels in the long-run as part of the global solution. That hypothesis runs strongly against a chorus of current economic commentaries from almost all sources, which is doubtless influenced by how such an outcome would be out of line with previous examples from modern history (see Obstfeld and Taylor, 2002). Deficits running at anywhere near 5% of GDP for any country have always proved to be “unsustainable” (see Chapter 5 for more detail). And the present deficit is out of line with previous US experience, even exceeding as a percentage of GDP the levels recorded in the late nineteenth century when the US was a rapidly developing economy. It remains to be seen what weight should be given to a fairly short period of historical evidence, most of which has been under very different institutional setting. In Tables 1.1 and 1.2, we can easily see how far out of line with “normal experience” is the present structure of net capital flows – even though there has been some considerable variability over time. Back in 1975 and 1980 (both years partly covered by recession) the US was in small surplus. Western Europe, Japan, and the Asian countries were in small or modest deficit. Latin America was in huge deficit (by over 1% of US GDP in 1980). The Middle East countries were in huge surplus (by around 1% of US GDP in 1980, and 1.5% in 1975 – both years soon after an oil shock). The aggregate global gap was not far off today’s level relative to US GDP (around 1%). In broad terms the East Asian savings surplus had not emerged yet on any substantial scale (albeit that the Japanese surplus had begun to show through in the late 1970s, but was then temporarily suspended by oil price shock and US recession) and nor had the US savings deficit. The mid-1980s snapshot reveals a Japanese savings surplus and US savings deficit already of large amount (around 2.5% of GDP for the US). And Europe was in modest surplus. Massive UK savings deficits had not yet appeared. The Asian Tigers (Hong Kong, Singapore, Taiwan and South Korea) were in small deficit as were the other Asian countries (including China) further behind in development. The Western Hemisphere deficits had collapsed in the wake of US and some European banks lost in the earlier lending boom to that region. And

Main Currents 23

the Middle Eastern oil surpluses had all but disappeared. And so the big differences with 2005 were, in sum, the situation of non-Japan Asia (still in deficit) and of the Middle East (not in huge surplus – as indeed the mid-1980s were a period of cheap oil). In the snapshot for 1990, the US savings and current account deficit had fallen back, mainly under the influence of recession. The Japanese savings surplus, which had temporarily declined during the bubble years of the late 1980s, was already re-building. In Western Europe excluding the UK the savings surplus had fallen back as the German economy was on the threshold of its unification boom, whilst the UK was in huge deficit, in line with its then real estate bubble and consumer spending boom. Latin America was still quiescent as a net borrower. On into 1995 (a year of mild growth cycle downturn for the US economy associated in part with the Mexican “shock”) the main new developments were a modest growth in Continental Western Europe’s savings surplus as the German unification boom was followed by bust and France had been driven into near depression conditions by the “Seven Years War of the Hard Franc” (Aeschmann and Riché, 1999). Savings deficits in the Asian developing countries had grown substantially in line with the economic boom and bubbly real estate markets in that region. And Latin America had enjoyed a renaissance amongst international investors (albeit that was beginning to change with the Mexico shock, in which default was only avoided with massive US financial aid). The Middle East countries were still in around zero balance. In the snapshot for the first year of the 21st century (2000), the big change is the emergence of a mega US current account deficit (at over 4% of GDP). This reflected in considerable part the information technology led investment spending boom (or even bubble) together with a further fall in US household savings. The euro area had swung into small deficit in line with its own mini-boom. The big new elements in the global flow of funds were the transformation of the advanced and developing small economies in East and South East Asia into large aggregate surplus and a jump in the aggregate global gap. The obvious factor behind the former development (Asian surpluses) was the recessionary influence of the 1997 Asian debt crisis and the end of the investment spending bubbles throughout the region. A related factor was the attempt of global portfolio investors to reduce their net asset holdings in the Asian developing countries (and other emerging market economies).

24 What Drives Global Capital Flows?

How to identify currency turn-tables and round-trips As we have seen, world current account balances are the key to measuring the net flow of funds across the globe, from savings surplus to deficit countries. But they have little to tell us about where and how currency turntables are operating or about the extent and nature of round-tripping. A first handle on this comes from the detailed tables on capital flows which are published as a component of each country’s (or currency area’s) balance of payments. A second handle comes from various types of survey data. Consider for example the capital account of the euro-area balance of payments. The euro-area in the early and mid-2000s has been the currency turntable par excellence – attracting large amounts of funds from outside, particularly Asia, and re-exporting these. The euro-area itself has been in only small savings surplus or deficit. An indication only of the size of the euro-area turntable can be found in Table 1.3 (see p. 10). The clue is under the debt section of portfolio investment. In 2003 and 2004 over €200bn of foreign inflows were recorded into bonds issued by euroarea residents, with a similar amount of outflows (investment in bonds issued by non-residents of the euro-area) taking place. These bare numbers, however, reveal only hazy information about the underlying currency flows. A large share of the bonds issued by euro-area borrowers and bought by foreign investors might have been denominated in currencies other than the euro. And foreign investors in turn might have bought many euro-denominated bonds issued by non-residents of the euro-area. These latter purchases would not be registered directly in the euro-area balance of payments (but would exert influences – for example via the issuer having swapped the euro proceeds into another currency – which would show up elsewhere, for example under the heading of credits and loans). The foreign bonds purchased by euro-area residents might largely be in euro denominations (non-resident borrowers issuing in euros), and it might be the corresponding borrowers who are in fact taking the currency risk of exporting funds from the euro-area. It is plausible that many borrowers outside the euro-area and mainly in the traditional savings deficit areas of the global economy (where interest rates tend to be higher than elsewhere) have taken advantage of the new deep capital markets in euros to issue debt there, and some without hedging the implicit currency risk. (If they hedge, then they are not in fact playing any part in the export of funds from the euroarea). It is possible that before the euro was launched, some interna-

Main Currents 25

tional borrowers had below the optimum share (in terms of risk diversification) of their liabilities in European currency denominations due to the lack of developed bond markets in them. Most likely the Asian savings surplus countries have played only a negligible part in this liability shift. In broad terms, the telling of the story of the euro-area turntable in the global flow of funds has to remain largely anecdotal. Evidence of the latter type includes media interviews with leading fund managers and large corporate treasurers about their long-run strategies. Some evidence might come from data on bond issuance in the international capital markets broken down by currency and residence of borrower. And there is also sometimes information (on turntable flows) derivable from balance sheets of external assets and liabilities. The same type of patchwork story can be put together for the case of the UK turntable. The data (see Tables 1.4 and 1.5, p. 10 and p. 12 ) is consistent with the story of the UK being a substantial source of capital flow into the US in the form of direct investment. Total direct investment outflows (to all destinations) ran at around £33bn p.a. in 2002–4. At end-2003 the UK had net external assets in the form of direct investment amounting to over $250bn. There is no geographical breakdown available of capital flows into or out of the UK. This means that direct evidence of the turntable hypothesis – that the UK plays an important role in channelling capital flows to the US via importing capital from the savings surplus countries and itself buying US businesses – is unavailable. Some limited data on geographical breakdown comes from survey data on the outstanding external assets and liabilities of the UK, but this is not broken down by type (portfolio, or direct investment, for example). More data is available from the regular 5-year surveys by the US Commerce Department on US external assets and liabilities (by country). But there are huge problems in deciphering these – not least due to the distinction between the legal place of ownership (for example a Netherlands Antilles holding company) and the actual residence of the final owner. Asian flows into Sterling might come via banks in Switzerland, the euro-area, or the US, and geographic analysis of UK bank liabilities by country would provide little information as to ultimate source. Huge net portfolio inflows into UK bonds or inflows via the UK banking sector (run-up of foreign deposits in Sterling) are also consistent but not conclusive with respect to the main story (capital inflows from Asia coming into the UK and being recycled partly in the form of

26 What Drives Global Capital Flows?

direct investment outflows to the US). It might well be that much of the eventual sourcing of the UK’s net external liabilities at end-2003 of £75bn on portfolio account and £256bn under “other investments” might lie in the savings surplus countries, but who can prove it? The same paucity of evidence on geographic breakdown handicaps seriously any effort to statistically verify or even estimate the amount of round tripping. For example, some evidence on round-tripping can be seen in Japanese statistics. According to Ministry of Finance data the stock of external assets in the form of direct investment amounted to ¥39tn and liabilities to ¥10tn at end-September 2004, making a net asset position in this category (direct investment) of ¥29tn. Offsetting that is a net liability position in equities of ¥38tn (with foreign holdings of Japanese equities estimated at ¥71tn and Japanese holdings of foreign equities put at ¥33tn). A reasonable presumption taking account of anecdotal evidence is that the geographical spread of direct investment outflows from Japan – with substantial concentrations in North America and Europe – is similar to that of portfolio inflows into Japanese equities (largely from European and US fund managers). But there is also likely some nonoverlap, with respect to important flows of Japanese direct investment into the Asian developing countries and small advanced economies, with no corresponding significant equity inflows from these. Hence there could be a small amount of currency turntable activity involved in the Japanese global flow of funds on direct and equity portfolio account. (In this, European savings surpluses are transformed by the intermediation of the Japanese corporate sector into inflows to the emerging market economies).

How to map currency flows The capital accounts in the balance of payments, together with the analysis of currency turntables and round-tripping, are stepping stones towards constructing currency flow of fund tables for the main areas of the world economy. As already discussed these combine current account and capital flows and focus on the ultimate sources (originators) of currency flows rather than on the precise point at which funds enter or exit a particular political jurisdiction or currency area. In practical terms that means banking flows are largely excluded, in that banks for the most part are passive agents carrying out currency flow instructions rather than creating substantial net open positions (in foreign exchange) for themselves.

Main Currents 27

The currency flow of fund tables are either historic (relating to a period which is past and for which all statistical information is already available) or in the nature of a forecast. The order of construction here is to start with the savings surplus countries (Japan, small advanced Asian economies, non-EU savings surplus countries in Western Europe, Middle East oil exporters), moving on to the tax havens and offshore centres, then to China, the euro-area turntable, the Sterling flow of funds, and finally the dollar flow of funds. We start with the Japanese yen flow of funds (Table 1.6, p. 13), constructed in late 2005 for the 2-year period 2005–6 (and so combining evidence for 2005 with a forecast for 2006). A main source of inflows to yen is the huge Japanese current account surplus (meaning that Japanese exporters’ sales of foreign currency for yen far outweigh Japanese importers’ demand for foreign currency). This surplus is forecast at ¥18tn p.a. for 2005–6. On top ¥8tn p.a. of foreign funds are projected to move into Japanese equities (involving the purchase of yen against foreign currencies). Notoriously volatile equity flows are of course hard to forecast. The underlying assumption here is that the improved profitability of Japanese companies and the fact of their

25

20

15

10

5

0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Figure 1.1 value)

Foreign holdings in Japanese equity markets (as % of total market

28 What Drives Global Capital Flows?

prospective 1-year forward earnings yields being no longer far below US levels for the first time in over two decades mean there could be a further period of catch-up demand (in flow terms) from abroad. That forecast, however, is not made with confidence. Turning to outflows from yen, a key assumption is that the government of Japan will remain an important buyer of foreign currency assets, albeit only on an intermittent basis and on a much reduced scale from 2003 and early 2004 (mainly US dollar bonds and money market instruments). On top, there is a small amount of Japanese buying of foreign equities, and a continuing net flow of direct investment out of Japan (with investment abroad by Japanese companies outweighing foreign direct investment in Japan). These items – as indeed the previously mentioned categories of inflows to yen (equities and current account surplus) – all correspond one-to-one to items found in the traditional balance of payment data. The novelty is to make a direct guesstimate of the remaining large outflows – first, changes in the total of Japanese net unhedged holdings of foreign currency bonds or money market instruments and second, additions by non-Japanese borrowers to their yen liabilities (for the purpose of financing non-yen assets). The first outflow would also include Japanese residents (corporations or investment institutions) reducing their foreign currency liabilities by re-financing in yen. The second outflow has sometimes loomed large in Japanese currency flows, being labelled the “yen carry trade”. This describes the borrowing of yen at near zero rates to help carry inventories of higher yielding non-yen assets. Some of these (non-yen assets) are in euro-denomination, meaning that they play a role in developing the euro-area as a turntable in the global flow of funds (see above). But most are in the higher coupon currencies – mainly US dollars, but also British pounds, Canadian dollars, and Australian dollars for example – issued (with the exception of Canada) by countries in savings deficit (chief of which is the US). Any estimates of the carry trade’s size have been highly tentative. Data from the Bank for International Settlements (BIS) shed some light on non-bank foreign (non-Japanese) borrowing of yen, whether from banks in Japan or offshore. But much of the carry trade may have been in the form of borrowing dollars, and then carrying out currency forward or currency hedge transactions, which would “wash up” in Japanese balance of payments statistics as inter-bank borrowing of yen (by foreign banks from Japanese banks). Much else, however, washes up under that same category – including changes in the extent to which Japanese institutional investors hedge their holdings of foreign currency bonds.

Main Currents 29

Typically the conventional data on Japanese capital flows show large but volatile outflows into foreign bonds, matched in part by external inflows via the banking sector and external borrowing operations of the non-bank sectors. Several large Japanese investment institutions play foreign bond yield curves on a massive scale – meaning that they buy bonds and borrow short-term funds in the same foreign currency (or equivalently hedge in the forward exchange market). These yield curve plays do not induce currency flows but they loom very large in Japan’s balance of payments data. Another implicit assumption in preparing the yen flow of funds for 2005–6 is that there is no significant international build-up of funds in the Japanese currency. Balance of payments data may show some long-run increase in foreign holdings of Japanese bonds, but these are likely offset by a rundown in foreign holdings of near zero-rate yen money holdings, either with Japanese banks or banks outside Japan. And there is some long-run shrinkage of the foreign euro-yen bond market (issues of yen bonds by non-Japanese borrowers), meaning that part of the inflows from abroad into the Japanese government bond market are not new additions to final foreign demand for yen fixed-rate assets (but instead replacement of one form of yen bond investment by another). A decrease of non-Japanese holdings of foreign yen euro-bonds (matched most likely by a repayment of outstanding amounts by foreign borrowers) would not normally give rise to an outflow in the portfolio section of the traditional capital account (in Japan’s balance of payments) but somewhere in the labyrinth of banking and credit transactions. (Let us make the usual assumption that the foreign issuer of the euro-yen paper had no exposure to yen risk, having swapped the initial yen liability into a non-yen one. Then the combination of its repayment and foreign investors moving the proceeds into Japanese government bonds would result in an inflow via the Japanese portfolio capital account matched by an outflow somewhere in the banking and credit sector). The flow of funds table for the yen is designed to cut through arcane balance of payments accounting to show what is really going on in terms of yen currency flows as triggered by ultimate investors and borrowers shifting their currency mix. But there is huge imprecision in the cutting! Next we move on to the group of small advanced economies with large savings surpluses in Asia and Europe (see Tables 1.8 and 1.9). In principle the data here is largely consistent with capital flows in the

30 What Drives Global Capital Flows?

balance of payments. Only the Swiss franc amongst the various respective currencies is used significantly as an international money (with large amounts of foreign borrowing in that currency). For monies which are mainly national in use there is less scope for divergence between currency flow and capital flow tables. The main guesstimates here concern portfolio flows. Available balance of payments tables do not adequately distinguish underlying non-bank from bank flows or hedged from unhedged bond transactions. The aggregate buying (across the two groups of savings surplus countries) of foreign currency bonds (on a unhedged basis) and equities may well amount to around $115bn p.a. Then there are the present (2006) high savings surplus countries in the mid-East (enjoying a bonanza of oil revenues). Their aggregate

Table 1.8 Small Advanced Asian Economies* – External Flow of Funds, 2005–6 (US$ bn p.a.) Inflows

Outflows

Aggregated Current Account Surplus

45

Official Reserves

Net Direct Investment and Equity Inflows

20

Portfolio Outflows Foreign Money and Bonds Foreign Equities

65

30 35 (35) (10) 65

* South Korea, Taiwan, Hong Kong and Singapore

Table 1.9 Non-EU Savings Surplus Countries* – External Flow of Funds, 2005–6 (US$ bn p.a.) Inflows

Outflows

Aggregated Current Account Surplus

120

Portfolio Outflows Foreign Equities Foreign Money and Bonds** Foreign Borrowing***

80 (25) (55) 30

Inflows into Equities

10

Net Direct Investment Abroad

20

130 * Norway, Sweden and Switzerland ** includes operations of Norwegian State Pension Funds *** almost entirely foreign borrowing of Swiss Francs (in the so-called “carry-trade’’)

130

Main Currents 31

current account surplus in 2005–6 is estimated at around $240bn p.a. (see Table 1.10). In addition there is a small amount of net direct investment inflows into their oil sectors. Private and public sector acquisition of foreign portfolio assets are merged into one category given the difficulty of distinguishing what is what in the desert kingdoms or sheikdoms which make up this category. We skirt over the group of countries described as tax havens and offshore centres, because this subject is dealt with in depth in the next chapter (see Table 1.11). Suffice it to say that the large amounts of investment income accumulating in these centres are treated in official statistics of global balance of payments as if they are extra-terrestrial locations. Their balance of payments with the rest of the world finds no place in the IMF reporting system. By the method revealed in the next chapter, the savings surplus in this hidden area of the world economy is put at around $80bn. Around $50bn of this total could be attributed to that proportion of investment income received on hidden wealth there which is rolled over into new investments. On the basis of anecdotal evidence (about fund management practises of Swiss and Luxembourg private bankers, for

Table 1.10 Mid-East Oil Exporters (High Savers) – External Flow of Funds, 2005–6 (US$ bn p.a.) Inflows Aggregated Current Account Surplus Net Direct Investment Inflows

Outflows 240

30

Public and Private Portfolio Outflows (Bonds) (Equities)

270 (225) (45)

270

270

Table 1.11 Tax Havens and Offshore Financial Centres – External Flow of Funds, 2005–6 (US$ bn p.a.) Inflows Hidden Investment Income Saved

Outflows 50

50

International Money and Bonds

40

Equities

10 50

32 What Drives Global Capital Flows?

example) we could guesstimate that around $40bn p.a. of the reinvestment goes into international monies (principally US dollars and euros) and $10bn p.a. into the main equity markets (in Europe, US, and Japan). (see Table 1.11). Turning next to the Chinese external flow of funds, the illustrative number in Table 1.7 (see p. 14) suggest that the main inflows to the yuan come from a current account surplus (US$110bn p.a.), direct investment inflows ($50bn) and speculative borrowing by Chinese corporations (who are replacing local currency with US dollar borrowing in the hope of profiting from an eventual revaluation or upward float of the yuan). The projected offsetting outflows from yuan take the form of China accumulating foreign exchange reserves (by around $80bn p.a.) and similar size portfolio outflows by Chinese residents mainly into foreign currency deposits (with local banks) but also into bonds and a small amount into equities. (Note that in the traditional balance of payments concept, Chinese accumulation of dollar deposits with resident banks would not be treated as a capital outflow – as these are a domestic asset. The outflow recorded would be any resulting on-lending abroad or investment abroad by Chinese banks. In fact, what occurred in 2004–5 is that Chinese residents reduced their holdings of dollar deposits at Chinese banks, concerned about the risk of exchange loss, and Chinese banks were simultaneously facing a surge in demand for dollar loans from corporate borrowers. The shortfall resulted in Chinese banks increasing their net borrowing abroad. But the banks were not the primary actors in the speculative currency flows – only passive intermediaries. Hence they do not appear in the yuan flow of funds).

Table 1.12

Sterling Flow of Funds, 2005–6 (US$ bn p.a.)

Inflows Net Inward Equity Inflows Portfolio Inflows (into Equities) (into £-bonds and money*) Direct Investment Inflows

Outflows 10 75 (20) (55) 20

UK Current Account Deficit

40

Direct Investment Abroad

45

Portfolio Outflows Equities Foreign Currency

105 * includes borrowing in foreign currency by UK residents to finance £-assets

20 (15) (5) 105

Main Currents 33

Finally before we come to the euro and US dollar flow of funds there is Sterling to consider (see Table 1.12). As we have seen, the UK is an important savings deficit area within the European context and also plays a significant role as a currency turntable. These points can be drawn out from the illustrative Sterling flow of funds (see p. 32). The main source of net outflows from Sterling into foreign currencies is the huge (relative to UK economic size) current account and savings deficit. Direct investment abroad runs at £40bn p.a. (in which there is a large US-directed element). The main inflows to Sterling are worldwide money and bond investment (mainly from Asia and Continental Europe). In addition there are small inflows in the form of direct investment and equity buying. The big guesstimate here, virtually calculated as a residual, is portfolio inflows into Sterling money and bond markets – defined to include UK resident borrowing of foreign currency to finance pound-denominated assets. (Note that data in the UK balance of payments for these items are a jumble of bank and non-bank flows and do not indicate the ultimate source. An investor in Singapore placing funds in a Sterling deposit in Paris or buying a Sterling-denominated bond issued by a non-UK borrower would be an ultimate source of demand for Sterling, but would be hidden from UK statisticians recording where capital from abroad hits the UK shore). When we come to the euro-turntable, the amount of guesstimating becomes even larger (than in the case of Sterling) (see Table 1.13). It is impossible from published data to form any reliable estimates of the new funds which global investors (outside the euro-area) are putting into euro money and bonds. Inflows into debt instruments, as shown in the euro-area balance of payments, include foreign currency liabilities in addition to euro-liabilities of euro-residents, whilst excluding inflows into euro-paper or deposits issued by non-residents of the euro-area. The capital inflow data (in the euro-area balance of payments) do not distinguish well bank intermediaries from original wealth-holders. And there is no way of distinguishing inflows into bonds from final investors taking an open currency position in euros from a whole range of financial institutions who might simply be “playing the yield curve” in euros without taking any currency position. Indeed the distinction between bank and non-bank in the analysis of global capital flows is sometimes nebulous. Is a Swiss bank acting as a fiduciary agent for an ultimate investor picked up in the data as a bank or non-bank? IMF data provide estimates of central bank reserve changes by currency and BIS data throw light on non-bank deposit activity in the euro-money

34 What Drives Global Capital Flows? Table 1.13

Euro Flow of Funds, 2005–6 (€ bn p.a.)

Inflows

Outflows

Current Account Surplus

15

Net Direct Investment Abroad

60

Euro-equities

90

Foreign Equities

60

Foreign Currency (Money and Bonds)

30

Euro-money and Bonds*

180

Foreign Borrowing of Euros to Finance Non-euro Assets 285

135 285

* Includes borrowing in foreign currency by Euro-area residents to finance €-assets

markets outside the euro-area (but in the so-called reporting area). But there remain large unknowable areas. As a guesstimate we put the amount of additional funds (originally in a currency other than euros) being put by ultimate wealth holders (including corporations and investment institutions) on a unhedged basis into euro-denominated bonds and money market instruments wherever situated at around €180bn in 2005–6. (This amount includes non-euro borrowing by euro-area residents to finance euro-assets, whether in the form of financial instruments or real assets). Much of this surely comes from the Asian savings surplus countries and also from the savings surplus countries in Europe outside the EU (Switzerland, Norway, Russia), mid-East oil exporters, and tax havens or offshore centres. There are two other big guesstimates in the euro flow of funds. First, there is the amount of new capital put by euro-area resident ultimate wealth-holders into foreign currency money and bonds. (This should be calculated as net of any switch in liability composition of euro-area residents away from euros and back into foreign currencies). Second, there is the amount of net borrowing in euros by non-residents of the euro-area, for the purpose of financing activities or assets outside the euro-area. (The banking sector can be assumed to wash out in this analysis as it typically does not assume large currency positions on its own account). Again, some small clues can come from BIS data on offshore transactions (broken into bank and non-bank components). But these only go a little way towards improving our understanding. As illustration, we put outflows into foreign currency assets (money and bonds) at around €30bn p.a. and foreign borrowing of euros at around €130bn p.a.. (This

Main Currents 35 Table 1.14

US Dollar Flow of Funds, 2005–6 (US$ bn p.a.)

Inflows Asian Central Bank Reserves

Outflows 220

Other Reserves

50

Foreign Buying of US Equities

70

Foreign Private Sector Buying 480 of US Dollar Bonds/Money (on unhedged basis): Japan (100) Other Asia (50) (including China) European Non-EU High (30) Savings Mid-East High Savers (100) Euro-area (20) Others (e.g. Russia) (20) Grey areas of World (160) Economy (incl. capital flight, laundering, etc.) 820

US Current Account Deficit

800

Net Direct Investment Outflows

40

US Buying of Foreign Equities

50

Net Foreign Borrowing of Dollars*

–70

820

* less US borrowing of foreign currency to finance acquisition of US dollar assets (financial or real) This item includes also, for example, speculative borrowing of dollars by Chinese corporations

would include for example a UK real estate company financing its UK property holdings partly in euros or Brazil financing a part of its current account deficit in euros). The grand culmination of the flow of fund analysis is the US dollar, summarized in Table 1.14. As for all the other flow analyses in earlier tables, the focus is on ultimate foreign (here non-US) wealth holders’ allocation of new funds to the currency in question (here the US dollar) and on ultimate borrowers (non-US) adding to their net liabilities in the given currency (here dollars). (There is a smaller additional item – foreign currency borrowing by US residents to finance holdings of US dollar assets – which is netted from the borrowing total – see the footnote to the table). Hence much of what looms large in conventional balance of payments data drops out (for example US banks borrowing and lending abroad, US non-bank sector lending and borrowing in dollars with foreign counterparties) and some important omissions are brought back in (for example, foreign accumulation

36 What Drives Global Capital Flows?

of dollar paper issued by non-US residents or dollar deposits in banks outside the US). The largest inflow is on the part of Asian Central Banks (including Japan, China, small advanced economies in East and South East Asia, and other developing countries). Central banks outside Asia typically plough back only interest earnings into reserves without making new additions from heavy foreign exchange market intervention. (There are some exceptions – for example Russia in the mid-2000s on the back of huge energy revenues. Moreover, there is some lack of clarity as to what part of Mid-East oil export surpluses feed official foreign exchange reserves as against private sector portfolio investments). The next biggest identifiable inflows (to US dollars) are by private sector investors in Asia. Japan is the single largest element here, but the other countries are also as important in aggregate. Primary balance of payments sources do not reveal the extent of such flows with any clarity. Raw data fail to identify directly buying of dollar paper issued by non-US borrowers including banks. (As already mentioned, there will be some reflection of these primary transactions on the US capital account, but it is virtually impossible for the analyst of the latter to decipher where the original force lies behind the statistical movements observed) Then comes the deployment in dollar money and bonds by mid-East investors, and by the owners of funds held in offshore centres and tax havens (including for example, Switzerland, Luxembourg, Caribbean islands) reinvesting saved income. (Much more is discussed about this last-mentioned item in the next chapter). And last – on the in side of the dollar flow of fund ledger – comes the biggest guesstimate of all, the amount of investment funds flowing into US dollars from the grey or black areas of the world economy (excluding re-invested income in tax havens). This item includes capital flight, money laundering, the investment of legitimate income such as shipping revenues accruing offshore and some other categories. These are the subject matter of the next chapter. We turn next to the funds flowing out of US dollars. The biggest item here is the mega current account deficit of the US. Then there are two quite modest items – net direct investment abroad (there is a tendency in recent years for US outward direct investment to exceed foreign direct investment in the US) and net US funds going into foreign equities. Although modest, these net items are quite volatile from year to year. Then we come to what is in practice calculated as a residual item – net foreign borrowing in US dollars to finance invest-

Main Currents 37

ment outside the US less US resident borrowing of foreign currencies (non-dollar) to finance investment in the US. A main example of the first type of flow (net foreign borrowing in dollars) is speculative borrowing in dollars by Chinese companies (to finance investment in China) hoping to gain from an eventual appreciation of the yuan (see p. 32). Other examples would include governments of developing countries financing themselves in US dollars (as has happened intermittently on a large scale in Latin America, for example and further back in Europe – where sovereign names such as Italy, Belgium, and Spain, were top favourites in the euro-dollar bond markets). Such flows can only be guessed at even when data on new international bond issues by country and currency are available. (For example, the fact that a jumbo bond issue by a given borrower is denominated in dollars does not mean an increase in dollar liabilities overall for that particular name, given the likelihood of offsetting swap transactions to alter currency exposure). An assumption behind the guesstimates in the Table 1.14 is that the present only small current account deficits or even surpluses in countries which have been typically large borrowers of dollars (Asian developing, Latin American developing) is likely reflected in a low overall foreign borrowing total. One further element justifying that assumption is the extent to which non-dollar currencies, particularly the zero or low interest rate yen, have gained ground vis-à-vis the dollar in the external liabilities of those borrowers. (That tallies with the anecdotal evidence on the amount of “carry trade”). A main example of the the second type of flow (resident borrowing in foreign currency) is also essentially speculative. In particular, US corporations may be taking advantage of lower interest rates abroad and betting that these will not be offset by adverse exchange rate change. The reader might well ask at this stage whether given the huge imprecision in the estimating of global flow of currency data the effort is worth the candle. Unfortunately the answering of that question will take quite a few chapters more of explanation. But jumping ahead of our story, the answer is yes! And already, in looking at the final table on the global flow of dollar funds, the reader might already be even more dubious than before of simplistic accounts of how present large US savings and current account deficits are unsustainable. There is a broad – and strong range – of global inflows into US assets, amplified as the case may be, by powerful turntables. Much work has to be done before even a highly tentative judgement could be made about sustainability.

2 Black Money

It is impossible to give a comprehensive picture of international money flows without at least sketching the movement of black or grey capital around the globe. For obvious reasons, officially compiled balance of payments data provide no direct measures which would help in the sketch. Fortunately, however, for the analysis of global capital flow, even grey and black capital does not move completely without trace on the data. The principles of double-income accounting (which apply also to balance of payments data) and the zero sum condition (all current account balances should add up to zero) means that hidden capital flows leave clues somewhere in the global payments records. A first step towards utilizing what clues are available in the data is to set out a description of sources, destinations, and intermediaries, in the hidden global flow of capital. One main source is wealth, itself generated in wholly legal economic activity, which seeps out of high tax or high-risk political jurisdictions into low or zero tax safe-haven centres. Safety and low tax are dependent on keeping the assets invisible to tax and regulatory authorities in the country of origin (of the funds). Offshore financial centres and tax havens, especially those with wellenforced banking secrecy, play an obviously important role both as intermediaries and destinations with respect to this type of capital flow. The inflow of legally-earned money into hidden areas of the world financial system should be distinguished from funds whose source is in criminal activity including narcotics dealing and trafficking. And a related distinction can be made with respect to the use of funds once having entered the safely hidden areas. Some funds simply accumulate there, with growth dependent on investment returns, and may be spent in a way that is wholly legitimate (mainly the acquiring of goods 38

Black Money 39

and services for the owner or his/her chosen beneficiary as a genuine gift). Others are spent for the purpose of furthering criminal activity (including terrorism).

Grey vs. black At the level of international governmental co-operation the distinction just made between hidden capital flows which are criminally tainted and those which are not is critical to which official agency is involved in policing and with what degree of government backing. Almost all governments are involved in tracing and hopefully impeding global capital flows which stem from and feed criminal activity. This is a central component of what Moisés Naím (2003) has famously described as the Five Wars of Globalization. These are the battles to control the illegal trade in drugs, arms, intellectual property, people, and money. According to Moisés governments have been fighting these battles for centuries, and generally losing them. Thanks to the changes spurred by globalization over the last decade their losing streak has become even more pronounced. Most financial centres and tax havens ostensibly co-operate in search and destroy missions against criminal activity making use of secret transit or even long-time parking facilities within their banking system. The Financial Action Task Force (FATF) was established in 1989 at a G-7 Summit with the brief of co-ordinating and spearheading an international campaign against criminal money laundering. (The FATF’s secretariat is housed at the OECD’s Paris headquarters but is an independent organization). Its ultimate sanction against recalcitrant nations (which refuse to co-operate) is a recommendation for economic sanctions. There are at present (2006) only three identified non-co-operating nations – Nauru, Myanmar and Nigeria (see FATF, 2006). The effectiveness of the FATF has been questioned. In particular, the ultimate criminal organizations behind certain capital flows might well have been successful in disguising their true ownership even from the banks. And there are grounds for difference of opinion as to whether the authorities in the various financial centres or tax havens are trying hard enough to uncover the various disguises. Back in 1999, Raymond Baker of the Brookings Institution concluded that anti-money laundering efforts around the world are a failure (see Baker, 1999). But the effort continues and has been most recently intensified with respect to terrorism.

40 What Drives Global Capital Flows?

By contrast, there is not universal (or even near-universal) agreement on co-operation regarding the flow of capital in and out of grey areas in the world financial system where the source and end-destination are noncriminal. The responsible authority with respect to making such flows more transparent for taxation purposes is the OECD. That organization derives its authority in this field from a May 1996 declaration of Ministers (whose governments belong to the OECD) calling upon the OECD to “develop measures to counter the distorting effects of harmful tax competition on investment and financing decisions and the consequences for national tax bases”. A preliminary report and recommendations were approved by OECD ministers in 1998, (“Harmful Tax Competition: An Emerging Global Issue”) with Luxembourg and Switzerland abstaining. The OECD Committee on Fiscal Affairs was instructed by the Ministers to also develop a dialogue with non-member countries (of the OECD) and formulate measures. In 2000, that Committee, in a report under the title “Improving Access to Bank Information for Tax Purposes” proposed an “agreement on exchange of information on tax matters”, whereby the tax authorities in each country would share information about income (particularly interest and dividend payments) paid to each other’s residents. (For example, France would be obliged to provide German fiscal authorities with information on request about income paid by French banks to a particular German resident). So far, the OECD efforts on tracking down for taxation purposes the movement of capital through grey areas of the international financial system have lacked momentum at a global level. Within the EU, however, considerable developments have taken place. All member countries (of the EU), with the exceptions of Austria, Luxembourg, and Belgium, signed up in 2004 to an exchange of information (with respect to interest income paid to EU residents) from June 2005. (The three mentioned countries have been given a 10-year exemption, to be reviewed subsequently in the light of whether Switzerland, in particular, has signed up to the OECD convention on information sharing). In return for the exemption, the three EU countries as just listed have agreed to levy a withholding tax on income received by residents of other EU countries. Switzerland has agreed to apply the same tax as Belgium, Austria and Luxembourg, on EU resident accounts (with the revenues mainly recycled to the governments of the political jurisdiction in which the particular non-resident lives). The tax starts at a rate of 15% in 2005–8 (June to June), rises to 20% in 2008–11, and finally to 35% from 2011 onwards.

Black Money 41

The Swiss government points to the fact that non-declaration of investment income is not a criminal offence in Switzerland and so its enforcement agencies will not co-operate with foreign governments seeking to pursue this particular suspected misdemeanour on the part of their residents or nationals who are clients of Swiss banks. Beyond the issue of economic self-interest for Switzerland (based on the importance of its financial sector) lies the belief of some political liberals (both in Switzerland and the world outside) that banking secrecy is a basic right. It is up to governments to design taxation systems around this (putting higher taxes on visible wealth and on consumption, and less on income which can be diverted to secrecy-protected banking systems). And indeed that is what happens in some degree. Viewed in this light, banking secrecy in tax havens might be seen as a useful external limit to governments pursuing populist taxation agendas which could eventually lower the general level of economic well-being. In addition it is a chance for all to share in some haven from an allpowerful or all-prying state. Bank secrecy provides a vital chance to gain protection (albeit not 100% certain) from the demise of that state or its defeat in war. So far the principle of banking secrecy in Switzerland and Luxembourg has been upheld against considerable pressure from outside. These two countries, however, are not alone in offering banking secrecy. Singapore, and various Carribean offshore centres also enforce secrecy (see Suss et al, 1988). (Singapore, unlike Switzerland and most Carribean centres – which are UK dependents – does not co-operate with the EU in the taxation of income paid to EU residents). These centres (Singapore and Carribean), however, are exposed to distinct political risks – actual or potential – from the mainly EU-related risks in Switzerland or Luxembourg. (In particular, could Singapore have to bend to Chinese military and economic might under certain circumstances and curtail or infringe banking secrecy or other forms of protection for specified groups of clients)? The popular opponents of banking secrecy quote estimates of the huge amounts of funds flowing through the grey areas in the international financial system which largely depend on the institution of banking secrecy. But these numbers do not distinguish criminal from non-criminal flows. As illustration, Raymond Baker (1999) in testimony to the US Senate Committee on Government Affairs, concluded, “The passage of corrupt money from developing and transitional economies into the US and Europe is estimated at a minimum of $20bn per year and perhaps as high as $40bn per year. Mispriced international trade generates a flood of money from developing and transitional economies

42 What Drives Global Capital Flows?

into the US and Europe of at least $80bn per year. The total of these two components of illegal flight capital is therefore at least $100bn per year flowing into western economies. It is estimated that at least half is immediately or eventually transferred into the US. A more exhaustive examination of illegal flight capital, including an estimate of the exploding wire fraud component and money that spills from developing economies directly into offshore tax havens often without immediate assistance by western business people and bankers, although eventually lodged in US and European accounts, would produce substantially higher figures, likely multiplying the total to several hundred billion dollars annually.”

Methods of detection Indeed, when it comes to tracking the flow of money through the international financial statistics which are available, the distinction between criminal and non-criminal source or destination is virtually impossible to make. Drug king-pins can use the same methods as the legitimate business owner to channel funds into the chosen tax haven without these coming to the attention of regulatory (including tax) officials. (In fact, increasingly, the king-pins use ostensibly legitimate business enterprises, often in areas of the economy where much of the turnover is usually for cash, to carry out these fund movements). They may also use the same methods to extract income or capital from their wealth secreted in tax havens for the purpose of buying goods and services, without the extraction becoming visible to prying authorities. In sum, though detective work into the publicly available international financial data can yield some return to effort in terms of identifying global flow of funds passing through grey areas of the world economy they cannot in general distinguish the shade of grey – whether nearer black (criminal) or white (legitimate). An exception to that rule is the criminal diversion of supranational agency lending to governments of developing countries into the private accounts of their rulers. The technique used by researchers in this area is to estimate the amount of liabilities to supranational agencies (for example the World Bank) for a given country according to loan data available (from the agencies themselves). Then external liabilities of the given country as reported to the IMF and BIS are compared with these estimates. If the reported liability total seems too small, it could well be that the shortfall has a counterpart in (hidden) private capital outflow on the part of the rulers. There could be currency flow implications if the official

Black Money 43

loans are in a different currency denomination from the assets accumulated by the rulers. But there are no grounds for presuming such a divergence as a general rule. Another technique used by “capital flight detectives” (not directed at embezzlement by rulers as above) is to reconcile exports as reported by country A to country B with imports from A reported by country B. A systematic excess of reported imports (into B from A) over exports (from A to B as reported in A) would suggest that there is underinvoicing (of exports from A) occurring as a means of effecting hidden capital exports (from A). Specifically, exporters in country A might be quoting lower amounts on their invoices used as trade documents than what in fact they are receiving – with the difference being paid directly by the buyer (in B) into a foreign bank account (controlled by the exporter). Implicitly part of the story must be the buyer (in B) entering (for official purposes) the whole of the amount paid (the invoice amount plus the supplemental payment) and this being picked up (by trade statisticians) in B’s import total. (If, by contrast, the buyer has to conceal the extra payment, then there would be no revealed discrepancy). Another similar practice is for (a firm in) A to be over-invoiced for imports from B, with the supplier in B rebating an amount direct into a foreign bank account controlled by (the firm in) A. If in B’s trade data, the export to A is registered as the net amount received less the rebate, but in A’s trade data, the import from B is recorded at the full invoice amount, then there is a detectable discrepancy. Researchers who have used these two techniques have come up with some remarkable results. For example, one study (Boyce and Ndikumana, 2003) estimates that in the period 1970–96 capital flight from 25 lowincome countries in sub-Saharan Africa totalled more than $190bn. With imputed interest earnings the accumulated stock of flight capital from these countries would amount to $285bn – meaning that they were in fact net creditor nations (see also, Collier, 2003). The two techniques are indeed ideal for investigations into capital flows pertaining to one country or group of countries. When it comes to detective work on global capital flows there are techniques (in fact two main ones) of broader relevance. These involve scrutiny of two error items identified in global balance of payments data and sometimes discrepancies in reconciliation between national income accounts and balance of payments data might be suggestive. The two error items include first, the total of so-called errors and omissions entries, summarized across all countries; second, there is the total of all reported current account balances (and its difference from zero) which should

44 What Drives Global Capital Flows?

equal zero (if all countries reported) but in practice is a large negative amount. Let us look at these in turn.

Errors and omissions The average annual total of errors and omissions in national balance of payments data (summed across all countries reporting to the IMF) in the 5-year period 2000–4 was a negative $55bn. (In three years the total was large and negative, in two small and positive). What could contribute to this? (Note that by averaging over several years we seek to eliminate random sources of error in the estimation process). At a national level, there are several main possible reasons (other than randomness) for the balance of payments failing to balance – hence the need for the statistician to insert a balancing item for unrecorded items. These include unregistered capital exports (for example, in the form of banknotes). Such (unregistered) capital outflows are a source of negative contribution to the errors and omission total. Then there are smuggled imports (these could include illegal substances, including narcotics; but there is also the smuggling of legal merchandise to avoid payment of value added tax). These also are a negative source of errors and omissions in the balance of payments. Negative contributions (to errors and omissions) can also stem from invoice tampering undertaken by exporters or importers in the given country (A) to facilitate hidden capital outflows from a trade partner (country B). We describe this form of hidden capital outflow as “synthetic” in that no direct international transfer of funds is made by the ultimate capital exporter. An example of tampering is the payment of supplementary amounts to foreign suppliers of goods and services (as described in the section above). This only becomes a source of negative contribution to total errors and omissions (across all reporting countries) if the payments are not registered in the import total (of the country where the buyer is resident). There is no general rule on this – sometimes it is included in the import total, sometimes not. A similar source of negative errors and omissions exists with respect to rebates of amounts paid by customers in the trade partner country. Take the example of an exporter in country A receiving the full invoice price for goods sold to a customer in country B. The exporter then rebates a part amount (as a settlement discount) into the customer’s foreign bank account (so facilitating a hidden export of capital by the latter). If balance of payments data collectors in country A register the full export amount on the invoice

Black Money 45

with no account being taken of the rebate, this would give rise to a negative errors and omissions item. In any one country’s balance of payments, hidden capital flows and related goods flows might net out to show no trace (in the errors and omissions item). But when the trade partner’s balance of payments data are considered too, all trace cannot usually be erased. Specifically, in country B above, unregistered capital exports and an overstatement of imports (or understatement of exports) both might cancel each other out. (In simple terms, the trade surplus is estimated at a lower level than the underlying reality, and capital exports are similarly under-recorded, and so the balance of payments arithmetic is not affected). The errors and omissions item in the balance of payments data for country A, however, or a negative sum of trade balances (in goods and services) across all reporting countries, might well give the game away. Traces can indeed emerge at the global level (in the form of a negative trade balance total), even though various invoice practices, and the quirks of how these are picked up by the statisticians, mean that errors and omissions either at the level of one particular country or added up for all reporting countries reveal little. Of course different traces might become so inter-laced as to make clear decipherment impossible. Hidden capital inflows, in particular, can leave traces opposite in sign to hidden capital outflows. An example (of hidden capital inflow) would be foreigners disguising their ownership of assets (in the given country) under a resident name for fear of confiscation or freezing in the event of war or revolution. An alternative motive for hiding can be the evading of restrictions on nonresident ownership. For example, overseas Chinese participated in this way in the booming real estate market in China during 2003–5. Capital inflows so disguised (funnelling into a phoney resident account) are a source of positive errors and omissions in the balance of payments statistics. Another example of hidden capital inflow would be exporters of narcotic drugs from developing economies stashing the proceeds via money laundering transactions into resident owned accounts in the US and Europe. In itself, goods smuggling sometimes gives rise to offsetting errors in the two countries which are party to the particular trade. In the country exporting narcotics, there might be a positive contribution to errors and omissions (from the given export), whilst in the importing country there might be a negative contribution. The word “might” is used because in many cases narcotics exports will have a direct counterpart in the form of hidden capital outflow; and the import of

46 What Drives Global Capital Flows?

narcotics may be associated directly with hidden capital inflows; and so there is no decipherable trace anywhere in the balance of payments statistics. As another example of blurred traces, some hidden capital exports from country A in the form of banknotes (giving rise to negative errors and omissions in country A) might be credited to so-called resident accounts in country B which are in fact non-resident owned and will so contribute to a hidden capital inflow there (giving rise to a positive errors and omissions item in country B’s balance of payments). But netting out is far from total. Some goods and services which are smuggled into country A may be registered as exports in B. Some capital exports in the form of notes go directly into accounts which are registered as non-resident in the receiving country. In Table 2.1 an illustrative breakdown is given of net contributors to a “normal” total errors and omissions item, summed across all countries reporting to the IMF, of a negative $55bn p.a. (corresponding to the 5-year average referred to above). Of course in any particular year there can be a large amount of white noise (including non-offsetting mistakes in recording wholly legitimate and transparent international transactions in goods, services, and capital) affecting the outcome (which can be very different from the hypothesized average underlying amount). The numbers given in the table are “underlying” values for each item. Each estimate is largely a guess (except for the total error which is deduced from an averaging procedure for IMF published data). Disguised capital inflows (item 1) have sporadically been a source of large positive errors and omissions items in the US (back in the late 1970s and early 1980s, for example, subsequent to the US freeze of Iranian assets) and most of the time in Switzerland (where some black foreign money is reputedly registered in the name of resident attorney accounts). Anecdotal evidence suggests that various disguising practices have been widespread in the London residential real estate market (resident names as purchasers standing behind an ultimate foreign owner) and in a variety of hot property markets around the globe where non-residents cannot participate directly. Given the weight of evidence which is available, $125bn per annum seems well within the ballpark of annual capital inflows worldwide hidden under resident names. In general the purchase of real estate under “white” resident names is a main route for laundering black or grey foreign wealth. Hidden capital outflow in the form of banknote exports or other unregistered forms (for example, wire transfers) is shown at $100bn

Black Money 47

(item 2). This is almost pure guesswork, but together with item 4 (synthetic hidden capital outflow in the form of invoice tampering not picked up by data collectors on either side of the trade transaction) and item 3 (smuggling of goods) less item (1) (disguised capital inflows) add up to the correct total (a net negative $55bn). The smuggling of imports is a net figure – with the underlying gross amounts of smuggling (including the hidden illegal export and import of narcotic drugs and armaments, for example) considerably larger. There are more tax incentives to smuggling imports than exports (for example, avoidance of sales taxes) and so a net import amount of $40bn is shown. Capital flight facilitated by invoice tampering (under-reporting exports with the balance paid into a foreign account or over-reporting imports with a rebate of amount paid put into a foreign account) non-reported on either side of the border is shown at $40bn. That is guesswork. But for the purpose of capital flow analysis it is the sum of items 2 (nonreported capital outflows) and 4 (synthetic capital outflows created via invoice tampering non-reported by both exporter and importer) that matter, not the precise division between them. We know little about the geographic sources of the capital flight in the direct form of banknote and other unregistered capital exports or in the synthetic form of secret invoice tampering (hidden from data collectors in both countries – importing and exporting). Anecdotal evidence and other research suggests that there is a large share from developing and transitional economies. But also included is the suitcase money from European investors with destinations in Luxembourg and Switzerland or from US investors into the Caribbean centres. And of course there are the mafia and other crime organization whether in the advanced or developing economies which use the full array of invoicing and banknote export techniques for laundering ill-gotten gains in a way which fuels the hidden outflow of capital. One of the most blatant techniques was uncovered in March 2002 when the authorities located a tunnel across the Mexican-US border through which billions of dollar banknotes had been smuggled in one direction in exchange for narcotic drugs passing in the opposite direction. Some of the hidden outflow of capital from particular advanced economies flows back in. For example US mafia organizations having exported funds to the Cayman Islands (in a way which contributes to the negative errors and omissions items in the US balance of payments) might then place them there in US dollar money or bond instruments. This re-placement would give rise most likely to a recognized (by US balance of payments statisticians) capital inflow to the

48 What Drives Global Capital Flows?

US. Implicitly, in Chapter 1, the total foreign flow of funds into US dollars from grey areas of the world economy (see Table 1.14) excluded this recycling of US owned capital (to the Caribbean and back). But that same item does include a guesstimate of the bilateral balance of payments between the US and the exporters of narcotics. As illustration, the US current account deficit might be around $20–30bn larger than the published amount due to the non-recording of illegal narcotic drug imports. The global net export revenues of narcotic suppliers (not recorded in any balance of payments data) might be around $50bn annually. Net export revenues translated into hidden capital accumulation by drug exporting kingpins should be distinguished from estimates of trade turnover which are some ten times higher than this. Suppose $40bn of those revenues end up in various forms of dollar investments, whether in the US or elsewhere. Then we could say that the narcotics trade and associated capital flows (which do not include the already mentioned capital export activities of drug dealers in the US) might generate a net inflow of as much as $20bn annually in the global flow of dollar funds. That amount is much smaller than the amount of funds coming into dollars worldwide from hidden capital flows (in direct and synthetic form) as derived above from the errors and omissions item across all balance of payments data (in Table 2.1 under items 2 and 4). This is one key component of the data detective’s estimate of total foreign grey capital flowing into dollar assets. The other key component comes

Table 2.1 Total Errors and Omissions, 2005–6 (summed across balance of payments data for all countries reporting data to IMF) (US$ bn p.a.) (1) Disguised Capital Inflows (hidden under resident names)

Total Net Errors and Omissions (negative)* (1) – (2) – (3) – (4)

125

55

180 * based on average of past 7 years

(2) Capital Outflows such as banknote exports and other unregistered forms

100

(3) Net Smuggling of Goods

40

(4) Synthetic Capital Outflows in form of trade invoice tampering which is hidden from data collectors in both exporting and importing countries

40

180

Black Money 49

from an analysis of the total of the current account balances in the world balance of payments and its difference from zero, described in what follows as the aggregate current account gap.

Aggregate current account gap clues We have already seen in the previous chapter (see Tables 1.1 and 1.2) that the total of world current account balances typically (during the past three decades) amounts to a negative amount equivalent to between 1 and 2% of US GDP. The sources of this discrepancy have been reviewed at fairly regular intervals by the IMF statisticians (see for example, IMF World Economic Outlook, October 2000). That analysis only goes so far as it excludes the more speculative considerations about grey or capital flows that concern us here. But it is nonetheless a useful starting point in the detective work. The IMF single out a number of factors contributing to the aggregate gap – missing investment income, missing income of shipping companies, discrepancies in merchandise trade and transfers. Other researchers, including the study by two Federal Reserve economists, (Marquez and Workman, 2001), follow the same approach. Missing investment income has long been recognized as a big factor in the aggregate global trade gap. According to IMF estimates for 2004 the sum of investment income surpluses and deficits across all reporting nations came to a negative sum of around $100bn compared to a total current account gap widely projected for 2005 of around $130bn. (For example, the OECD secretariat in June 2005 forecast a gap of $140bn for 2005 and $200bn for 2006. That compared with an average of $135bn p.a. for the five-year period 1999–2003). Discrepancies in this account reflect mainly misreporting of portfolio investment income. These discrepancies stem from incentives to hide capital outflows, the growth of offshore financial centres, and some recording idiosyncrasies. The incentive to underreport capital outflows arises largely from the scope to evade tax on the corresponding investment income. Under-reporting of capital outflow leads to an under-reporting of investment income. Balance of payments statisticians use cumulated capital outflows to estimate the corresponding stock of claims on foreigners. These estimates are then used to compute investment income. Thus understating capital outflows translates into understating the associated income. We have already discussed some forms of under-reporting capital outflows – those which contribute to the aggregate errors and omissions item, diversion of official loans by

50 What Drives Global Capital Flows?

corrupt rules of developing economies into their private wealth pool (in a tax haven), and wealth accumulation by drug barons out of the export proceeds of narcotics sold to the advanced economies. It is important to realize that the total of missing investment income is not comparable one-to-one with the current account balances of reporting countries. The latter, as we have seen in the previous chapter, correspond to savings deficits or surpluses. That is not the case with missing investment income. We must first analyze how much of the missing income is saved and how much spent, and where the spending is recorded. We can construct a hypothetical country, say Global Tax Havens, into which all the missing investment income flows, and into which there is a large continuing flow of grey or black capital from the rest of the world matching unreported aggregate income there. Suppose all the spending by Global Tax Havens (whether out of investment income or capital as the case may be for any particular investors with secret accounts there) were recorded as net exports of goods and services by the IMF reporting countries (in aggregate) and could be identified as equal to say $50bn annually. (This $50bn figure in fact is the estimate used in our analysis below – see Table 2.3). Then the reporting countries in aggregate would have an underlying surplus on trade (in goods and services) of $50bn and an overall current account deficit of $50bn (allowing for their aggregate deficit on investment income account of an estimated $100bn as discussed above). The hypothesized equivalence (between spending out of hidden investment income or capital in tax havens and net exports from the reporting countries) holds only if two conditions are satisfied. First, all the spending would have to be picked up as exports in the statistics of the reporting countries. Second, there must be no consistent influences pushing the world aggregate trade balance away from zero other than net trade with the Global Tax Havens as discussed. In fact neither condition is satisfied, as we shall see below. As regards the first condition, we could imagine a hypothetical situation in which indeed all spending out of the Global Tax Havens would be recorded as exports in the rest of the world. Wealthy residents of developing countries, for example, might find only abroad the type of goods and services that they seek. (This might apply, for example, in the special case of health services). Both they and residents of advanced industrialized economies might be trying to avoid conspicuous consumption in their own country where it could draw the attention of the tax authorities. Their spending might be picked up largely as tourism exports in the reporting countries. Entrepreneurs with secret

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accounts in tax havens might inject funds into their legitimate (or illegitimate) businesses by having some of their purchases of services invoiced to companies under their control and registered in an offshore centre (and then not charging the respective businesses for them). This is more difficult to do in the case of goods (in that in most cases the entrepreneur would not want these shipped to where the offshore company resides). In the case of services, there is no official track of to which geographic location they are delivered. In practice, it must be doubted whether all spending from Global Tax Havens is indeed registered as exports in the reporting countries, but this could be nearer the truth in the case of trade in services than in merchandise. Recorded world trade in services is in modest deficit (by an estimated $20bn annually on average in recent years). This is despite an un-recording of shipping revenues (corresponding to fleets registered under flags of convenience) estimated at around $60bn annually. There could be some offsetting positive bias in non-shipping services trade due to errors in recording of transfers. IMF economists suggest that the total of service exports, ex-shipping, might be overrecorded by around $20bn due to advanced economies treating remittances back home of foreign workers as transfers (in their balance of payments) whilst the recipient country treats them as foreign earned income. But that would still leave net services trade including shipping revenues (adding back in the estimated omission of $60bn as above) in surplus by around $20bn. Some of that surplus might be due to spending on services by the shipping companies themselves. Equivalently, their net revenues, before purchase of ships, might be near say $50bn rather than $60bn and it is that smaller total which should have been added to the crude estimate of the world trade balance in services. Even so that would leave the services balance, adjusted to exclude net shipping revenues and for errors in transfers accounting, in slight surplus. And to judge the information content of that slight surplus we have to acknowledge the non-fulfilment of our second condition above. There is indeed an important bias tending to push reported world trade in both goods and services into deficit – and that relates to the systematic under-reporting of export income by economic agents seeking to export grey or black capital. The bias stems from the under-reporting being one-sided (by the exporter, but not the opposite-number importer), as against the two-sided under-reporting which is a source of negative errors and omissions totalled from all reporting countries’ balance of payments (as described above).

52 What Drives Global Capital Flows?

The fact that the non-shipping global services trade balance is in slight surplus despite this bias towards negativity, suggests that there is an important volume of service exports invoiced to offshore centres and tax havens (and for which there is no corresponding import reported) and of offshore-financed tourism. Indeed in recent years, tourist trade balances reported to the IMF for all countries sum to a positive $30–40bn, consistent with under-reporting of tourism imports. That would characterize the situation of spending by offshore-financed tourists not being recorded as imports in their country of residence. (Some of this spending might be out of newly arrived capital into the tax havens rather than as a deduction from current income). Part of the total spending out of Global Tax Havens is inevitably categorized as domestic expenditure in the reporting countries – and this (incorrect classification) tends to push the world trade balance into smaller surplus (and the world current account balance into greater deficit) than would match the underlying balance of trade (and current account balance) of the Global Tax Havens. In particular, some residents of the advanced economies use offshore bank credit cards or simply cash (collected from their foreign accounts) to pay for goods and services in their own country. (This particular practice has become more hazardous in recent years, given widespread investigations by the US Internal Revenue Service and more recently the UK Inland Revenue into the credit card companies). And there are many other ways of disguising the origin of funds used to finance expenditure that would be registered as domestic in the national income accounts. The classification of some exports to Global Tax Havens as domestic spending tends to drag the aggregate registered trade surplus of the reporting countries below its theoretical level (and thereby pushes some estimates of hidden wealth transfers into offshore financial centres to well in excess of underlying reality). There is also the treatment of shipping to consider (in explaining how the actual aggregate trade balance of the reporting countries might differ from theory). In the illustrative calculations above regarding the services trade balance we suggested that shipping companies saved as much as $50bn annually offshore (gross revenues of the offshore shipping companies less current expenditures). Some part of these savings could be spent on new ship deliveries, not recorded in any national balance of payments as imports – meaning that perhaps as little as $20–30bn annually accumulates to the offshore ship owners on a net basis. (As illustration, Greece, where many shipping concerns are registered, does not include a shipping account in its balance of payments, treating such

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business activity as offshore). By the same token, global merchandise imports are most likely under-recorded on account of shipping. IMF economists suggest, moreover, that synchronization problems in themselves mean that the total of merchandise trade balances should sum to a substantial positive number (rather than zero). The synchronization problem is based on the observation that when world trade is growing (the norm), the lag between export and import registration (exports registered first) means that world trade would tend to be in recorded surplus. Another source of positive bias is the tendency for OPEC countries to report oil sales at the official price and importing countries at the actual price (taking account of secret discounts). There is also the smuggling of imports to avoid quotas (where these goods are reported as exports in the delivering country) or various forms of taxation. (On a net basis such smuggling has already been “guesstimated” at $40bn in Table 2.1). Despite these considerable positive biases, the overall recorded world merchandise trade balance has been in only modest surplus (by around $35bn p.a. on average in the 7-year period 1998–2004). That would be consistent with manipulation of export and import prices, undertaken so as to effect hidden capital exports. (This manipulation occurs, of course, both with respect to merchandise and services trade). The form of invoice tampering is identical to that already discussed above under the heading of total errors and omissions in the world balance of payments. But this time, there is asymmetric treatment by the official statisticians on both sides of the transaction. As illustration, an exporter under-invoices customers and arranges for an additional sum to be paid into a secret bank account in a tax haven. The statisticians in the exporting country record deliveries at face value of the invoice. But in the importing country, suppose the statisticians record the full value of the goods or services including the payment into the secret account. The business in the importing country would label the extra amount as a commission of some type, and there may possibly be some type of paperwork supplied by the exporter in this regard. The importing business might intend to claim the expense of the commission against its own profits for tax purposes. As a result of the asymmetric treatment, a net deficit contribution is made to the global balance of trade. The same analysis applies in the situation of an importer over paying for goods and then being refunded part into a secret account. If the refund is recognized by statisticians in the exporting country (as a rebate of some type), then again there is a negative contribution to the world trade balance.

54 What Drives Global Capital Flows?

Invoice tampering is an important element in the overall reconciliation of the global current account gap with the estimate of savings in the Global Tax Havens. This is done in Table 2.2. The estimated global current account gap in 2005–6 is put at $130bn. To that we must add estimated net spending on smuggled goods (recorded by the exporting country but not the importing) and missing ship imports – see line 5, US$55bn – and timing differences (which lead to understatement of the total current account deficit of the reporting countries) amounting to an estimated $25bn (line 7), making a total of $210bn (line 1 + line 5 + line 7) which has to be explained by missed sources of savings in the world economy or underrecorded savings. A guesstimate is that saving out of investment income accumulating in tax havens and offshore centres amounts to around $50bn (line 2). Then there is an adjustment item – line 4 – which relates to spending by Global Tax Havens wrongly categorized as domestic expenditure within the reporting countries rather than as exports (to Global Tax Havens). Finally there is the residual item – line 6 – hidden net capital exports to offshore centres and tax havens in the form of invoice tampering which contributes to the global current account gap. By subtraction, this item amounts to $115bn annually. It is important to realize that these hidden capital exports are calculated net of any amounts spent out of them during the current year. Such spending would add to recorded exports.

Table 2.2

Analysis of the Global Current Account Gap, 2005–6 (US$ bn p.a.)

(2) missing savings accumulating 50 in tax havens out of investment income

(1) estimated global current account gap

(3) savings surplus of international shipping companies off-shore

25

(7) timing differences in trade

25

(4) domestic spending financed by off-shore funds

20 (5) unrecorded spending on imports of ships and smuggled imports

55

(6) hidden net capital exports 115 in form of invoice tampering (transparent in one but not both trade partner countries) 210

130

210

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This category of hidden capital inflow to the offshore centres and tax havens together with the investment income accumulating there must either be spent or saved. That is the basis of the reconciliation shown in Table 2.3 below. It is important to realize that the inflows recorded here (under line 1) are only those omitted from the savingsinvestment (or implicitly net export) balance estimation in the reporting countries. The large amount of transfer payments – of savings recorded but transferred clandestinely either to tax havens or between reporting countries – are excluded. Many of these have been described in the previous section (see Table 2.1). In broad terms the inflow of unrecorded savings from the rest of the world into the tax havens estimated at $115bn (line 1) plus income received on undeclared (secret) assets held there estimated at $100bn (line 2) equals spending from the offshore centres ($50bn) (some of this is recorded as exports from the rest of the world to the Global Tax Havens, the other part – put at $20bn above – as domestic expenditure) (line 3) plus net accumulation of capital in the Global Tax Havens (estimated at $165bn p.a. as in line 4). Table 2.3 Tracing Trade Balance Divergences to Global Tax Havens, 2005–6 (US$ bn p.a.) (1) inflows (to havens) via invoice tampering which effects global current account gap

115

(3) spending from offshore centres out of investment income

(2) investment income in off-shore centres

100

(4) net savings in offshore centres

215

50

165 215

Reconciling the loose ends How do the around $115bn of new savings annually flowing in to offshore centres and tax havens (excluding the re-investment of savings from income accumulating there) together with unregistered capital exports from the reporting countries amounting to $100bn and synthetic outflows of $40bn referred to in Table 2.1 (lines 2 and 4) (but which do not detract from savings as estimated in the reporting countries) relate to the around $180bn of inflows to dollar bonds and money market instruments from “grey areas of the world economy” as

56 What Drives Global Capital Flows?

identified in Table 1.14? If we deduct a guesstimated $20bn of net accumulation in dollar instruments by the shipping companies, that leaves $160bn to be explained. We might reduce that amount ($160bn) by around $25bn (see p. 48) to take account of a net demand for dollars guesstimated at in the narcotics trade (the US is a net importer of narcotics, but exporters of narcotics globally are attached to the US dollar as their main investment vehicle). The remaining $135bn comes out of the net unreported savings of $165bn in Global Tax Havens, the $140bn hidden transfers of savings (already registered in global aggregate national income totals) from the reporting countries (Table 2.1) net of any induced foreign (non-US) borrowing of dollars to finance these (in the context of external balance), and the corrupt diversion of loans from official agencies to governments in the developing countries (see pp. 42–3). Are there any other clues to hidden capital flows, especially those generating global demand for US dollar assets, in any of this? At the beginning of this chapter we referred to the residual income error – the difference between the savings surplus or deficit identified in the national income accounts and the current account in the balance of payments. As a matter of national income accounting, this difference is identical to the divergence between the measure of national income based on the expenditure or production estimates and that based on aggregate income estimates. (In principle, if measurement were accurate there would be no error). There are many possible sources of divergence, none of which appear to be systematically related to the generation of hidden capital flows. The income measure appears to more subject to white noise over short periods of time. One possible source of systematic divergence (between income and expenditure measures) is failure of national income statisticians to identify fully final expenditures and for some of these to be counted as intermediary outputs. On the income side of the ledger, however, these are not counted as deductions from corporate profits. And so estimates of national income would be greater than of national expenditure – a positive income residual. An important example of this phenomenon was during the years of the US bubble economy in the late 1990s, when the US current account deficit was systematically greater than the recorded savings deficit by around 1% of GDP. And that compared to expenditure-based measures of the economy being around 1% below income based measures. One particular source of difficulty (in identifying correctly final expenditure) has been that enterprises in the new economy could not

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readily identify that part of their sales which were to final customers (consumers) as against other enterprises. As illustrations both computer software and hardware makers had no precise knowledge as to what share of their output was satisfying retail or business demand and the latter was overestimated. (Equivalently, too many new economy sales would be picked up as intermediary business expenditure rather than as private consumer expenditure and so excluded from estimates of GDP). In principle investment spending might be underestimated in grey or black areas of the economy (and treated instead as intermediary output). Mafia organizations presumably do not present corporate accounts in which business investment is presented at full value. And some of their consumer spending might be camouflaged. But the underrecording of spending which results would often be closely matched in an under-recording of income. Similarly, all the forms of export and import invoice tampering discussed would have an equal impact on income and spending measures of the economy without affecting the national income residual (and thereby creating a divergence between the savings and current account gap). In any case, the divergence of the savings deficit below the current account deficit (or equivalently of the expenditure-based measure of GDP below the income measure) dwindled during the early 2000s and indeed went substantially into reverse (with the savings deficit exceeding substantially the reported current account deficit in 2003, for example). That reverse residual (income based measure of GDP below expenditure based measure) narrowed sharply during 2004 and early 2005, virtually disappearing, but there was no evident explanation this time. A simultaneous emergence of a large positive errors and omissions in the US balance of payments could be consistent with a leap in unrecorded exports, but there was no obvious reason to associate that with any grey or black economic activity. The reverse residual widened in the middle two quarters of 2005, suggesting that white noise was an important part of any overall explanation. In practice, thereby, it is possible to restrict the statistical pursuit of hidden capital flows to the balance of payments data rather than delving into a study of national income residuals. The subject of hidden net capital flows, identified by the techniques illustrated in this chapter, can be distinguished from the much bigger topic of estimating the size of the grey economy, whether nationally or globally. Hidden net flow analysis, as in this chapter, depends on an interpretation of statistical differences, not levels. Even so, a fuller picture of secret

58 What Drives Global Capital Flows?

capital flows would clearly require an array of anecdotal evidence, drawn in particular from private bankers in the offshore centres and tax havens. But for obvious reasons of client confidentiality this is not in general available.

Information from banknote markets and flows The detective statistician seeking to trace the flow of grey and black capital internationally may well try one further route to those discussed so far. This involves a direct exploration of international wholesale banknote markets and of available evidence on net banknote flows. The links are obvious. We have already seen how a considerable element of hidden capital outflows take the form of residents (of the country in question) exporting banknotes (on a clandestine basis) and having the proceeds directly credited to accounts outside their own political jurisdiction. Traditionally Switzerland has been the principal centre of the wholesale international banknote market – something of a niche market, in effect. Capital flight in the form of banknotes has entered the country in large quantities. There are two options for the foreign owners of these – either they credit them directly to an account denominated in the same currency and then move on from there (into their chosen investment), or they sell the banknotes in the market in exchange for Swiss francs. As illustration, a Belgian dentist arriving in Geneva with a suitcase of 100,000 euros in say 500 euro denomination has the choice of either crediting these directly to a euro current account (with his Swiss bank) or selling them for francs. Normally there would be an administration charge for crediting them to a euro current account – but still if his or her ultimate intention is to buy a euro or US dollar investment, for example, that would be a cheaper course of action than converting first into Swiss francs. The Swiss bank would find itself with a euro liability (the newly created euro deposit owned however transitorily by the Belgian dentist) matched by assets in the form of euro banknotes. Whether the Swiss bank sends these (the euro banknotes) to its correspondent in the euro-area for crediting or offloads them in the Swiss wholesale banknote market depends entirely on where the present wholesale banknote market quote lies relative to the inter-bank transfer rate (for bank deposits in the respective currencies). The bank must take account of transportation costs (mainly related to security) with respect to note shipments. Much will depend on whether the actual

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demand for euro notes in Switzerland (mainly on account of Swiss residents visiting Switzerland, but also, for example, on the part of euro-area residents converting some undeclared revenues into euros for spending purposes back home) is greater or less than the present supply. Moreover Switzerland as an entrepot centre in the banknote trade may experience large demand from wholesalers in other centres (outside the euro-area) for euro-banknotes, if indeed the rate at which these are offered is less than the cost of shipment directly from the euro-area (to the third party country). Can officials at the ECB, by monitoring the total of physical shipments of euro notes to and from Swiss banks as reported by euro-area banks obtain any idea of the extent of grey or black capital outflows? The answer is most likely negative. First of all the reports on banknote flows are obtained at a national level in the member states rather than at the euro (ECB) level. Second, the implications of net flows in either direction are unclear. A large flow of euro notes from Swiss banks back to euro-area banks might indeed imply that some capital flight is occurring, but it could also be the case that there is not a substantial demand on the part of Swiss residents in the eurobanknote exchange market. Rather they may have a large float in euro banknotes which in the main are obtained against accounts held directly with euro-area banks. Or it could be that euro-area residents tend to buy their Swiss francs for tourist spending purposes in Switzerland (where banknote transaction charges are relatively small), whilst Swiss residents largely use bank cards or credit cards in their foreign spending. Even so, in some cases, data (available usually only to the central banks concerned) on non-euro banknote flows in and out of Switzerland might have informational content with respect to hidden capital flows. For example, the UK central bank might suspect that persistent large net flow of pound banknotes from Switzerland to UK banks was indicative of some capital flight from the UK – even though other explanations were plausible (for example, banks in Germany or Central Europe might find it cheaper or more convenient to obtain pound banknotes for selling to their own tourists – visiting the UK – in the Swiss wholesale market than directly from UK banks). By contrast a large persistent net flow of pound banknotes to Switzerland, not corresponding to an imbalanced trade in tourism (more Swiss visitors to the UK than UK visitors to Switzerland), might be indicative of hidden investment income in Switzerland being converted into pounds for spending in the UK. But all of this is very tentative.

60 What Drives Global Capital Flows?

In the case of non-convertible currencies, the analysis of banknote flows is somewhat different. Non-convertible currencies are subject to a range of exchange restrictions, and these usually include limits on the import or export of banknotes (denominated in the given currency). In particular, foreign banks would not be able to ship banknotes back to the country of issue and credit them there on a 1:1 basis into bank deposits (in the given currency). For example, Chinese citizens who smuggle yuan banknotes to Singapore or Hong Kong sell them there for the local currency. But in principle the yuan banknote exchange rate could fall well below the official rate (the yuan buying less dollars in the banknote market than the official) as the dealer in the wholesale market is not able to credit any excess inventory to a yuan deposit account. Much of the time there may be no such discount (of the banknote below the official rate) as tourist demand for yuan banknotes might easily absorb supplies at the official rate. (The extent of tourist absorption can be restricted by the given country – in this case China – putting restrictions on the amount of banknotes which tourists can bring in). In addition, in recent years, there has been some speculative demand for yuan banknotes outside China on the part of investors seeking to profit from an expected appreciation and unable to invest directly in yuan deposits. In principle the discount of banknotes on an inconvertible currency below the official rate can be an indicator of capital flight pressure from the country of issue. But lack of a discount does not mean that capital flight is absent. Some part of wholesale banknote market activity, of course, is related to accumulation of US dollar banknotes and to a lesser extent of euro banknotes within the global grey or black economy. In many parts of the world, especially now that nominal interest rates are everywhere so low compared to recent historical experience, these banknotes are hoarded as an important form of saving. They also have important transaction uses (with the dollar being used widely as unit of account outside the US). Many residents of developing economies would hold US dollar or euro banknotes in a vault (or under a mattress) as an ultimate safe-haven. They may not be dealing in the size required to have access to offshore banking centres. Dealers (or in some case smugglers) would in many cases buy the dollar or euro banknotes in the international wholesale market centres (for example Zurich) and ship them into the respective developing economies, charging in many cases considerable mark-ups in their onward distribution to local investors. In many cases the dealers would receive local banknotes in exchange. Somehow they must succeed at the end of the line in exchanging these

Black Money 61

into convertible currencies that can be used as payment in their wholesale banknote market transactions. The methods used might include recourse to the procedures already mentioned earlier in this chapter – for example, siphoning the local banknotes into local cash enterprises which in turn can use various invoice tampering techniques to export them to the international market-place. According to US balance of payments data, the annual flow of US banknotes to foreign investors (a credit item in the capital account) has ranged between $15 and 25bn p.a. in the past 10 years (1995–2004). A study by the Federal Reserve in 2002 (see version as BIS paper, 2004) put the estimated amount of US dollar banknotes held abroad at between US$310bn and US$435bn (out of a total circulation of $620bn). The models used for estimation purposes are based on confidential data about currency shipments to and from the Federal Reserve Banks, data collected by the US Customs Service, data on cash processing at the Federal Reserve Banks and less formal information collected during international study trips (see also report of US Treasury Secretary, 2003). The Federal Reserve study took a mean estimate of foreign holdings at $414bn, of which $120bn (29%) was in Russia and other former Soviet Union members, $95bn in Asia (23%), $57bn in Middle East and North Africa (14%), $12bn in sub-Saharan Africa (3%), $46bn in Europe (11%) (including central and Eastern Europe), and $83bn in Latin America (20%). The Federal Reserve study notes five basic motivations for international holding and using of cash dollars. First, in times and places where the political or economic situation is uncertain, dollars are held for security against inflation and general calamity. Second, expatriate workers throughout the world often carry their earnings to their home countries in dollars and between visits home some of these workers hold dollars in cash rather than in the bank. Third, travellers to other parts of the world carry dollars because they are easier to exchange than local currencies. Fourth, cross-border trade in many areas is conducted largely in dollars. Fifth, the informal or “off the books” sectors in many economies are highly dollarized. According to the Federal Reserve’s study no more than 30 institutions worldwide participate actively in the wholesale buying and selling (including transport and delivery) of physical US banknotes (see also testimony to Congress of Baxter, 2004). In 1996 the Federal Reserve Bank of New York (FRBNY) established an extended custodial inventory (ECI) program – prompted by the Treasury’s introduction of new design banknotes and in recognition that an assured supply of US

62 What Drives Global Capital Flows?

currency abroad helps to maintain stability in international financial markets throughout the world. An ECI facility is an overseas cash depot maintained by a private sector bank that holds currency for the FRBNY on a custodial basis in a segregated area of its vaults. The FRBNY manages the ECI program and bears the costs associated with providing management oversight and monitoring the program. It coordinates the shipment and receipt of currency between the Federal Reserve facilities and the ECIs. All banknotes while in inventory at an ECI, and during transit between a Federal Reserve facility and an ECI, are carried on the books of the FRBNY. The dealers account with the FRBNY is debited when he delivers notes to his customers and credited when he buys notes and adds them to inventory. Each wholesale dealer that enters into an ECI arrangement maintains an account at a Federal Reserve Bank. The dealers that operate the ECIs must enter into a contract with FRBNY, with a number of requirements to be met. These include correct sorting (of old and new notes), attention as specified to counterfeiting (with various reporting obligations). The principal hubs for the distribution of US banknotes are Frankfurt, London, Zurich, Hong Kong, and Singapore. Wholesale banknote dealers purchase approximately 90% of the US banknotes that are exported to international markets from the New York Federal Reserve. According to the contracts (between the dealers and the FRBNY), each operator (dealer) is specifically prohibited from engaging in transactions affecting ECI inventory with countries against which the US has imposed sanctions. ECI operators are also obligated to provide the New York Fed with monthly reports showing all countries that engaged in US dollar transactions with the operator during the preceding month and the volume of those transactions. The information provided by the ECIs to the New York Fed has given the US government a valuable tool for estimating stocks and flows of US currency abroad. In practice, there is the risk of false reporting and illegal (against the terms of the contract between the dealer and the FRBNY) shipment of notes. One important case of such transgression came to light in 2003, following the discovery (April 2003) of $650m of dollar banknotes in Baghdad by US armed forces (see Baxter, 2004b). The trail, involving in part the tracking of serial numbers, led eventually to the UBS ECI facility in Zurich, and eventually that bank disclosed that it had not correctly reported (to the FRBNY) shipments of notes, and that there had been important despatched of these (by UBS) to Iran in particular and also Cuba, Libya and the former Yugoslavia (all sanctioned countries). The conclusion of this affair included the cancelling of the contract

Black Money 63

between the FRBNY and UBS, the Swiss Federal Banking Commission (EBK)’s suspending UBS’s license to conduct banknote trading business, and the payment of a $100m civil money penalty by UBS. In effect UBS had deceived the FRBNY systematically over an 8-year period. The penalty should be compared to the total net profit made by UBS in banknote currency trading during the 5-year period 1999–2003. Until the suspension, UBS had been transacting $140bn annually in the wholesale banknote market (in more than 100 currencies). Its banknote processing facility at Zurich airport had processed each day four million individual bills – with a headcount of 65 full-time and 180 part-time staff. In 2004, the New York Federal introduced new procedures and amended outstanding contracts (with ECI dealers) so as to hopefully prevent the same type of avoidance occurring in the future. The euro, as a supranational currency, is not subject to the same type of distribution regime (in the global banknote markets). Indeed, as a principal international asset in banknote form it can be seen as a successor of the Deutsche mark (see Seitz, 1995). This had a payments and store of value role throughout Eastern Europe estimated at as much as DM80bn ($50bn) in the 1990s (Bundesbank, 1995). With the demise of Deutschemark banknotes (2002), euro-banknotes took over that role. And in line with the largest denomination Deutsche mark note being 1000, the largest euro banknote was fixed at 500. But of course in most of the member countries of EMU there had not been such a large banknote. The rapid growth in demand for euro currency in the years following its launch (in banknote form) (2001) went way and beyond what could be explained by the reversal of the run-down in cash holdings before the changeover (from old notes in the individual currencies) took place. The IMF in its 2005 report on the euro-area endorsed the view that demand for euro cash was being buoyed by its use in the grey or black economy, both in the euro-area itself and globally. The same IMF report cites estimates that in 2004 around 15% of the total value of euro banknotes circulated abroad (outside the euro-area), well short of the 65% equivalent estimate for US dollar banknotes (circulating outside the US). But the ECB and IMF comment on a continuing large net shipment of euro banknotes to outside the euro-area which could be consistent with a growing role for these in the global grey economy. The launch of a 500 euro banknote did spread some concern right from the start that this might emerge as a magnet for international crime (given that the largest US dollar banknote is only 100). As an apparent counterpoise to this threat, the ECB has disclosed plans to

64 What Drives Global Capital Flows?

incorporate Radio Frequency ID (RFID) tags into the largest denomination euro banknotes. Hence law enforcement officials would be able to employ monitoring equipment (at airports for example) to learn the serial numbers of euro-banknotes surreptitiously at short-distances (see Juels and Pappa, 2003). There are many technical and political issues raised by such a proposal. Could criminal elements use the same monitoring equipment to locate cash hauls? And could the monitoring equipment pick up a whole series of serial numbers in a stack of notes? Liberals are concerned with the ability of state officials or private detectives to monitor how individuals spend and whether their spending power comes out of illicit cash hoards. It is fairly easy to imagine techniques for evading the new Big Brother controls, but these all involve varying degrees of inconvenience. And there is the obvious constraint that if one country moves to tagging its banknotes it may well lose out in international banknote markets to other countries which do not.

3 Driving Forces

What drives the global flow of capital? Earlier in this volume (Chapter 1), a geography of the main currents was presented. These start off in (currency) areas of the globe in savings surplus and end up in areas of savings deficit. But what are the forces which drive the currents? And from what source do these forces derive power? The driver of the currents is the prospect of an improved rate of return to capital, measured to take account of risk. Or put more technically, the force behind the current is the attraction of a better overall portfolio mix (from the viewpoint of the investors and borrowers) between risk and expected return (or cost). What power fuels that force of attraction? In analyzing the force of attraction (to global capital flows) and the source of power (behind the force) it is necessary to take account in particular of exchange risk, exchange rate expectations, and political or credit risks, alongside several other factors. Further, it is essential to distinguish the flow of capital under hypothetical situations of stable long-run equilibrium from those of disequilibrium or only transitory equilibrium. The most simple and direct force of attraction is interest rate spreads. As a tendency, but not as a general rule, capital tends to flow out of countries where (real) interest rates are low into those where interest rates are high. A further tendency, with important exceptions, is for interest rates in savings surplus countries to be low and for those in savings deficit countries to be high. Similarly, expected returns to equity investment in the low interest rate country tend to be also low – a fact in itself encouraging an outflow of this type of capital (equity). Hence (real) interest rate spreads play a large but not exclusive role in the driving of capital flows out of the savings surplus countries into the savings deficit countries. The ultimate power sources are the factors 65

66 What Drives Global Capital Flows?

behind the emergence of savings surpluses and deficits. Examples include demographic trends, investment opportunity, asset bubbles (followed by bursting), and expectations of strong trends in real exchange rates. As investors resident in the savings surplus countries (with generally, but not always, low interest rates) add to their wealth over time there will be a flow of funds into the savings deficit countries, on the reasonable assumption that they allocate a share of their portfolios to higher rate of return monies (and to national equity markets where expected earnings returns are relatively high). And as borrowers around the globe add to their liabilities denominated in the low interest rate currencies for the purpose of financing assets accumulated in the high interest rate currencies the flow gathers further strength. In order to understand more fully how interest rate spreads can potentially drive the flow of capital it is helpful to consider in some depth the concept of rate neutrality, both within a domestic and global context. Neutral rates are conceptual based on a hypothetical situation in which full economic and market equilibrium holds. They cannot be identified in a simple survey of the market landscape.

A question of neutrality The origin of the concept of interest rate neutrality goes back to Knut Wicksell (1851–1926). He defined the natural interest rate as that at which the hypothetical closed economy would be in overall equilibrium – meaning resources (labour and capital) fully utilized and no inflationary or deflationary pressure. When the interest rate is at its natural level, the marginal rate of return to new investment in the given economy is equal to the marginal rate of time preference (the premium which households put on the utility of present consumption compared to future consumption) which is equal to the given interest rate. The definition of natural rate can be elaborated to take account of such real world facts as uncertainty, heterogeneity (assets belonging to different risk classes – for example equities and bonds), steady-state inflation expectations and significant exchange risk between sovereign (or regional monetary union) currencies. These additional facets emerge in what follows (both in this and subsequent chapters). In monetary economies there is no automatic mechanism such that market rates are continuously near or at their natural level. And the natural rate itself cannot be perceived directly. But there are equilibrium forces which cause market rates to tend towards the natural rate

Driving Forces 67

over long periods of time in a well-ordered monetary system. The dynamics stem from the central bank’s efforts to preserve price level stability (or in the Wicksellian context, to maintain the national currency on the gold standard). If the market rate is persistently below the unknown natural rate, then an inflationary process would get under way (or the inflation rate, up to now stable, would start rising). And so the central bank would take steps to push market rates higher (into line with the natural rate). Conversely if the market rate is persistently above the (unknown) natural rate, then a deflationary process would develop. And so by trial and error the central bank would edge market rates close to the natural rate. The problem is that trial and error might be very large and noisy (meaning serious inflationary or deflationary disequilibrium). The lags are long and variable. Moreover the natural rate of interest is itself likely to be fluctuating through time. And so the central bank is seeking to estimate by trial and error a moving target. An additional issue is that the natural rate of interest is a real variable, and so its estimation based on observed nominal market rates amongst other factors is dependent on an assessment of inflation (or deflation) expectations. (Specifically, the nominal rate of interest which corresponds to the natural rate differs from it by expectations regarding the movement of the price level over time). To Wicksell, there was no such thing as steady state inflation or deflation – only price level stability (consistent with periodic upswings and downswings in prices which cancelled out over the long run). In today’s world, however, stability is generally defined in terms of low but stable inflation. In particular, under the late period of the Greenspan Federal Reserve, in which the search for the “neutral” rate became the guiding them of monetary policy, the unofficial aim was to hold the average inflation rate over time at somewhere between 1 and 2% p.a. (some FOMC members preferred a lower rate). The concept of neutral rate used by Federal Reserve officials differs from the natural rate in that it is defined in nominal terms (rather than real) and in the context of stable low inflation rather than long-term price level stability. Through the buzz of comments from Federal Reserve officials came the message that they viewed neutral rates as being within a 3–5% range and expected trial and error over the medium-term to reveal the true level. Some officials justified the gradualist adjustment of money rates (rather than large bold moves) in terms of the painstaking search for neutrality – allowing time for careful analysis of the economic impact of earlier rate moves.

68 What Drives Global Capital Flows?

When Federal Reserve spokespersons talked about the neutral interest rate they referred implicitly to short-term money market rates. Some other economic commentators, and the older literature on the natural rate of interest, focus on an implicitly longer maturity interest rate. In practice there is always some degree of blur surrounding the choice of maturity. Consumers and business decision-makers take their cue not from an overnight money rate but from an average level of interest rates which they expect to pertain over the period from now until their horizon date. The central bank does not and cannot fix the interest rate over such long time-periods – but its monetary stance and short-maturity rate setting practices can be an important influence on the market rate levels for longer periods (particularly the short and intermediate maturities). The situation of long-maturity market rates diverging from neutral and driving the economy towards higher inflation can occur through misjudgement in the market-place as well as through monetary error. But the process would only go so far without monetary ratification (the central bank sharing in the misjudgement of neutral). Suppose as illustration long-term rates had been set in the market-place at too low a level, meaning for example a capital spending and a consumer boom got under way, creating inflationary pressure. The responsibility of the central bank would be to promptly tighten monetary conditions, most likely by pushing up money market rates. The reality (perceived with the benefit of hindsight) is that for much of the time market rates are out of line with neutrality. This misalignment has both a domestic and international dimension. In the real world, it is essential to extend the concept of neutrality beyond the closed economy to a global economy with several distinct currencies. In this context, interest neutrality is defined by two sets of conditions. The first refers to the domestic dimension, already discussed above. The second refers to the global dimension. The international spread between neutral rates, with exchange rates at a level consistent with long-run equilibrium (see below), must be sufficient to drive capital flows equal in size to the matching savings surpluses and deficits. The determination of the neutral level from a domestic standpoint (meaning that the economy operates at full productive potential with stable low inflation) and from a global standpoint is part of a joint process involving also the discovery of the equilibrium path for exchange rates through time. In any given economy there is a trade-off (from the viewpoint of domestic equilibrium) between the neutral level of the interest rate

Driving Forces 69

(defined in real terms) and the real exchange rate. A fall in the real exchange value of the national currency, meaning that profits increase in the traded goods and service sector of the economy, provides a stimulus to aggregate demand. A rise in the (real) interest rate would have an offsetting influence on domestic demand. And so there is a continuum of real exchange rates and interest rate levels (a higher international value of the national or area currency going together with a lower interest rate) at which the economy would be in overall balance from a domestic viewpoint. But also an external equilibrium condition has to be met. There is a continuum of interest rates and exchange rates, for which net capital outflows (or inflows) equal the current account surplus (or deficit), in turn equal to the savings surplus. At a higher interest rate (relative to those abroad), the given economy would require a higher international value for its currency, as a higher interest rate means a lower momentum of capital outflows. Hence for external balance the current account surplus must fall. (A higher international value of the national or area currency means – everything else the same – a smaller current account surplus). Hence in the continuum of real exchange rates and interest rate levels consistent with external balance a higher exchange rate goes along with a higher interest rate. There is one unique pair of real interest rate and exchange rate at which the particular economy is in both external and internal equilibrium, determined for a given level of foreign interest rates. In a global general equilibrium solution, in which all interest rates are at a neutral level from both domestic and external viewpoints, it would be true that all economies were in balance (meaning output equal to productive potential, inflation low and stable), that capital flows were equal to the underlying savings surpluses or deficits, and that these summed to zero (across the globe) (see Bosworth, 1993). There would be one set of equilibrium exchange rates (both spot and forward) between currencies corresponding to that solution. The forward rates for maturities stretching out far into the future would be close to the perceived equilibrium path of the exchange rate. (The path is a probabilistic concept, based on an average of future possible economic scenarios – see Chapter 8, p. 221). The relationship between forward rates and the spot rate would be in line with neutral interest rate spreads as determined by interest rate parity conditions. Most of the time, actual exchange rates and interest rates around the globe are different from the hypothetical and invisible set of equilibrium exchange rates and neutral interest rates at which internal and external

70 What Drives Global Capital Flows?

balance would hold everywhere. At a given level of foreign rates, out of line with the conceptual set of neutral rates for the global economy, it is still possible for one or more economies to be in full internal and external equilibrium. The central banks in those economies may be well satisfied that the Holy Grail of neutral interest rate level has indeed been found. But that satisfaction could be undermined by a shift in foreign interest rate levels and exchange rates. The warning signs of a looming shock could be a seizing up of global capital flows (as described in the next chapter) – symptomized perhaps by spiralling exchange rates between certain currencies and large internal imbalances (for example a high degree of slack) in various major economies. In sum, the search for the neutral level of interest rate in any large country or currency area should be undertaken in principle as part of a wider search for the general equilibrium solution to the global economy. In practice, several commentators and most officials would satisfy themselves with a partial discovery of neutrality – for a given level of foreign rates. Foreign exchange or foreign interest rate shocks are treated as exogenous events rather than something waiting to happen from an initial disequilibrium situation. Nonetheless, the concept of a general equilibrium solution, which could well incorporate large and continuing capital flows between countries (or currency areas) corresponding most likely to a spread between interest rates in each currency, proves useful in market analysis, as we shall see. That general equilibrium solution depends on the nature of the international monetary regime. A change in the global monetary system can lead to a shift in neutral interest rates and equilibrium exchange rates. In particular, a reduction in exchange risk (as would occur in the shift from a freely floating system to say an international dollar standard) means that much larger global capital flows occur in response to a given spread between real interest rates (in different currencies). As illustration, the neutral level of US interest rates would be lower in the case of the Asian countries with huge savings surpluses having their currencies anchored firmly to the US dollar than in that of their currencies floating freely and with considerable independence. As a corollary the neutral level of Asian interest rates would be lower in the floating case (than in the dollar anchor case).

Currency preferences Strong currency preferences on the part of investors in the big savings surplus countries could in principle cause (neutral) interest rates to be

Driving Forces 71

lower in some important savings deficit countries than in some modest savings surplus countries. To illustrate this point, let us suppose that if the euro-area and US were each closed economies, their neutral level of interest rate would be the same – meaning most likely that savings propensities and investment opportunity were broadly similar in each. Then let us superimpose on this the emergence of a huge savings surplus in East Asia, with investors there having a strong preference for US dollars over euros. (A manifestation of that preference would be Asian investors allocating a much higher share of their savings to dollars than to euros if dollar and euro interest rates were at the same level). The Asian currency preference (for US dollars) would cause US interest rates to fall below euro rates. (Both sets of rates – euro and US dollar – would most likely decline in absolute terms as part of the process of generating savings and current account deficits to offset the Asian surpluses). The US would eventually be in much larger savings and current account deficit than the euro-area, but with a lower level of interest rates on dollars than on euros. The extent of the divergence (between US and euro-area savings deficits and between interest rates) would be held in check by a tendency of Asian investors to reduce their target proportion for dollars in response to their growing interest inferiority (below euros). Other influences holding the divergence in check would include US investors stepping up their investment in euros (in response to its growing interest rate advantage over US dollars) and other global investors or borrowers responding similarly (investors switching from dollars to euros and borrowers from euros to dollars). Suppose the starting position (before the emergence of the Asian savings surpluses) had been a modest US savings deficit and an equally modest euro-area savings surplus, reflected in US interest rates being somewhat above euro-area rates. In principle, a strong dollar preference amongst Asian investors could turn that situation around into the US having a huge savings deficit, the euro-area a small savings surplus or modest savings deficit, and with US interest rates below euro rates. That result would depend on there being considerable inelasticity in global portfolios (both amongst borrowers and investors) with respect to changes in the interest rate spread between euros and US dollars. (If the elasticity were high, then the strong Asian preference for dollars would be offset by other investors switching from dollars to euros and borrowers in the opposite direction). Indeed when in 2003 the US was in around 4.8% of GDP deficit and US interest rates across short and medium-term maturities were below

72 What Drives Global Capital Flows?

euro-rates, it was possible to construct such a theoretical justification, especially if account were taken of the around 2% of GDP steady state capital inflows to the US dollar from grey and black areas of the world economy (as outlined in Chapter 2). But there was a competing explanation. According to this a falling savings propensity in the US (including the government sector) was playing a role in widening the US current account and savings deficits and in fact actual market rates on dollars had fallen well below the conceptual neutral level for the US economy. Indicative of that situation was the overall weakness of the US dollar. If low US rates reflected a strong Asian preference for dollars only, then the dollar should have been generally strong. Subsequent events were more in line with the competing explanation. By second-half 2004 the US savings and current account deficits exceeded 6% of GDP and interest rates at short and medium maturities had risen substantially – to well above euro rates. In 2005 the US (savings and current account) deficits were at near 6.5% of GDP, and the euro-US dollar rate spread widened further (in favour of the US) (see Figure 3.1). Hence it was evident that not all the US savings and current account deficits were an induced response to a strong dollar

3.5 3.0

10-yr swap spread US – Euro

2.5

2-yr swap spread US – Euro

2.0 1.5 1.0 0.5 0.0 –0.5 –1.0 –1.5 99 Figure 3.1

00

01

02

03

04

US$ vs. Euro, 2-yr and 10-yr swap rate spreads

05

Driving Forces 73

preference in the savings surplus countries. Indeed, some of the savings surplus in Asia and elsewhere might even be seen as explained by the higher-than-otherwise global level of interest rates which was a consequence of the low US savings propensities and buoyant residential construction – related to the red-hot residential real estate markets. (It is not mutually exclusive to hypothesize that high foreign savings induced low world interest rates which in turn stimulated US spending, and that the readiness of the US household sector to be stimulated helped to keep a floor under world rates and so sustained a high savings surplus outside the US).

Capital flight and unpopular currencies The opposite case to a savings deficit country having relatively low interest rates, reflecting strong global currency preference in its favour, is a savings surplus country having relatively high interest rates because of the unpopularity of its currency. Popularity (or unpopularity) should be interpreted broadly to include a range of financial, economic and political considerations. An example of the phenomenon (of currency unpopularity) is the currency of a country in which capital flight is rampant and where global investors perceive a high degree of monetary and political risk. Domestic investors have a strong demand for foreign assets (hidden outside their own political jurisdiction) so as to escape from high taxation and the risk of confiscation or exchange controls. The risk or actuality of high inflation in the domestic money might also be a factor in domestic investors targeting a high proportion of foreign assets (in their portfolios). The strong momentum of domestic capital outflow means that the given country might have to run a current account (and savings) surplus to match (see p. 8), requiring a cheap real exchange rate together with high real interest rates. (The dampening effect of high real rates on domestic demand is offset by the stimulatory effect of the low real exchange rate). There is a possible alternative offset to the stream of domestic capital outflow – an influx of foreign capital. That could occur where there is asymmetry between risks as perceived by domestic and foreign investors in the given country. For example, foreign investors might be confident that any redistributive taxation or exchange restrictions will be applied to domestic investors only. And in that only a small share of their worldwide portfolio is allocated to assets in the given country

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they might be much more tolerant of inflation risks there than would be domestic investors. In this last case, political and inflation risks do not become a source of large real rate spreads in favour of the country in question nor does it emerge with a large savings and current account surplus. Instead the risks drive a large amount of round-tripping. Large foreign inflows into the country (attracted by somewhat elevated real rates) are matched by strong waves of domestic capital flight. Even so it is likely that the given country would be in some degree of savings and current account surplus, unless there are the additional factors of robust investment opportunity and perhaps a low personal propensity to save. Examples of the phenomenon of an economy in large savings surplus (on a long-run basis) with relatively high interest rates – explained by a momentum of capital flight without fully matching inflows – have included both developed and developing economies. There were stages in the quarter century ended 1995 when several European countries, including Italy and Belgium, had large savings surpluses and high interest rates together. Analysis of these periods, however, is complicated by the fact that the respective currencies were not always freely floating. In an adjustable peg system large but usually transitory interest rate spreads can reflect principally expectations of a coming adjustment of the currency parity. Amongst developing or transition countries, Brazil and Russia provide illustrations of large savings surpluses co-existing with interest rate levels that are high by international comparison, reflecting a strong momentum of capital flight. There is a further example of where an economy with a relatively high neutral interest rate level (by global comparison) could also be a long-run net exporter of capital. That is where the government is pursuing a policy of aggressively accumulating foreign exchange reserves over a long period of time (decades), funding this by issuing debt denominated in its own currency. Technically this type of foreign exchange reserve build-up is described as “sterilized intervention” – meaning that there is no overspill into monetary creation. In practice, most episodes of sterilized intervention have ended in failure and were not announced as a multi-year, let alone multi-decade, policy. The successes have been the governments of small countries where the propensity to save is high not low and so where the neutral rate of interest is low. Two contemporary examples (of the exception) are Norway and Singapore, where public agencies accumulate massive amounts of foreign assets on an announced long-run basis. In the absence of these

Driving Forces 75

accumulations, the real exchange rate of the national currency (meaning its international value) would be higher and the neutral interest rate would be lower than its already depressed level. Various commentators (for example, Dooley et al, 2004a) have suggested that some governments of East Asian developing economies (Singapore is an advanced economy) might be pursuing long-run policies of foreign exchange accumulation so as to depress their real exchange rates. The purpose would be to give a fillip to economic growth via the export sector, in accordance with the hypothesis that exports play a special role in fostering overall development. That view is in itself questionable. Productivity growth might be fastest in the non-traded goods and services sectors. And if the method used to depress the real exchange rate pushes up the neutral rate of interest that would surely be a drag on the overall rate of domestic investment spending, intuitively a counter-growth strategy. That criticism applies to the method characterized by massive accumulation of foreign exchange reserves financed non-monetarily. The demand for foreign assets on the part of the government would in itself drive the neutral interest rate up and the real exchange rate down. The higher neutral rate would go along with a raised domestic savings surplus that would be the counterpart to the public capital outflow into foreign assets. And the lowering of the real exchange rate would stimulate aggregate demand (via its influence on net external demand) as an offset to the drag from the higher rates (on domestic demand). There are limits in any case to the effectiveness of non-monetary (sterilized) long-run accumulation of foreign assets by the government as a means of depressing the real exchange rate. In particular, the climb in domestic interest rates which results could induce a massive inflow of foreign funds. The inflow would temper the climb (in rates) long before there would be much impact on the domestic savings surplus. In effect a huge round-trip could get under-way – foreign capital inflows matched largely by public sector accumulation of foreign assets, with little effect on the real exchange rate or on the neutral level of interest rates. In practice, this round-trip might be limited in extent under a currency regime where there were restrictions on capital inflows or where asset markets in the given currency were very poorly developed. Even so, there could be speculation that the policy would not be sustained in the long run, triggering huge short-term inflows of capital. These would undermine the policy. Dooley et al (2004b) implicitly suggest that West European nations successfully followed a policy of depressing their real exchange rate via

76 What Drives Global Capital Flows?

massive purchases (sterilized) of foreign exchange (US dollars) during the era of the Bretton Woods System (say, 1958–71). And indeed some West European countries at that time had remarkably underdeveloped financial markets and comprehensive restrictions on capital flows (both of which might would have inhibited capital inflows and so the round-trip phenomenon described). (The restrictions in the main applied only to the export of capital by domestic residents but nonetheless they detracted from the potential investment appeal of the given currencies). But the historical experience of Germany (during the late 1950s and 1960s) certainly does not fit the case-book. Foreign exchange accumulation by the Bundesbank occurred in spurts corresponding to periods of speculation on revaluation of the Deutsche mark, not in accordance with a policy determined by the government in Bonn for depressing its real value. The massive accumulation of dollar reserves by East Asian countries during 2003–4 was the backdrop to Dooley and Garber describing them as belonging to a re-vamped version of Bretton Woods (see Figures 3.2 and 3.3). There are several problems with the analogy.

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Driving Forces 77 300

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Figure 3.3 Hong Kong, Taiwan and S. Korea – foreign exchange reserves, 2002–5 (US$ bn)

First, it is not obvious that any country under Bretton Woods Number One followed a strategy of real exchange rate depression via a long-run program of massive foreign exchange accumulation. Second, in the mid-2000s none of the Asian countries intervening on a large scale (in foreign exchange markets) announced that this was part of a strategy of long-run sterilized foreign exchange accumulation. Rather, public pronouncements suggested that the accumulation was related to short-run foreign exchange policy tactics (countering “speculative” moves). In the case of China, official foreign exchange purchases on a massive scale in 2004–5 could be seen as a substitute for private capital outflows, seriously inhibited by exchange restrictions, in matching an emerging huge underlying savings and current account surplus (at an estimated 7% of GDP in 2005). Third, the intervention in several instances was not sterilized, or at least not fully. In so far as a country intervenes to stabilize its dollar exchange rate, leaving the intervention unsterilized, it is in fact not following a policy of long-run depression of its real exchange rate. The

78 What Drives Global Capital Flows?

follow-on monetary expansion (as the intervention spills over into money supply) would push up the domestic price level relative to that abroad (and so contribute to real appreciation of the currency if remaining at a fixed nominal exchange rate). In principle, a government which saw a low real exchange rate as vital to economic development would do better to encourage a high rate of domestic saving (including fiscal surpluses) and remove all barriers to capital exports rather than relying on a massive long-run program of official foreign asset accumulation (financed via the debt markets rather than via monetary creation). It is open to debate as to how far any government has followed such a strategy explicitly, rather than perhaps by accident. For example, during Germany’s golden period of growth in the late 1950s and early 60s, a high savings rate (of which strict fiscal discipline was one element) and exchange market liberalization (controls on capital outflows were abolished by the end of the 1950s) meant that the Deutsche mark could remain at a cheap overall real level (albeit that there was one small revaluation in 1961) despite a strong momentum in domestic capital spending. Most recently the high savings rate in China could be seen as one potential element in an overall strategy aimed at maintaining a low real exchange rate for the yuan. But there is no evidence that the Chinese authorities ever saw this as the grounds for promoting domestic saving and they have been unwilling to remove restrictions on capital outflows – a step which would have been essential to full implementation of any such strategy. Sometimes domestic capital flight can perform the role of keeping the real exchange rate down despite vigorous domestic investment (and despite a corresponding tendency for the overall savings surplus to fall, before considering the knock-on effects to saving from upward pressure on interest rates stemming from capital flight), in much the same way as sterilized foreign exchange market intervention over a long period. The limit to that role comes from the possibility of a largescale round-trip getting under way. As we have seen, in the country from where capital flight is taking place foreigners might believe they are less subject to various risks (or more able to dilute them) than domestic investors. In that case capital flight goes together with heavy capital inflows and even an overall savings and current account deficit. A historic example of the phenomenon of capital flight braking a tendency for real exchange rate appreciation in a country experiencing an investment spending boom was Germany during its brief economic miracle of the interwar period (1924–7) (see Brown, 1986). Interest rates remained substantially higher in Germany than in the US,

Driving Forces 79

despite the German currency’s stabilization (in 1924 under the socalled Dawes Plan), reflecting both domestic political and financial risks and also foreign concerns about an eventual inability (of Germany) to service external debt. In effect continuing domestic capital flight and risk aversion of foreigners meant that the savingsinvestment balance swung into only modest deficit and there was only slight real appreciation of the mark (price level in Germany rising relative to in the US) even though there was tremendous pent-up demand for capital towards reconstruction (following the damage and depletions of war and its hyperinflationary aftermath). The counterfactual historian would argue that the German miracle would have been greater and long lasting if there had been no drag of capital flight, even though this benefited the export sector by depressing the real exchange rate below where it otherwise would have been. At lower interest rates there would have been more rapid reconstruction. A full analysis of the German interwar miracle years would also have to take account of the influence on the equilibrium solution (real exchange rate and interest rates) of reparation payments. More modern history – with illustrations drawn from the developing countries, especially in Latin America – also provides examples of the dampening influence of capital flight on the real exchange rate level and so acting as a substitute for long-run sterilized foreign exchange intervention aimed at the same result. But the economic benefits of that situation are as dubious as in the earlier examples above.

Speculation on real exchange rate trends So far, in analyzing the force of interest rate spreads between currencies driving global capital flows, we have not considered the possible influence of strong expectations regarding exchange rate change over long periods of time. Where such expectations exist, interest rate spreads (between currencies) are better viewed simply as part of a general equilibrium solution rather than as a driving force with its source of power in divergences between savings or investment propensities. As we shall see, divergences which can be identified in such circumstances might well be created in considerable part by feed-back effects from the exchange rate expectations. A first illustrative example is based on the so-called Balassa effect. As normally expressed, this refers to an underdeveloped economy which is rapidly growing and catching up with the advanced economies. The hypothesis is that productivity growth in the traded goods and services

80 What Drives Global Capital Flows?

sector outpaces that in the non-traded (goods and services) sector by considerably more in the catch-up economy than in the advanced economies. Correspondingly prices in the traded goods and services sector fall relative to those in the non-traded sector, with this relative price decline being much faster in the catch-up economy (than in the advanced economies). On the basis of the Law of One Price holding (traded goods prices are the same everywhere when converted at current exchange rates), that translates into a real appreciation of the national currency (its nominal exchange rate depreciates by less than the positive inflation differential between itself and other countries or appreciates by more than the negative inflation differential, as the case may be) of the catch-up economy. An unfamiliar variation of the Balassa effect, but one that is potentially important in the major currency markets, is the case of an advanced economy where up until now its non-traded goods and services sector has been notoriously unproductive (with its level of productivity much lower relative to that in the traded goods/services sector than is the rule for most other OECD economies). Japan and to a lesser extent Switzerland are examples of such countries. Suppose in the long-run there were to be a catch-up of productivity levels in the non-traded goods and services sector of these laggards amongst the advanced economies. The catalyst could be social and economic reforms and a new opening up of hitherto protected economic activities to foreign competition. (For example in Switzerland, several commentators see the new bilateral treaties entered into with the EU in 2005 as being just such a trigger). Then the relative price of traded to non-traded goods (and services) in the laggard economies would tend to rise towards the benchmark (relative price) in the other advanced economies – meaning a trend real depreciation of the national currency (Swiss franc or Japanese yen in our example). We could call this the reverse Balassa effect. Suppose all markets are in equilibrium and then a reverse Balassa effect emerges as a dominant expectation as regards the next decade, taking for illustrative purposes the Swiss franc. At the pre-recognition (of the reverse Balassa effect) level of the Swiss franc and of Swiss interest rates there would now be external imbalance. The Swiss franc would fall to a lower level. For internal balance the interest rate (in Switzerland) would rise (in line with the stimulus to aggregate demand via the external sector from the lower value of the franc). In the new equilibrium, Swiss interest rates would be higher and the franc would be lower than previously, plus there would be a built-in expectation of further real depreciation of the franc (on the assumption that previously there had been no

Driving Forces 81

expectations of real appreciation or depreciation). But some of the initially expected real depreciation would have happened up front. In effect, during the early stages of the reverse Balassa effect Switzerland would be pushed (by higher interest rates) into larger savings and current account surplus (with correspondingly larger capital exports). Swiss interest rates now would be higher in absolute terms and relative to the rest of the world. In general where the national currency is expected to be in long-run real decline, the given country could be both a capital exporter and have interest rates which are high by global comparison – the reverse of the more usual situation of savings surplus countries having relatively low interest rates. The savings surplus is an induced response (via interest rate rise) to the shift of expectations (towards weakness) regarding the real exchange rate. In the Swiss case, rates may well remain low by international comparison, but by a smaller margin than prior to the recognition of a reverse Balassa effect. This is because the savings surplus is already so large (see Figure 3.4). The introduction of the reverse Balassa effect would mean it (the surplus) becomes even larger.

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Figure 3.4 Switzerland – current account and net investment income, 1980–2004 (as % of GDP)

82 What Drives Global Capital Flows?

The same type of analysis applies to the Balassa effect in its mainstream sense (rapidly developing country with a currency which is appreciating in real terms as a reflection of productivity growth in its traded goods sector much faster relative to in its non-traded goods sector than is the case amongst the advanced economies on average). Here the emergence of expectations regarding long-run real appreciation go together with an immediate rise of the currency, a fall in the neutral level of interest rates, and larger net capital imports (corresponding to a diminished savings surplus induced by the lower interest rates). And so in the case of strong expectations regarding the real appreciation of a currency, the capital importing country could have relatively low (by global comparison) interest rates (again the reverse of the more usual situation). The Balassa effect is not the only grounds for strong long-run expectations regarding real appreciation (or real depreciation in the case of a reverse Balassa effect). (And in any event, “strong” must be qualified by the realization that no-one can be sure that the process of economic convergence will continue). For a country running a huge savings surplus and so exporting capital there might well be expectations regarding long-run real appreciation. These would stem from perceptions of a rising surplus on investment income account (in the current account). Under some scenarios (to be discussed more fully in Chapter 5), the rising investment income surplus might mean that the trade surplus in goods and services would have to fall (as a share of GDP) over the long-run, and this might have to be induced by a real appreciation of the domestic currency. This is all very tentative. To give the reader a glimpse of a special scenario to be viewed later (Chapter 5), if the rate of return on foreign assets is below the growth rate of the capital exporting country, and its savings surplus is edging higher in the short and medium-term, then a long-run steady state could be reached in which external assets as a share of GDP remains constant, and where the real exchange rate is no higher than at the start. But let us suppose that the central scenario is for some gradual real exchange rate appreciation of the given currency as a consequence of rising investment income. Then the neutral level of interest rate would be somewhat lower and the real exchange rate path somewhat higher than in the case of where no such appreciation were expected. The present savings balance would shift in a negative direction (smaller surplus or larger deficit). As we shall see in the next chapter it may be that due to the constraint of the zero rate boundary (in a conventional monetary system nominal interest rates cannot fall below zero) real interest rates cannot fall to the possibly negative level which would

Driving Forces 83

correspond to the equilibrium solution under conditions of strong expectations regarding real appreciation (especially where a high savings surplus is already depressing the real neutral rate). In the practical example of Switzerland, already referred to, any expectations regarding long-run real appreciation of the franc due to a rising investment income surplus (Switzerland’s savings and current account surplus runs at 10–15% of GDP) might well be cancelled out by the real depreciation tendency that would result from the reverse Balassa effect. The same cancelling out of expectations (regarding real appreciation and depreciation) might also hold in the case of the Japanese yen. On the one hand, there is a clearly rising trend through time of investment income relative to Japanese GDP (see Figure 3.5). On the other hand over the long-run there will surely be some convergence of productivity in the Japanese non-traded goods and services sector with the much higher level in other advanced economies – a process which as we have seen generates expectations of real depreciation over the long-run. (Japanese productivity in the traded goods sector is already at, or in some sectors above, the best level in other advanced economies).

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Figure 3.5 Japan – current account and net investment income, 1980–2004 (as % of GDP)

84 What Drives Global Capital Flows?

Equity flows and the rapidly growing neighbour next door How can we reconcile the attempt to describe global capital flows as driven by interest rate spreads adjusted for exchange rate expectations and exchange risk with the fact that two main items in traditional capital account data (a part of the overall balance of payments) – direct investment and equity portfolio (flows) – are not evidently responsive to interest rates? A first point is that a flourishing of direct investment opportunity (in a given country A) for foreigners is in fact likely to go along with a neutral interest rate higher (in A) than on average elsewhere. The neutral rate rise would go along with the frontier of investment opportunity expanding by more than domestic savings. If foreign companies investing in the given country take advantage of the new investment opportunity by raising capital in the domestic credit market (of country A), then in aggregate they put upward pressure on interest rates there. If instead they bring in capital from abroad, domestic rates would still rise (in line with the higher neutral rate), but there would be less foreign inflow into the domestic money and debt markets and less foreign corporate borrowing there. In effect direct investment inflows financed outside A would tend to reduce the extent of (uncovered) interest rate arbitrage opportunity for outsiders (not involved in direct investment) in the form of borrowing in foreign monies to lend in the domestic money (of country A). The overall equilibrium interest rate spread would not be different in the two cases. So, in general, direct investment inflows, in so far as they are financed abroad, substitute for inflows of capital that otherwise would have come through debt and money market channels. Just because the flow of capital out of a savings surplus country into the savings deficit countries takes mainly the form of direct investment does not mean that the normal (neutral) rate spread would fail to emerge in favour of the capital importing country. A similar point can be made with respect to equity flows. In so far as equity inflows from abroad are induced by a flourishing of investment opportunity in the given country (A), these are a substitute for money and debt inflows, but they may well not change the final neutral rate spread (in favour of the given country), unless home bias in equity investment is less than for bond and money investment. As illustration, suppose perceived investment opportunity picks up in country A, meaning that expected domestic earnings growth of corporations quoted in its equity market improves. If this rise in expected

Driving Forces 85

equity earnings growth goes along with a rise in interest rates (in country A), then foreign inflows of capital would most likely go into both equity and bond (or money) markets there. The foreign demand for equity would likely go along with some new issue of equity by domestic corporations (as well as debt) to finance their stepped up investment spending. In effect capital inflows in both equity and debt would contribute towards the financing of the investment boom, accommodating a rise in that country’s savings deficit. Only in the special case of foreign investors in equity having no home bias, might it be possible to imagine huge foreign equity inflows going along with a fall in the leverage ratio of the corporate sector (in A) (as corporations there issued equity to retire debt) and a narrower neutral interest rate spread in A’s favour than if the inflow had been constrained to take place entirely in the debt or money markets. One main form of direct investment opportunity is that created by the combination of cheap labour costs and the shrunken costs of global management. The information technology revolution in particular has made it more profitable for corporations in the advanced economies to tap cheap labour resources abroad, in that management control over vast distances is now lower cost and more efficient. And foreign plants or service centres can now more cheaply be integrated into global supply operations of the given firm. The flow of capital out of the advanced economies to take advantage of the new direct investment opportunities would tend to push up the level of neutral interest rates there (advanced economies) as part of the process of inducing an increased savings surplus. As regards the level of economic welfare in the advanced economies (from the viewpoint of labour) there would be two opposing influences. On the plus side would be an improved terms of trade, as the developing countries generated an increased demand for hightechnology imports, whilst there own exports tended to fall in price. On the minus side, the capital-output ratio in the advanced economies might fall, or fail to rise as much as otherwise, meaning some potential downward pressure on real wage levels there (compared to where they otherwise would be). (For a discussion of this point, see for example Slaughter and Swagel, 1997). It is possible, though, that none of this (capital flows from advanced to developing countries) would take place if the process of rapid economic growth driven by new investment opportunity in the developing countries generated a rapid rise in savings propensities there. Then global savings might outstrip the new investment opportunities.

86 What Drives Global Capital Flows?

The above analysis of the influence on global interest rates and rate spreads of the emergence of direct investment opportunity in the developing countries requires some elaboration in applications to the case of the “neighbour next door”. Much depends on the particular circumstances. As illustration we might consider Japan as the big advanced economy next to China, or Germany next to the emerging market economies in Central and Eastern Europe (including Russia). In both cases enterprises in the advanced economy (Japan or Germany as the case may be), because of their geographic position and historic (including linguistic) links, have an advantage compared to outside (corporate) investors in exploiting the new opportunities. If the new opportunities are mainly in the form of producing low technology goods for export to global markets (not just the capital exporting country) then there may be a new turntable role for the neighboring advanced economies. In the illustrations, the capital outflow from Germany or Japan would put some upward pressure on interest rates in those two (capital-exporting) countries, which would in turn pull in financial capital flows from the rest of the world. There could be some modest real depreciation of their currencies (the euro and yen respectively) compensating for the drag on domestic demand from higher interest rates. But any interest rate or exchange rate effects could be muted by the turntable flows assuming mainly equity rather than debt form. Specifically non-German investors, for example, might view equities of German companies which are in a position to gain from the new direct investment opportunities in Central and Eastern Europe as “hot”, and these companies might in turn use a substantial amount of equity finance towards their Eastern expansion, raising their equity-debt ratios in the process. If by contrast, the new investment opportunities in the big developing country (or group of countries) next door go along with a compression of investment opportunity in the particular advanced economy (Germany or Japan) then the outcome might be a real depreciation of its currency (the euro or yen), more substantial in size than in the previous example, and a lowering of its neutral interest rate level. An example of compression would be German companies finding that they could more profitably locate operations next door (in the cheap labour market country) than domestically for the purpose of meeting both domestic and global demand for their product (or service). And foreign (non-German) companies would not be able to come in and make profit on the domestic operations now given up by the German companies (as

Driving Forces 87

they would face competition from the German transplant operations across the border and they might not possess the same management resources or know-how inside the German economy). Moreover, the demand for imports into the developing country might not be focused on the country (Germany) which is supplying most of the direct investment capital.

Disequilibrium scenarios We have observed (see p. 69) how for much of the time market interest rates are out of line with neutrality (from both a domestic and global perspective) and exchange rates (spot and forward) out of line with the fundamental equilibrium path. And, as we saw in Chapter 1, savings surpluses and deficits as estimated by the statisticians might be well out of line with the levels that would prevail in a state of general equilibrium. Hence the analyst of global interest rate relationships and exchange rates should become familiar with the analysis of disequilibria. We return to this theme later in this volume (Chapter 8), but provide two introductory examples at this stage. First, take the example of the huge US current account deficit that burst through all previous records in 2004 and beyond. There was much talk amongst economic commentators and policy-makers about the non-sustainability of the US current account deficit and the possible over-stretching of the normal market mechanisms of adjustment. Some commentators were bold enough to maintain that the dollar could only fall, and by a big amount, over the long run and by more than was presently discounted in the market-place. (The topic of sustainability is discussed in greater detail in Chapter 5). Contrarian economists argued, however, that the giant US deficit was in large part a reflection of autonomously large savings surpluses abroad. Surely there existed a set of neutral interest rates (higher in the US than in the savings surplus countries) and equilibrium exchange rates at which private capital flows between the savings surplus countries and the US would be in balance and all the major economies in internal equilibrium? The big question was where lay the source of present disequilibrium, reflected in the sliding dollar. Had there been a prior mistake in assessing the equilibrium long-run path for the dollar, now evident with the unveiling of new information? Or were US rates below neutral, or euro rates and yen rates above neutral? And depending on the answer to these questions was the dollar likely to eventually rise or fall from present apparently cheap levels?

88 What Drives Global Capital Flows?

If the source of disequilibrium had its source in euro-area monetary policy, with interest rates there (the euro-area) well above neutral levels, then it would be possible to imagine a path to eventual equilibrium in which euro market rates would fall, US market and neutral rates rise, and the US dollar appreciate. The rise of the dollar would be the counterpart to a stronger momentum of capital inflow into the US – in line with the widened rate spread in its favour – and a narrower US current account deficit in the short-run at least. The implications for the ultimate size of the US current account deficit and euro-area current account surplus would be ambiguous. These tentative conclusions stem from the following considerations. Once the European Central Bank eventually edged money market rates down to a level consistent with neutrality, an expansion of the euro-area economy would mean stronger demand for US exports. If the US economy were previously in internal equilibrium (no inflationary pressure and resources fully utilized), interest rates there would now rise and so would the dollar. It is possible that as economic activity picked up in the euro-area (stimulated by the stronger dollar and lower interest rates), the savings surplus there would eventually rise in absolute terms, as households there took advantage of increased income levels to boost their savings rates and corporations acted similarly. During the long period of economic shock and compressed incomes, Europeans may have been delaying their savings for retirement, more concerned to maintain their current living standards. In that case the neutral level of euro interest rates and the euro (versus the dollar) would be even lower than if there had been no such secondary effect (from a rise in euro-area savings propensities). The currents of capital flows into the US and out of the euro-area would be correspondingly stronger. A second example of disequilibrium is where there has been a rapid growth in exports (perhaps reflecting a productivity surge or the gaining of competitive advantage from non-price sources, for example the development of new products) meaning that the trade surplus might be running ahead of the underlying savings surplus. A symptom (of the disequilibrium situation) would be an overheating of the domestic economy coinciding with a rising current account surplus. The implication would be that the equilibrium real exchange rate had risen. In the short-run, as the central bank sought to cool the economy, market rates might be raised above the neutral rate. Hence the savings surplus would rise temporarily above its underlying level. The exchange rate would rise and overshoot its new higher equilibrium

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level. Private capital exports would gain momentum, driven by the speculative expectation of a subsequent depreciation of the national currency back down to its (raised) equilibrium level once the economy had cooled down to a normal temperature. The expected depreciation would outweigh somewhat any interest rate advantage on the national currency. It might seem to the casual observer that the example of the overheating economy just given was another exception to the normal situation of capital exporting countries having relatively low interest rates. But the economy is not in a stable state. Rather the strong momentum of net capital exports despite relatively high interest rates would be indicative of the economy being out of equilibrium, but on the road back to stability. During the road back, there would be strong expectations of a subsequent move down of the national currency. And so the relatively high interest rates in the capital exporting country described here are a special example drawn from a disequilibrium situation of the general principle discussed in the previous section. Strong exchange rate expectations can break the one-to-one link between savings surpluses and relatively low interest rates by global comparison. How can we differentiate a rising trade surplus that is due to an autonomous gain in export efficiency from one that reflects an endogenously rising savings surplus? If the source were a rise in savings propensity, then the currency would be tending to fall, along with real interest rates (derived from market interest rates adjusted for inflation expectations). If the source is growing export efficiency, then economic overheating and a rising exchange rate would be more likely. The actual size of the recorded savings surplus is little guide as to source. As a matter of economic arithmetic (as we have seen already in Chapter 1) the savings surplus equals the current account surplus. The question is whether recorded savings are in line with equilibrium tendencies or “forced”. Unanticipated inflation might be one mechanism producing forced saving (via the windfall erosion of monetary assets’ real value and households’ attempts to recoup this loss). Another mechanism could be the non-availability of goods and services (meaning long queues and waiting periods). An imperfect example of the disequilibrium situation described is that of China in 2004, when a rising current account surplus was accompanied by evidence of overheating. The example is imperfect because the Chinese currency was at a fixed exchange rate, not floating, and private capital outflows from China were heavily restricted. The argument put forward by many economic commentators was that the

90 What Drives Global Capital Flows?

Chinese currency (the yuan) should be re-valued or allowed to float higher and monetary policy be tightened simultaneously. The essence of their case was that the equilibrium level of the yuan’s real exchange rate – consistent with both internal and external equilibrium of the Chinese economy – had risen. The rise in interest rates (towards their neutral range) would induce a higher underlying savings surplus and currency appreciation would bear down on the export surplus. As the two came into line (underlying savings surplus and export surplus) inflationary pressures would subside. A question of debate was whether in long-run stable state, China would be in net savings surplus or deficit, and if surplus, how large? Commentators who focussed on the likelihood of some fall-back in the investment spending ratio from present speculative highs tended to point to the possibility of a large savings surplus emerging. Then, from a long-run perspective, the equilibrium level of the yuan’s exchange rate in real terms might not be very different from its present (before any appreciation) level and might even be lower (see for example Bosworth, 2004). If the yuan were to shift to a floating rate regime, then it might rise initially, and then subsequently fall. If instead it (the yuan) were simply re-valued within an unchanged fixed rate regime, then there might need to be a subsequent devaluation, once the equilibrium level of the yuan fell. Evidence available in 2005 seemed to back the commentators who focussed on the increase in China’s underlying savings surplus, as inflation fell back and yet the current account surplus soared to a new peak (over 6% of GDP). One issue in the Chinese currency debate was the relevance of huge foreign direct investment in the economy – with recorded inflows running at as much as 5% of GDP in 2004. Much of this was in the form of foreign companies perceiving opportunities in China that local companies could not have exploited and the finance was most usually in the form of cash from the relevant foreign head office. In effect, the participation of foreign companies in China meant that the frontier of domestic investment opportunity was pushed out beyond where it would have been if only local companies had been players. If China were a market economy fully integrated into the global economy, that expansion of investment opportunity would have mean a lower savings surplus, a higher neutral interest rate, and a higher real exchange equilibrium level, than otherwise. The fact that the direct investment was taking place via an injection of foreign cash rather than via borrowing in the domestic credit markets would not be a relevant consideration (to determining the

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equilibrium level of interest rates and exchange rates), as already discussed above in general principle (see p. 84). If the foreign companies switched to borrowing in the domestic credit market (rather than bringing in foreign cash) then there would be less capital outflows from China in other forms (borrowing by subsidiaries of foreign companies from domestic banks in yuan is categorized as a capital outflow). In particular there would be stronger uncovered arbitrage inflows of capital in the form mainly of Chinese companies borrowing in foreign currency rather than yuan and less strong household sector outflows into foreign money deposits (mainly in the Chinese banking system). In terms of the capital flow data, an unchanged level of direct investment inflows (the total is unaffected by how financed) would go along with an increased total of foreign corporate borrowing from Chinese banks and a decreased total of net lending abroad by the Chinese household and corporate sectors combined. If in fact there were a large savings surplus in China, with investment spending there running at a lower level than savings, and that situation were to co-exist with large direct investment inflows (as foreign companies preferred to bring in cash rather than deal in the inefficient domestic credit market), then there would be such an excess supply of savings in the domestic credit market that huge resident capital outflows would be induced. The Chinese household and corporate sectors in aggregate, together with the Chinese government (including Bank of China) would be huge net lenders abroad. That is all on the assumption that exchange controls do not stand in the way of the capital outflow. Consider the situation instead where China is not fully integrated into the world economy and where specifically exchange restrictions prevent or inhibit the arbitrage type of capital flows just described. Then the real exchange rate could indeed settle at a higher level as a consequence of direct investment inflows being financed abroad rather than locally (from Chinese banks). In the scenario of new direct investment opportunity emerging and this being financed in China – by the relevant foreign subsidiaries borrowing from Chinese banks in yuan – real interest rates would rise (in line with the fall in the saving surplus). But there would be at most only a weak inflow of foreign funds to the domestic credit markets to take advantage of higher rates there – as the flow would be impeded by concerns about the non-convertibility of the yuan and the possibility that today’s inflows might not be redeemable. A particular concern might be the possible bankruptcy of Chinese banks and the lack of any possibility of investing in yuan

92 What Drives Global Capital Flows?

outside the Chinese banking system. And the response of Chinese private capital outflow (in so far as this could take place legally or illegally) would be quite weak (in response to real interest rate change). Chinese real interest rates would settle at a higher level, the real exchange rate of the yuan at a lower level, capital inflows at a lower level, and the current account surplus at a higher level, than in the free market solution of a globally integrated Chinese economy discussed above (where the channel of direct investment inflow – whether by cash injection or borrowing from local banks – made no difference). One form of direct investment inflow – foreign speculation in the domestic real estate market – requires special consideration. This is not a case of foreigners creating investment opportunity that brings about a rise in the level of business or household sector capital spending relative to savings. Rather it is a case of foreigners wishing to diversify their portfolios into a new asset class (Chinese real estate). If China were fully integrated into the world economy, increased foreign demand for Chinese real estate would be largely matched by raised Chinese demand for foreign assets. (Chinese investors would respond to the lower returns now available on domestic assets by increasing their rate of diversification into foreign assets). If there were any influence on the real exchange rate or real interest rate level it would come from spill-over effects – such as higher real estate prices stimulating increased construction spending or higher consumer spending. If by contrast Chinese capital outflows are restricted, then there is potentially a much larger real exchange rate effect, but possibly less of a real interest rate effect. For in this case, the capital inflows into the real estate market must be matched to a greater extent by a fall in the current account surplus. This comes about via yuan appreciation (in real terms). And if the increased spending prompted by higher real estate prices is not sufficient to bring about the matching fall in the savings surplus, then real interest rates might even have to fall. In a full analysis we would have to consider also the negative influence of yuan appreciation on foreigners’ perception of direct investment opportunities in China. A slowdown in direct investment inflows might play an important part in accommodating the inflows into the real estate sector, meaning less adjustment would be required in the savings surplus (and the real exchange rate). Some estimates suggested that in 2004 as much as 50% of the inflow of foreign direct investment into China was in the form of real estate speculation. The non-convertibility of the yuan resulted in their being no safety valve of private capital outflows to relieve the yuan shortage

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in the foreign exchange markets. Hence directly the non-convertibility of the yuan contributed to the underling imbalance in the foreign exchange markets induced by large inflows into Chinese real estate markets. The Chinese government in accumulating foreign exchange reserves was in principle acting as a proxy for how a liberated private household sector would have functioned.

4 Short Circuits

Ever since the great debates about German Reparations in the 1920s, there has been an intermittent current of concern in the international economic literature about whether under certain circumstances general equilibrium in the global economy might be unattainable. Specifically, could there be no combination of interest rates and exchange rates (spot, forward, and expected) at which each and every major economy would be in internal balance and where there would be a stream of net capital flows between them (over time) in line with their respective savings surpluses and deficits (with total net capital flows adding up to zero) both in the present and in the future? In the situation of the early 1920s when the Entente Powers imposed reparation obligations on Germany, following its defeat in World War One, Keynes made his famous claim that it was economically impossible for the stipulated bill to be paid (see Keynes, 1919). “Only if it were possible to enforce a regime in which for the future no German drank beer or coffee, or smoked any tobacco, might a substantial saving (necessary to the payment of reparations) be effected”. Other economists, including the Swedish economist Ohlin (see Ohlin, 1930) and the French economist Rueff (see Mueller, 2000), took a quite different view from Keynes, claiming that he had overlooked all important income effects in his analysis of the problem (the boost to income and so spending in the countries which received the reparations and the converse in the paying country). Subsequently, in the mid-1970s, some economists claimed that the new burden of payments imposed on the oil importing countries by the OPEC cartel would mean permanent recession and physical controls. Later still, in the mid-2000s, when the US economy slid into huge current account deficit, there was a chorus of commentators 94

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claiming that the size of capital flows out of the savings surplus countries into the US would be simply in some sense too large for the normal market mechanisms to support. Economists employed in the main supranational organizations (IMF, OECD, BIS) trumpeted the view both in research papers and public pronouncements that the US reliance on foreign capital inflows was now in the danger zone where governments of all other countries in a similar economic situation had been forced to slam on the emergency brakes to prevent a slide into financial chaos (see for example, Obstfeld and Rogoff, 2000; Edwards, 2004 and Freund, 2000). The rest of the world could not be counted upon or indeed expected to transfer capital to the US on the present scale.

The transfer problem defined The historically continuing debate about possible breakdown in the international economic order or national bankruptcy under the weight of an external payments burden can be summarized under the title of the “Transfer Problem”. Fritz Machlup, a renowned scholar of this issue, defined the problem as follows (Machlup, 1964): If a country undertakes to make very large payments abroad – for military expenditures, subsidies, war indemnities, foreign aid, loans, or investments – the question arises whether it will thereby exhaust its reserves of gold and foreign currencies (or have its own currency depreciate without a definite limit) or whether its trade balance will adjust to the flow of capital and unilateral payments and thus produce the international means of payment with which the foreign commitments can be met. This in a nutshell is the transfer problem. Machlup cites a range of historical examples, from Britain’s payments to its Allies during the Napoleonic Wars (1800–15), France’s payments of reparations to the newly founded German Empire after the Franco-Prussian War (1871–5), German reparations after World War One (1921–32), US aid transfers to Europe under the Marshall Plan and towards re-armament in Western Europe following World War Two (1949–55). Given the time of his writing on the subject (1950s and 60s), Machlup could not make any contribution to the issue of sustainability of large private capital flows from the rest of the world into the US in the mid 1980s or again in the late 1990s and first decade of the 2000s.

96 What Drives Global Capital Flows?

One distinction not made by Machlup is between the transfer problem in the form of first, paying taxes (or other burdens) imposed from without (by victorious allies, oil-cartels) and second, bridging large divergences between savings rates or investment opportunities internationally (an important factor behind the present huge capital inflows to the US). In principle, though, these two variants of the transfer problem pose different issues. With imposed burdens the question is whether this might be simply too high – beyond the capacity of the country, in some to-be-defined-sense, to pay. When it comes to international private capital movements in pursuit of investment returns, the question is whether market mechanisms crucial to sustaining the flow can somehow seize up and stop working if the flow becomes too large or if the monetary environment itself becomes highly unstable. A common thread through the discussion of both variants (of the transfer problem) is the potential elasticities of substitution in production and consumption between so-called traded and non-traded goods and services. Net transfers out – whether in the form of private capital outflows or reparations to victors – have to be matched by a surplus in the production of traded goods and services over consumption of these. If the elasticities (of substitution) are low, and the share of traded goods and services in total production also low, then the capacity of a given economy to pay reparations might seem to be only a small fraction of its total economic size (see Aliber, 2004 and Krugman, 1999).

Reparations re-visited It is important to realize, however, that reparations burden is a liability item which should be considered in stock (present value) as well as flow terms. Providing international capital markets are functioning well and various political or monetary dangers do not loom large, the burden can be spread over a long period of time. Five years of heavy reparations burdens can in effect be re-spread over 50 years or more, meaning that the amount to be transferred in any year is only a fraction of the annual sum under the reparations agreement (normally policed by the actual or potential presence of a foreign occupying military force). That is what in effect happened with respect to reparations obligations after the Franco-Prussian War. The French government issued debt to effect the payment. There was still full confidence in French monetary stability, and France indeed remained long-term on the gold standard.

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France had gone through a civil war following the defeat (the suppression of the Paris Commune by the Republican forces), but that was quickly over albeit at huge human cost. The higher interest rates in France stemming from the government’s demand for funds (towards paying reparations) attracted large amounts of foreign capital (also from German investors). The cumulative surplus in France’s goods and services trade to match the reparations paid could be effected over a much longer period of time. In fact, in the preWorld War One decades, France moved into huge savings and current account surplus, with cumulative net capital outflows far exceeding the amount of reparations imposed by Germany. (This was the era when French investors accumulated vast holdings of Tsarist Russian bonds). There was a prospect of the problem of German reparations in the 1920s eventually being solved in similar fashion to the earlier French episode. The stabilization of the German currency under the Dawes Plan (1924), the eventual final stipulation of the reparations burden, and its spreading out over a period of decades (the Young Plan, 1929) meant that in principle the size of the transfer in any year would surely be small. And the Bank of International Settlements had been set up in Basel (1930) for the express purpose of taking the political sting out of paying reparations. In future debt servicing (related to the Young loans and Dawes loans) of issues made to finance transfers was to be effected through a supranational bank in a neutral country. The ultimate problem of German reparations was not that Germans had to stop drinking beer (or in more technical terms that trade elasticities were too low) but that as credit and political risks increased in Germany from 1929 onwards (the Nazis became the second largest party in the Bundestag in 1930) and the US appetite for foreign assets shrank following the Wall Street Crash, the market mechanisms essential to large net global capital flows were no longer sufficiently robust to spread out the reparations burden through time. Indeed, in 1930–1, Germany suddenly had to redeem a mass of foreign credits which were not being renewed, leading eventually to a payments crisis and effectively default (not just with respect to reparations, which were cancelled in 1932 by agreement, but also with respect to foreign private creditors). Some historians have pointed their finger at the inappropriate exchange rate regime in explaining the German payments debacle (see Brown, 1986). If the Reichsmark (the name of the German currency in the inter-war period and until its replacement by the Deutsche mark in 1948) had been freely floating or adjustable, then a timely depreciation

98 What Drives Global Capital Flows?

of the currency in 1928–9 might have jump-started a renewed inflow of capital and also stimulated the transfer of resources into the traded goods and services sector of the economy. Foreigners would have been attracted to German assets by the mark’s cheapness and the prospect of a subsequent re-bound. Other historians have claimed that so recent was the experience of the hyperinflation (1920–3), that a floating of the Reichsmark or its devaluation in 1929 would have been the catalyst to an even more intense flight of capital from Germany (on the perhaps irrational fear that the German government would again resort to the printing press to finance its deficits). In any case, we can see from this example that the transfer problem cannot be discussed in isolation from the monetary and capital markets context or from the currency regime in force. In principle, if the reparations problem is considered within the context of a gold standard system in the survival of which there is total confidence and where credit or political risks are low, then the potential to spread the burden out through time is very large. The amount of real exchange rate adjustment (fall in the national price level relative to that abroad) required, such as to generate a trade surplus equal to say the perpetual annuity equivalent of the present value of the reparations obligation over a term of several years, might be modest only. By contrast, where the reparations problem – or equivalent – is within the context of a freely floating currency regime, the amount of possible spreading out through time could be less. Exchange risk might mean that foreign lenders would require a greater rate of return. Some of this, however, could come from the currency (of the country paying reparations) undershooting its eventual equilibrium level, meaning that investors could look forward to some appreciation. Early on in the process (of paying reparations) the amount of cumulative real depreciation and trade surplus (to date) under the floating exchange rate case would be greater than under the gold standard case. The amount of economic waste, however, under the floating case might be less, if the process of achieving even a small real depreciation (deflation of the domestic price level) under the gold standard system means a long period of economic slack.

Post-oil shock transfer problems In the contemporary world, the currency regime is a floating exchange rate system, at least as regards the major currencies issued by the advanced industrialized economies (US dollar, euro, Japanese yen,

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British pound, Canadian dollar, Swiss franc). The example quoted sometimes as nearest to the reparations issue are the periodic attempts of the OPEC cartel to levy tax on the rest of the world. There are, however, important differences. OPEC’s power to tax is not based on military force but on ability to organize a multilateral reduction in members’ output and to limit exploration and development of oil (or gas) resources (in cartel countries). The oil consuming countries can take measures to avoid the tax – in particular by creating stimuli (in addition to the OPEC price action) to reduce domestic oil consumption and increase domestic production of oil and oil substitutes (for example, natural gas). The cartel’s power is based on an inherent instability. Any one member can gain from cheating on the others (by producing in excess of the quotas agreed), or by secretly increasing investment in future production capacity. But if all cheat the cartel collapses. By contrast, victorious allies can send in armies of occupation to seize national assets or resources in pursuance of their claims. Even so, the history of German reparations – in particular the Ruhr occupation of 1923 – shows that victor power has its own limits. The OPEC countries are themselves very small (in economic size) relative to the combined economies from which they are seeking to raise tax – the opposite situation to the coalition of Allies seeking to extract reparations from Germany (in the 1920s). OPEC denominates its tax demands in the currency of the largest payee (the US) and invests its surpluses in a basket of currencies from the major paying countries (amongst the advanced economies), including most prominently the US dollar. Hence, early on following an oil price jump, when the OPEC nations are largely saving their new windfall, they effectively lend tax payments back to those oil importing countries which issue international investment currencies, meaning they (the latter) face no immediate external imbalance. The historical tendency is for the OPEC countries to eventually spend most of their tax revenues on goods and services from the oil-importing countries, meaning that the income effect stressed by Ohlin and ignored by Keynes in the debates of the 1920s is very important in this case. The practical limit to the oil importing countries’ capacity to pay oil tax is not the elasticity of substitution between traded and non-traded goods (or less technically, their ability in aggregate to shift production into exports to OPEC and consumption away from goods and services demanded by OPEC). Instead, the short-run limit is set by the possibility of world economic slump (caused by energy shock undermining business

100 What Drives Global Capital Flows?

and consumer confidence and spending power), in which OPEC’s total tax-take would decline despite a sky-high price. And the long-run limit is set by the scope for substitutions in production and consumption in the oil-importing countries away from OPEC’s oil. The closest analogy between the OPEC cartel levying tax and Keynes’s account of the Entente Powers imposing reparations on Germany is with respect to those oil-importing countries whose own sovereign money plays no international role (and is thereby not sought by OPEC investors) and whose economies produce hardly any goods and services sought by OPEC. Such economies, in the face of oil price shock, might well experience a substantial rise in their interest rate level and a fall in the real effective exchange rate of their currencies. The depreciation stimulates production of traded goods and services (in which these economies are specialized) and curbs domestic consumption of traded goods and services in general – meaning that the given economy will increase its net trade surplus with other oil importing countries which are in turn better placed to gain from OPEC’s increased demand for goods and services (or from OPEC’s demand for particular asset-types). (By contrast, for example, exchange rate adjustment plays no major role in the adjustment of say the euro-area and the US to oil shock, unless there is a serious asymmetry in their dependence on energy imports or in their ability to supply OPEC markets with goods and services, or in the popularity of their respective currencies with OPEC investors). It is possible that in the short-run following an oil shock the most disadvantaged economies as described could not effect the raised amount of tax payments to OPEC at a level of oil consumption anywhere near its pre-shock level. Even at a very devalued level for their currencies and a higher level of domestic interest rates, capital inflows would not be forthcoming in sufficient extent (to effect the payments). Thus there could be short-run economic dislocation in which external balance would require interest rates rising well above their long-run neutral level and the exchange value of the national currency falling far below its long-run equilibrium level. The economy would pass through a period of slump.

Zero rate boundary as obstacle in solving transfer problem In general, though, the differences between the analysis of OPEC cartel shock and reparations are so significant that it is best to consider them as highly distinct examples of the transfer problem and how that is solved

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in particular instances. As such both examples (of the transfer problem) can be used to demonstrate a potential flaw in the process of market adjustment. This flaw can also be found sometimes in the case of adjustment to large changes in savings surpluses or deficits that are endogenous rather than induced by an exogenous event (reparations demands or oil shock, for example). The flaw stems from the impossibility of the real rate of interest falling to significant sub-zero levels in a conventional monetary system where inflation is very low or even negative (deflation). Take the case of reparations. In the country paying the reparations, national savings have to increase as the counterpart to the generating of the export surplus (out of which payment is made). This (the rise in savings) may occur via an increase in interest rates or through a swing of the national budget into greater surplus (or smaller deficit) before taking account of the reparations amount. There must be a counterpart fall in savings surpluses (or increase in savings deficits) elsewhere in the world, particularly in the countries that are receiving the reparations payments. In a market economy that fall in savings would come about through some combination of a decline in interest rates and an increase in the budget deficit (before taking account of reparation receipts in the case of recipient countries). Of course it is possible that in the new equilibrium (after imposition of reparations) the savings surplus in the paying country might have risen by less than the amount of reparations and the savings deficit in the receiving countries might have increased by less than the reparations received, with global capital flows bridging the gap. The receiving countries would be net lenders and the paying country a net borrower. This would correspond to the case of where the net cash outflows generated by reparation obligations are spread (via international borrowing) over a longer period than the legal term. It may be, however, that the zero rate barrier (the fact that nominal interest rates cannot fall below zero in a conventional monetary system) means that an equilibrium situation cannot be reached. Market interest rates in the recipient countries might not be able to fall far enough to be equivalent to the very low neutral level (often negative) in real terms (in some recipient countries) at which all countries (payer, receiving and all others) would be in full internal and external equilibrium. The result would be a long-run disequilibrium situation in which interest rates in the paying country had to remain well above neutral levels, meaning depressed economic conditions there. In turn, that weak economic situation in the paying country might add to political risks there, intensifying its economic disequilibrium.

102 What Drives Global Capital Flows?

In the example of oil shock, where the OPEC cartel suddenly restricts output to push up prices, there is likely to be a sudden (probably only short-run) rise in the global propensity to save. In the oil importing countries households may reduce their savings with the intention of cutting back their non-oil consumption by considerably less than the full extent of the increased payments of oil tax (to the OPEC cartel). But in the OPEC countries themselves the initial spending out of the oil tax receipts might be very low – and so their desired savings level rises by more than the counterpart fall (of desired savings) in the oil importing countries (measured in total aggregate terms). In that situation the average neutral level of interest rates in the world economy would fall – in some areas (for example countries whose currencies are the main investment vehicle of the OPEC countries) perhaps to below zero in real terms. And so the global economy in the aftermath of an oil shock might not be able to reach a new full equilibrium (if indeed in important areas the zero rate boundary combined with no inflation or deflation prevents the emergence of negative or even zero real rates).

5.0 OPEC current account balance as % of US GDP 4.0

3.0

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1.0

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–2.0 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Figure 4.1 GDP)

OPEC countries – current account balance, 1974–2004 (as % of US

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In the longer run, as OPEC nations start to spend a higher proportion of their revenues, and the average level of neutral rates (in real terms) in the global economy rises, a full equilibrium might again become feasible. In fact in the 1st and greatest oil shock of 1973–5 real interest rates on several major currencies fell to highly negative levels as this was possible in the context of the then double-digit inflation rates. (See Figure 4.1 for the history of the OPEC surplus during this and subsequent periods).

Impairment of global adjustment to raised savings surplus The more general example of the zero rate barrier acting as an impediment to international economic equilibrium is the situation of an endogenous fall in the savings deficit (or rise in savings surplus) in an important area in the world economy unmatched by a simultaneous opposite shift in savings balances elsewhere. (Note that endogenous means that the pressure – in this case on savings – comes from within the economic system, not from outside as in the case of OPEC cartel action or reparations demands). This means that the average equilibrium level of interest rates in the world economy declines and the neutral rate might move into sub-zero territory in at least one important centre. Some examples from recent economic history can usefully demonstrate the problem. First, there is the illustration from Japan’s Lost Decade, in the aftermath of the Crash of the Great Bubble Economy in 1990. It was not immediately nor even with a small delay realized by policy-makers or markets that there had been a big increase in the underlying private sector savings surplus in the Japanese economy. (The rise in surplus was due to first, greater caution in consumption by households as their wealth shrank and optimism on future income growth diminished and to second, a perception of diminished investment opportunity in the business sector). Hence market rates remained far above (what we now know to have been) the new sunken level of the neutral interest rate at which the Japanese economy could have reached internal and external equilibrium (see Figure 4.2). The reputation of bond markets as vigilantes against inflation did not carry over to being vigilantes against deflation. And central bankers knew no better. The result was that a deflationary process got under way and when much later (1998) a substantial body of opinion both in the marketplace and amongst policy-makers viewed the new equilibrium level of real rates as probably far below zero, there was no possibility (by then)

104 What Drives Global Capital Flows? 9.0 JGB 10-yr yield

8.0

Japanese overnight call rate 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 90 Figure 4.2

91

92

93

94

95

Japan – JGB 10-yr yield vs. overnight rate, 1990–5

under conventional monetary policy of market rates (expressed in nominal terms) falling to a low enough level (sub-zero) to bring that outcome about. By the time of Japan’s second post-bubble recession of 1997–8, nominal money market rates had fallen close to zero, but in real terms, taking account of deflationary expectations, these were at significantly positive levels. With the stream of capital outflows from Japan thereby weaker through most of the 1990s than what would have been the case if real interest rates had been at their significantly negative neutral level, the current account surplus was also less than the surplus (both current account and savings) which the Japanese economy would have run if in full internal and external equilibrium. The yen was well above the level which would have been consistent with that full equilibrium, and its elevated value was a key factor in depressing the current account surplus. In effect the Japanese economy reached a stationary disequilibrium or a Keynesian-type under-employment equilibrium in which the actual savings rate was below equilibrium level in part because aggregate national income was far short of full productivity potential and so Japanese households reduced their current saving in the attempt to maintain real living standards.

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Suppose markets and policy makers had more promptly recognized the fall in the neutral level of interest rates in the Japanese economy following the Crash of the Bubble Economy. With inflation still at a positive level a prompt fall of market rates to very low levels would have been equivalent to a real rate of zero or even sub-zero. There would have been a pair of interest rates and exchange rates (both well below those observed in practice during the period say 1991–4) at which the size of capital outflows, equal to the savings and current account surplus, would have been much above observed levels in line with substantially higher (than actual) economic output. Lower interest rates and the lower exchange rate would have stimulated aggregate demand, whilst the raised level of the export surplus (reflecting the cheaper yen) would have matched strong capital outflows (driven by ultra-low interest rates in absolute terms and relative to those abroad). It is possible, even so, that the underlying savings surplus in the Japanese economy had risen so far, that in the immediate aftermath of the Crash (1991) the equilibrium level of yen market rates in nominal terms had already fallen below zero, within the context of the currency regime in place (a floating yen). In principle there might have been a low level of the yen at which zero nominal interest rates could have been consistent with internal equilibrium (aggregate demand, including net exports, equal to the then productive potential of the Japanese economy). But external equilibrium might have been impossible even at a zero or very low positive nominal level. The large savings surplus might not all have flowed out into foreign assets (with the yen so cheap) as Japanese investors feared an eventual bounce-back of the yen were the economy to regain the path of prosperity. Investors might also have factored in some long-run tendency for the yen to appreciate on account of a rising investment income surplus. (It is possible, though, as we shall discuss more fully in the next chapter, for a rising income surplus to be consistent with long-run stability or the exchange rate rather than currency appreciation). Moreover a barrage of protectionist pressure from Washington and the continually broadcast simplistic (and wrong) analysis from the then Bank of Japan Governor, Yasushi Mieno (see Brown, 2002), that a big current account surplus meant inevitably a higher yen, might also have curbed the potential momentum of capital outflow. In sum, the zero rate barrier might already have been effective in the early 1990s, even if monetary and market opinion had been more astute. That would have meant full global economic equilibrium was not possible under the

106 What Drives Global Capital Flows?

currency (floating) and monetary (no possibility of negative nominal interest rates) regime in place.

Short-circuit in global capital flows, 2000–4 A second case-study from the laboratory of history regarding the implications for global and country equilibrium of an endogenous jump in savings surplus (or fall in savings deficit) comes from the bursting of the worldwide technology bubble and of the US economic bubble in 2000. Private sector (household and business sectors combined) savings propensities rose and investment propensities fell throughout the globe, but most of all in the US economy. In the absence of any fiscal policy change, the neutral level of US rates would surely have fallen relative to that abroad, and the dollar’s equilibrium international value would have decreased. Aggregate demand in the US economy would have been stimulated by the fall in interest rates and by the dollar’s depreciation. Capital inflows to the US would have moderated in line with the shrunken rate spread in the dollar’s favour. Reduced capital inflows would have been consistent, indeed, with the fallen current account deficit and savings deficit. There could have been internal balance in the major foreign economies brought about by a decline of interest rates, albeit less than in the US, offset only in part (in terms of effect on aggregate demand) by the drag from the external sector (reflecting the weaker dollar). The savings surpluses outside the US would have fallen in line with lower interest rates (in that the increase in savings propensities was less than in the US and thereby more than offset – in terms of actually realized savings levels – by the decline in rates). Matching the lower savings surpluses (outside the US) would have been a reduced momentum of capital outflow to the US (consistent with the shrunken rate disadvantage of the savings surplus currencies). Given, however, that Japanese money rates were virtually at zero before the US bubble economy and the world technology bubble burst, and the Japanese price level was falling, all the adjustments just described could not take place. Moreover, the European Central Bank, established only in late 1998, was not inclined to cut money rates in line with neutral rates, given that inflation was still above target and its reputation could suffer lasting damage from an early failure in achieving this. The narrowing of the average rate spread (across the major international monies) in favour of the US would be greater than in the

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equilibrium solution described above in that yen rates could not fall in real terms or nominal terms (and euro rates were being held high). It is possible that in 2001 the US neutral rate even in nominal terms could have turned negative with the Japanese neutral rate even more negative. Given market rates in both cases stuck at zero (unable to fall to the respective sub-zero levels), the spread between them would have been well below the spread between the hypothetical neutral rates. In consequence the yen would be above and the dollar below the level consistent with global economic equilibrium. The cheap dollar (compared to full equilibrium level) would most likely have meant that the US economy could be nearer internal equilibrium than the Japanese economy (saddled with an above equilibrium value of its currency). In practice, the analysis must be qualified by the observations that first, the yen itself had been in a bubble market during 2000 (see Figure 4.3), gaining from huge foreign inflows into the overheated Tokyo equity market and speculation on a bizarre tightening of Japanese monetary policy which did indeed get off to a brief start before being quickly reversed. Second, the big easing of US fiscal

1.4 EURO/USD 100 Yen/USD

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108 What Drives Global Capital Flows? 8.0 10-yr conventional yield

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policy which took place in 2001 under the new Bush Administration may well have helped to keep the neutral level of US rates just above zero (in nominal terms). In any case, a main difference between the hypothetical post-bubble scenarios described above and what actually happened was the long lag in US money and bond yields coming down to near the new sunken level of neutral rates. As in the earlier Japanese example, the monetary authorities and the bond markets were slow to appreciate how far neutral rates had fallen. In Summer 2001 (July and August), almost three quarters of a year after the recession started, federal funds rate still averaged 3.70%. It took the terror attacks on the US (September 11) to catapult the Federal Reserve into a bold easing of policy, with federal funds rate falling to 1.75% by end-2001. Only in Spring 2003 did the Fed funds rate reach its cyclical lowpoint of 1% – just at the time when we now know that the US economy had entered a growth cycle upturn (a period of above-trend growth). Private capital markets were not more perspicacious about realizing promptly after the bursting of the bubble economy that the neutral rate of interest for the US economy had fallen far. The yield on 10-year indexed bonds was still at 3% in early 2002, falling to around 1.5% for

Short Circuits 109 3.0

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the first time only in early 2003. Ten-year swap rates were still at around 5.5% in early 2002, falling to 4.5% and even lower a year later. (see Figures 4.4 and 4.5). Consistent with these long lags, it was not until 2002 (onwards) that the dollar depreciation occurred which was a key component of our hypothetical post-bubble scenario above. There is obvious similarity with the perverse rise of the yen in the immediate aftermath of the crash of the Japanese economy in 1990, also related to delayed realization (by both markets and the monetary authority) of the extent to which neutral interest rates had fallen. The process of dollar depreciation got a fillip from the so-called Bernanke monetary shock of Spring 2003. (Immediately after the toppling of Saddam Hussein, when financial markets were already optimistic about a US economic re-bound, Federal Reserve Governor Bernanke became the lead architect and spokesperson of a new expansionary direction in monetary policy). Some critics would say that belatedly the FOMC became aware of the extent to which the neutral level of US rates had indeed fallen and realized that past overestimation (of the neutral rate) had resulted in the inflation rate

110 What Drives Global Capital Flows?

falling to a dangerously low level below 1% p.a. (dangerous because that left little or no safety margin for the aggressive use of monetary policy – involving substantially negative real rates – in the next economic downturn). In any case, the US Federal Reserve in Spring 2003 resolved to breathe a somewhat higher rate of inflation into the US economy by cutting rates to below neutral (wherever that might be). According to the judgement of FOMC members a 1% Federal Funds rate was most likely below neutral and putting some upward pressure on the inflation rate. Subsequent events seemed to validate that judgement, even though some contemporary critics argued that the FOMC was now engaged in overkill and a period of higher-than-desirable inflation would be the result. With US rates finally (2003) down below (most probably) their sunken post-bubble neutral rate, but foreign rates still above neutral, global private capital flows out of the savings surplus countries and into the US largely seized up. The neutral rate of interest in real terms in Japan, for example, was surely below that in the US. In a hypothetical equilibrium scenario, if nominal rates could move to negative levels, then Japanese money rates might have been at –2%, US rates at 1%, and say euro rates at 0 or below. At those spreads capital would have continued to flow out of the savings surplus countries to the US, albeit at a lesser momentum that in the bubble economy years. Instead, Japanese rates were stuck at zero, whilst the ECB fretted about inflation still above its 2% target and protested that in the new world of European Monetary Union there were no grounds for monetary policy in Europe to bend before the might of the Federal Reserve. In fact, euro-central bankers were outspoken in their view that the FOMC was making a big inflationary mistake which they had no intention of following. In Japan, long-used to the policy issues concerned with the zero-rate boundary to monetary action, there was a response to the decline of US rates towards neutral and below (in Spring 2003). The decrease in momentum of private capital outflows (from Japan) as US rates fell towards Japanese rates meant that the yen came under strong upward pressure. A disequlibrium outcome threatened, in which the yen would have to rise high enough to bring the current account surplus down to the low level of private net capital exports out of Japan (held down by the decline in US rates and the above neutral rates on yen). The climb in the yen would intensify domestic deflation as interest rates could not fall so as to stimulate domestic demand.

Short Circuits 111

The spectre loomed of Japan descending into a more severe underemployment equilibrium in which private savings would indeed fall into line with the shrunken current account surplus – due to depression of national income far below productive potential. To banish that spectre, Japanese policy makers resolved on a program of massive foreign exchange intervention for which the theoretical justification was the near paralysis of private capital outflows under contemporary conditions of ultra-low US rates and where yen rates could not fall to negative levels. Japanese policy-makers of course did not present nor wholly perceive their policy in this way. Rather Tokyo’s currency diplomats defended intervention as designed to smooth out excessive volatility and resist perverse movements in currency values. An alternative way of presenting Japanese foreign exchange policy at that time (2003) would have been to set a target for foreign exchange reserve accumulation over the next few years, with clearly defined circumstances in which the pace of build-up would be reduced or increased. These circumstances would include the rate of deflation in Japan. Hence if deflation came to an end, and the neutral rate of interest (in nominal terms) on yen again became zero or positive (rather than sub-zero), then the zero rate boundary would disappear as an obstacle to the Japanese economy attaining internal and external equilibrium. A big rise in US interest rates would be another circumstance (in which the target for reserve accumulation would be reduced), in that the corresponding neutral rate of interest in Japan might then rise above zero. (The momentum of capital outflow from Japan would rise and so there might be a depreciated value of the yen together with a positive yen interest rate at which the Japanese economy could reach internal and external equilibrium). The principle behind the intervention (foreign exchange reserve accumulation), from the Japanese viewpoint, was that when market mechanisms are not functioning (due to zero rate boundary) a second best situation (compared to the first best of the market mechanism working) is to proxy the capital outflows which would have taken place. Of course there are no hard estimates as to the extent of capital outflows which would have taken place in such circumstances – and margin of discretion, susceptible to international negotiation (in particular between Tokyo and Washington) – becomes possible. In fact, given the excellent relations between the Koizumi government and the Bush Administration, there were no significant international constraints on Japanese intervention policy. And that was

112 What Drives Global Capital Flows?

despite the adoption of the slogan at the Dubai G-7 summit (Autumn 2003) calling for Asian currencies to become more flexible and by implication for intervention operations to be wound-down. But Japan had long been a special case, with the problems of deflation as a constraint on Japanese monetary policy options well understood in Washington. (see Lindsey, 1999). Suppose, however, in the situation of very low US rates and the Japanese neutral rate in nominal terms still below the zero rate boundary, Tokyo had indeed decided to heed the Dubai slogans and freely float the yen (meaning no foreign exchange market intervention at all). Was there any way of preventing shortcircuits in the global flow of capital of which one symptom would be an upward spiral of the yen?

Can monetary base policy prevent short-circuits? Some monetary economists might (and did!) hypothesize that an aggressive expansion of Japan’s monetary base (or more broadly high-powered money), even with interest rates stuck at the zero boundary, could provide relief (from short-circuit). If the rapid expansion of high-powered money (monetary base plus currency in circulation) indeed helped to convince the Japanese public and market opinion generally that deflation would soon end and indeed be succeeded by some inflation, then the real (medium-term) interest rate level which corresponds to zero nominal rates would fall, perhaps even into a sub-zero range. The result would be a stimulus to the outflow of private capital and the Japanese economy would avoid being pushed as far into a Keynesian-type underemployment equilibrium with an overvalued currency. The key theoretical issue is whether high-powered monetary expansion with rates already stuck at zero is indeed effective in pushing up aggregate demand. Otherwise the hypothesized effect on expectations would simply be a case of the Emperor’s New Clothes. The main potential channel is via asset prices. Suppose as illustration the Bank of Japan were to target an expansion of monetary base (defined as deposits at the Bank of Japan plus currency in circulation) over the following year equivalent to 10% of GDP, and used this to buy some combination of equities and foreign currency assets. (In terms of the amounts outstanding in 2005 this would mean a more than doubling of deposits at the Bank of Japan). Then net present holders of these assets (equities and foreign currency) would have to be induced out of them into yen monetary base (or yen deposits with Japanese commercial banks which

Short Circuits 113

are matched by bank deposits with the BoJ). (Of course, there can be many turntables along the way, so it is not the person who sells the foreign assets who has to hold yen money, but someone else down the chain of portfolio adjustment). The induced shifts would require that foreign currency and (Tokyo) equity rise in yen value – and both developments would help stimulate the economy. There is a second potential channel (between monetary base expansion and aggregate demand in the economy). Banks able to borrow zero rate funds in the interbank markets or wholesale money markets might seek to impose a higher rate of charges on retail customers (with respect to cash withdrawal, transfer, and account maintenance services). Effectively the retail rate of interest would become more negative. In response, retail customers would reduce the amount of bank deposits they hold in favour of more cash under the mattress or elsewhere. This switch in their portfolio composition might induce a higher rate of spending on goods and services. Japanese experience, however, suggests that banks are very reluctant to increase charges significantly. Perhaps they reckon that the large marketing costs of regaining customers lost during the period of zero rates would outweigh any present savings. And the elasticity of demand for cash on the part of the public might be very large with respect to an increase in charges. Then any significant rise (in charges) across the banking industry could trigger a run on the banks and bring into question their credit-rating or even survival. A systemic crisis could erupt. The third potential channel from monetary base expansion is its influence on wider money supply aggregates. Even if we accept the pessimistic hypothesis that the multiplier could be one or less (and indeed the levying of charges by banks and induced cash withdrawals would mean less than one) a huge expansion of monetary base could lead to a significant increase in money supply for a given year. As illustration, if in 2003–4, the Bank of Japan had pushed deposits with itself up to ¥60tn rather than stopping at ¥30–35tn, then maybe for a year at least wider money supply growth (M2+CDs) would have been 4% rather than 2%. If the demand for real money balances in Japan were a stable function of a few well-defined real variables, then the money supply acceleration could indeed have had an influence on the price level. But Bank of Japan experts and most outside economists (for an exception, see Hetzel, 2003) were convinced that no such stable demand exists in the contemporary Japanese situation.

114 What Drives Global Capital Flows?

A negative interest rate regime In Japan the experience with a policy of aggressive monetary base expansion at zero rates has been judged unfavorably by many critics. There is much scope in particular, to argue that the implementation of policy could have been bolder and that then swifter results would have followed. Boldness would have included huge and persistent (rather than intermittent) use of foreign currency purchases towards stimulating monetary growth. Without that element, boldness just in terms of rapid monetary base expansion achieved via traditional domestic asset purchases (including long-term bonds and bills) most probably would not have been sufficient under the given circumstances (characterized by the neutral rate of interest below zero in real and nominal terms). Policy implementation under conditions which excluded foreign exchange purchases by the Bank of Japan (a free float of the yen) might well have to include the use of non-conventional tools. One possible step to accompany a free float of the yen would have been a negative interest rate regime as described originally in The Yo-Yo Yen (Brown, 2002). Under this proposal the Government of Japan would announce that so many years from now, say five years, yen banknotes will be converted into new notes, with a conversion rate of say 1000 old = 900 new. In the interval, the 1:1 convertibility of yen banknotes into yen bank deposits would be suspended, and a sliding schedule of conversion rates be set instead. As illustration, the conversion rate would be 1000 yen notes = 1000 yen deposit at the start and moving gradually down, week-by-week or month-by-month, to around 1000 notes = 980 deposits at the end of the first year, 960 deposits at end of second year, and so on until 900 deposits at the end (of the 5-year period). There would have to be some fixed small charge on conversions around month end (or more simply all the time) to prevent arbitrage by the public in the form of putting notes into their deposits just before the next downward adjustment in their value took place and then taking them out at the start of the new month. The gradual slide in the value of yen banknotes would eliminate the usual constraint to money market rates falling below zero – in the form of the public avoiding them by withdrawing cash, and this in turn precipitating a banking crisis. So long as the negative interest rates are higher (less negative) than the rate of depreciation in the banknotes, no arbitrage is possible (in the form of converting deposits into cash). The central bank would be able to steer money rates anywhere above

Short Circuits 115

that lower negative limit (the rate of depreciation of banknotes). Deposits held by the banks with the central bank would earn interest at a negative rate, equal to the depreciation rate of banknotes. With money rates now able to fall to negative levels (meaning that longterm bond yields could also fall closer to zero), the economy (in this case Japanese) could reach external and internal equilibrium even under circumstances of very low US nominal rates. Despite its apparent attractions, the regime of negative interest rates remained a political non-starter in Japan through its years of recessionary deflation. There has been an array of objections. First, with the banks unpopular, how could politicians persuade the public that negative rates were not some backdoor method of bailing out the banks – allowing them to accelerate at no cost to themselves (in terms of the conventional profit and loss account) their write-off of bad loans made in the past. And indeed negative rates would have helped towards reducing this legacy more quickly. Second, small savers with most of their assets in the form of bank or postal savings deposits would be penalized to a greater extent than wealthier investors with large holdings of equities and foreign currency assets (which would jump in yen value as soon as the change of regime to negative rates became a publicly aired possibility). There could be some offset here, though, from a recovery in residential real estate prices. Third, there would be the complex issue of adjustment to the new regime (of negative interest rates and floating exchange rate between cash and deposits) by the retail sector, where cash transactions are especially important. (Banknote exchange would also present special problems in the grey and black areas of the Japanese economy – albeit that the substitution of dollar banknotes could ease these). In particular there could be considerable costs in re-tuning frequently cash vending machines and automatic teller machines (ATMs) (deposit balances would be debited by less than the amount of yen cash withdrawn). In order to cover themselves against these costs, retailers could mark up prices (in terms of banknotes) by more than the underlying conversion rates would suggest, and this would be unpopular. In some areas of the retail economy there would be dual pricing – one price for cash and one for cash for other means of payment. Fourth, there are the non-trivial security costs at the end (after five years in our example) of the operation of exchanging large stocks of banknotes. As comparison, these were estimated at as much as 1% of GDP in the case of converting the European sovereign banknotes into euros.

116 What Drives Global Capital Flows?

When short-circuits force abandonment of currency free float If indeed we were to conclude that a negative interest rate regime is not politically feasible, and that aggressive monetary base expansion at zero rates has only limited scope to influence aggregate demand or capital flows, then a free float of the yen in the situation described (of sub-zero neutral rates) would be a costly policy option. Is there a better alternative option than discretionary and potentially large-scale foreign exchange intervention? In particular, would there be advantage in formally fixing the yen-dollar rate? The same range of questions apply to any situation of potential short-circuit in the global flow of funds due to the constraint of zero rate bound to monetary policy under conditions of deflation. Another type of short circuit in the global flow of capital could be imagined as follows. Suppose the underlying US savings deficit were to narrow from its high level of the 2004–6 period, putting downward pressure on the neutral level of US rates. Suppose further there were no simultaneous autonomous fall in underlying savings surpluses elsewhere in the global economy. Then the average neutral rate in the global economy would fall. The neutral rate in some foreign (non-US) savings surplus countries (in addition to Japan) could dip below zero. Market rates above neutral (in those particular savings surplus countries) would mean their currencies (of those same countries) were above equilibrium value and the respective economies would fall into varying degrees of slack (recession or depression). The attraction of the fixed exchange rate solution to the problem just illustrated (of market rates stuck above sub-zero neutral rates) is that it allows the savings surplus country (of small or medium-size) to move to a higher (zero or above) neutral rate than under the floating rate regime and so to attain potential full external and internal equilibrium – subject to its change of regime not being important enough in the global economy to also pull the US neutral rate below zero! For in the fixed exchange rate regime, the neutral level of rates (in nominal terms) in the given country is the same as in the large country (or group of countries) whose currency (in our example, the US dollar) is used as peg. An advantage of regime change as a solution to the problem of subzero neutral rates (in nominal terms) is that the given country leaves itself less open to the charge of currency manipulation. In principle, a savings surplus country which switches to a fixed-exchange rate regime in response to a potential short-circuit in the global flow of funds

Short Circuits 117

(brought about by fall of its neutral rate level in the context of a floating exchange rate regime to sub-zero) solves the problem by bringing about a larger real depreciation of its currency than what have been possible under the discarded floating exchange rate regime. (One factor limiting real depreciation under a floating rate regime are speculative assessments of a possible eventual re-bound of the currency, leading to some current support for its exchange rate). That larger real depreciation (possible under fixed-rate system) can come about all at once via pegging the currency at a well-devalued rate or it can come more gradually through a process of the price level falling (as the corollary to a prolonged recession) at a fixed nominal exchange rate. As illustration, suppose with the yen at around 110 to the dollar, under a still floating exchange rate regime, US interest rates start to fall (reflecting an increased savings surplus in the US), and Japan is thrown into economic disequilibrium (as interest rates cannot fall below zero so as to sustain capital exports and help stimulate domestic demand as an offset to slacker external demand). The yen rises in line with the diminished US-Japan rate spread. The climb of the yen would be part of the process of reducing Japan’s current account surplus (consistent with the shrunken momentum of private capital export). If the yen were to indeed level out at a higher value – say 90 to the dollar – it could be imagined that the fall in the Japanese price level (exacerbated by the slacker economy) would in the end bring about a substantial real depreciation of the currency and this would unblock the road back to overall equilibrium. There would be no reason, however, to expect such a levelling out (of the nominal exchange rate) under the floating currency regime. Rather the yen’s nominal exchange value would tend to rise in line with the differential movement of the Japanese and US price level (in this illustration, Japanese prices falling and US prices hardly rising). It is the real exchange rate and real interest rate level, not nominal, which are determined in the process of achieving external balance and internal steady state equilibrium. The relation of nominal to real rates is determined by differential inflation. If, instead, the Japanese authorities were in the above situation (of a fall in the US savings deficit) to announce a new regime in which the absolute floor for the dollar would be 100 and the ceiling 110, then in time deflation would bring about a real exchange rate depreciation (of the yen). This would act as a stimulus to external demand in the Japanese economy. In longer-run equilibrium, the US would be in somewhat larger savings and current account deficit than at the start (just after US savings propensities rose), but with a much lower level of

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interest rates. Japanese nominal interest rates would be at the same level now as in the US (given no significant exchange risk between the two currencies, dollar and yen) and the yen would have fallen to a lower real value (than at the time of its fixing). The process of deflation in Japan to get to this solution could be avoided if in response to the US slowdown the Japanese authorities had immediately devalued the yen to say 110–120 – advancing the argument that as monetary policy was ineffective with rates already at zero, the move was an essential part of adjustment. Alternatively consider the currency regime choice for a country, again Japan, which is already in deflationary disequilibrium (without having to consider the new potential disturbance of a rise in US savings) and where nominal interest rates could not fall to the equivalent of the negative neutral real level due to the zero rate boundary. An exit from the disequilibrium is possible through fixing the exchange rate to a larger currency of an economy not in deflation (say, the US), and not in danger of falling into deflation as a result of the change in currency regime under question. A quick exit would be organized by fixing the new parity at a steeply devalued level – implying a large real depreciation. With interest rates in Japan and the US now at the same positive level (given that exchange risk is largely eliminated), a lower real (international) value of the yen would be part of the overall equilibrium solution for the Japanese economy (both internal and external) than when interest rates in Japan could in principle fall to much lower levels than in the US (albeit subject to the limitations of the zero rate boundary). If the yen had been at say 100, then as illustration the new pegged level might be 125. A much slower exit would be possible if the yen were pegged at 100. Indeed the rise in yen interest rates (in line with the absence of exchange risk) into equality with US rates would intensify the deflation in the short-run (if indeed US rates are significantly above zero). Longer-term relief and eventual exit would come from the process of real depreciation – effected by the internal price level falling yet the nominal exchange rate remaining fixed. The question of exit from deflationary disequilibrium – actual or potential – for the US, the largest economy in the world – is essentially different from the smaller country cases described so far (most of all Japan). Suppose that under the floating exchange rate regime, the neutral level (with respect to internal and external equilibrium of the US economy) of US interest rates (in nominal terms) falls below zero (presumably in a case where inflation is already very low or non-

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existent in the US). Perhaps a process of asset price deflation is the catalyst here. Most likely the neutral level of rates in several large foreign economies would also be below zero in that situation, given the importance of the US as a source of demand in the global economy. Under these circumstances, which historically match in several respects the situation of the global economic slump of the 1930s (see Kindleberger, 1986), exchange rate pegging cannot not solve the problem of disequilibrium. As a first point, it is not feasible for the US to peg its currency except as part of a multilateral arrangement. It is implausible that Japan and Europe would agree to the dollar being devalued as a prelude to a new fixed exchange rate system especially in the context of looming or actual US economic depression. And even if they did, it would intensify the threat of deflationary disequilibrium in their own economies. A series of competitive devaluations could follow, mimicking the currency wars of the Great Depression Era. Rather, the exit from the global disequilibrium described would be radical monetary policy pursued by all major economies, including the US, still within a floating exchange rate context. Most probably in the first instance radical policy would mean aggressive monetary base expansion. In the second instance there would be the introduction of negative interest rate regimes.

5 Sustainability

Perhaps the biggest topic in international economic policy discussions over recent years (2003–6) has been the so-called sustainability (or non-sustainability) of mega US current account deficits. The issue of sustainability had also loomed large back in the mid-1980s, a previous occasion of huge US current account deficits. It had largely faded from view in the late 1980s and early 1990s when the deficit had fallen substantially (under the influence of a long period of US economic slack and of a boom in Europe led by German unification). Even when the deficit bulged in the late 1990s it was largely ignored, being regarded as a natural counterpart of the capital spending boom associated with the then US miracle economy. The subject came back into focus as the US economy recovered from the 2001 recession and the deficit, powered by a large household sector savings deficit (see Chapter 3, p. 72) and a huge Federal budget deficit, reached new record levels (see Figure 5.1). What is meant by non-sustainability? At its simplest the concern is that as the trade deficit (in goods and services) continues to run at high levels, and the interest (or dividend) burden on the corresponding external debt (and other external liabilities including equity) grows, the US could find it ever harder to attract net capital inflows on the scale required to finance its total current account deficit. (This latter aggregate is defined as equal to the deficit on trade in goods and services plus net transfers abroad plus the deficit on factor income account. This last item consists in the US case mainly of investment income). Why might the financing get ever harder? As the US external debt grew relative to GDP, so the story goes, foreign creditors would become growingly alarmed about whether the US economy could service this in the long-run and demand an increased premium against risk. And in any case foreign investors would become resistant 120

Sustainability 121 2.0 1.0 – –1.0 –2.0 –3.0 –4.0 current account as % of GDP

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to accumulating dollar assets as these came to represent a higher and higher share of their overall portfolios. Even before such resistance “kicked in”, the rising current account deficit (as a share of GDP) on account of increasing interest and dividend payments to foreigners would surely tend to outstrip the underlying gap between equilibrium levels of savings and investment in the US, meaning that forces build up which would narrow the trade deficit. (These forces could take several forms including exchange rate and interest rate changes, budgetary shifts and asset price adjustments). A key issue in the discussion of current account deficit sustainability is the strength of these corrective forces. Is there a risk of market failure – meaning perhaps that these forces are in some sense too weak or fail to emerge altogether? Market failure in turn would provide justification for direct government or G-7 action to tackle the imbalances. A main source of possible failure – the zero rate bound to nominal interest rates blocking a fall of interest rates to a neutral sub-zero level in the savings surplus countries – has been highlighted in the previous chapter. Putting that possibility to one side, corrective forces should

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indeed emerge as foreign investors’ appetite (for US dollars) wilted, credit risks (with respect to US assets) increased, and the savings deficit lagged behind the current account deficit. Upward pressures would develop on US interest rates and downward pressures on the US dollar. Why – apart from the case of market failure above – could the invisible hand of the markets not be relied upon to hold the US and foreign economies to a long-run equilibrium path? An implicit theme of the pessimists (on sustainability) is that markets are ignoring some factors relevant to determining an equilibrium path for the US dollar through time. In particular, we have already seen that some pessimists are troubled by the market’s nonchalance regarding rules of thumb (p. 95). No country in history has ever run trouble-free current account deficits of more than 5% of GDP (see Slok and Kennedy, 2004 or Obstfeld and Rogoff, 2004). The experience if running for any length of time has always ended up in crisis. So why should we expect that the US would be an exception? (The US current account deficit crossed the 5% threshold already in early 2004). Other pessimists base their case on a consideration of so-called trade elasticities and provide horrendous accounts of how much relative price change or budget deficit reduction would be required to bring about a substantial narrowing of the US current account deficit from present levels. (See for example Brook et al, 2004). (The similarity of this strand of pessimism to that of Keynes in the reparations debate has already been highlighted in the previous chapter). Simultaneously they suggest implicitly that markets are presently underestimating the difficulty of future downward adjustment to the path of deficits. When inevitably the estimates become more realistic at some point in the future there will be an acute crisis of the US dollar, which would impose heavy costs on the world economy. Before reviewing these arguments in detail and analysing some further possible causes of market failure (in coping with huge US current account deficits) it is useful to derive the formula for how US external debt would grow through time on account of rising servicing costs (on the basis of the trade deficit running at a constant share of GDP).

Growth arithmetic of mega current account deficits Suppose at the start, year 0, the US has no external debt (net) and runs a trade deficit (including transfers) equivalent, as a proportion of GDP, to d. Suppose real GDP grows at an annual rate of g. And the trade

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deficit remains at d, as a proportion of GDP. The real interest rate is assumed to be stable at r. Then the size of the external debt as a proportion of GDP at the end of year T can be expressed as: 2 ⎛ ⎛ ⎛ 1 + r ⎞ T −1 ⎞ ⎡ ⎛ 1 + r ⎞ T 1+ r ⎞ ⎛ 1+ r ⎞ ⎟ = ⎢1 − ⎜ d ⎜1 + ⎜ + + LLLLL + ⎟ ⎜ ⎟ ⎜ ⎟ ⎟ ⎢ ⎝ 1 + g ⎟⎠ ⎜ ⎝1+ g ⎠ ⎝1+ g ⎠ ⎝1+ g ⎠ ⎠ ⎣ ⎝

⎛ 1 + r ⎞⎤ 1− ⎜ ⎟⎥ d ⎝ 1 + g ⎠⎥⎦

If rg then the external debt ratio eventually explodes. An arithmetical example gives the flavour of this formula. Suppose the real rate of interest on US external debt (averaged across all maturities) is 2%, the growth rate of the US economy 3.5% p.a. and the trade deficit (excluding interest payments) at 3% of GDP. (It is quite feasible for the neutral real level of interest rate on riskless assets to be less than the economic growth rate, even though in some simple growth models r is set equal to g. In particular, once equity risk is introduced, the growth models would have the average return to capital across equity and debt equal to g. Allowing for normal risk premiums, this would mean the riskless rate of return would be significantly below g). Then the external debt to GDP ratio would eventually stabilize at just over 200%, at which point the deficit on investment income account would have levelled out at 4% of GDP (meaning the overall current account deficit would have grown to 7% of GDP from its initial 3% level). But eventually means in practice around 100 years from now! After 10 years the net external debt to GDP ratio would be only 27% and after 20 years 52%, meaning deficits on investment income account of around 0.5% of GDP and 1% of GDP respectively. Hence if real interest rates are much below the long-run growth rate the build-up of debt servicing cost, relative to GDP, will be very slow. Whether indeed the rise in servicing costs will eventually require some interest and exchange rate adjustment to bring about a cut in the trade deficit depends on the evolution of the underlying savings deficit in the US economy and of savings surpluses in the world outside. If the underlying US savings deficit tends to creep higher, relative to GDP, and the foreign savings surplus (underlying) rises in step, then there need be no influence on exchange rates. No divergence would open up between the underlying US savings gap and the US

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current account deficit. Of course savings would tend to be related to national incomes (GNP) rather than GDP, and over time, given the current account deficit, US GNP would indeed grow at a somewhat slower pace than g (on account of the rising net interest payments to foreigners). Thus there would be some in-built tendency for the savings gap relative to GDP to widen slightly (on the assumption of investment spending remaining a constant proportion of GDP). In the above illustration, net national income at year 10 would be 0.5% less than GDP. If gross US savings stayed at around 25% of net national income throughout, then at year 10 the savings rate as a proportion of GDP would have fallen to 24.87%. If investment spending remained at around 28% of GDP, then the savings-investment gap would have widened out to 3.13% from 3%, short of the current account deficit total of 3.5% of GDP, implying some element of non-sustainability which had to be corrected. The same type of calculations applies to the long-run build-up of external wealth by the savings surplus countries. If the real return which they earn on their external assets is far less than their economic growth rate, then the growth in external wealth as a share of GDP will be very slow and bounded, and the rise in the investment income surplus, for a constant trade surplus, would be very gradual. It might well be that a gradual rising in the underlying saving surplus would mean that there was no built-in need for adjustment. And of course here national income would be growing faster than GDP, and if savings are related to the former and investment to the latter, then there would be an arithmetic very slight widening of the savings surplus through time. But this marginal widening would be less than the formula-driven rise in the current account surplus (as a share of GDP), meaning that if there is not some autonomous increase in the savings surplus then some forces of adjustment would emerge so as to bring the two surpluses – the arithmetic and the economic – into line with each other. There is one further arithmetic point to make. When it comes to assessing the importance of external debt or net asset position, it would be sensible to use as denominator not a flow measurement – in this case GDP – but another stock measurement, the total capital stock (excluding human capital and the government debt, but including consumer durables) estimated at around 350% of US GDP. And so in our illustration above, the net external debt as a proportion of national wealth after ten years would have grown from zero to 7.5%. The eventual stabilized proportion would be at just over 50% of national

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wealth. These are not in themselves eye-shattering proportions. And it could be that the national capital stock is growing as a proportion of GDP (consistent with the investment ratio remaining constant), meaning that the rise of the external debt to capital stock ratios would be even slower than suggested.

Economic concepts of non-sustainability The arithmetic of net external debt or wealth growth through time helps to set the dimensions of the economic discussion about non-sustainability. But arithmetic is not economics! In the literature and popular discussion there are two main economic concepts of sustainability and its opposite – non-sustainability. The first concept has been described well by Catherine Mann (2002). “A sustainable situation is one where the stock or flow imbalance generates no economic force of its own to change its trajectory. A current account deficit is sustainable at a point in if neither it, nor the associated foreign capital inflows, nor the negative net international investment position, are large enough to induce significant changes in economic variables, such as consumption or investment or interest rates or exchange rates”. Taking Mann’s definition, it could be that the arithmetic illustrative path of a trade deficit remaining at a constant say 3% of US GDP with r (the neutral interest rate) less than g (the long-run growth of productive potential) is sustainable, especially if the US savings deficit is tending to increase slightly, as are savings surpluses abroad. Then there would be no inbuilt requirement of adjustment (involving interest rate and exchange rate change). Non-sustainability on Mann’s definition need not involve any type of discontinuity or crisis – maybe just a modest turn in the trajectory of the deficit with interest rate and exchange rate changes no greater than already discounted. The second type of non-sustainability is hinted at in a further sentence of Mann’s definition (in italics). “Even if the current account deficit is sustainable by that definition today, its trajectory could be creating risks for the US and global economy.” Specifically a discontinuity might loom ahead. Perhaps conventional wisdom up until now in the market-place about the future long-run trajectory of the US and global economy is wrong and there will be a sudden wake-up call, bringing shock changes in exchange and interest rates. Or it may be that the task of powering a continuing immense flow of capital from the saving surplus countries into the savings deficit countries (and mainly the US) might prove to be beyond the capacity of normal market mechanisms, and these will

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suddenly snap or become impaired. This line of argument was implicit, for example, in a speech given by Federal Reserve Chairman Greenspan (November 19, 2004). To quote: A continued financing even of today’s current account deficits as a percentage of GDP doubtless will at some point in the future increase shares of dollar claims in international investor portfolios to levels that imply an unacceptable amount of concentration risk. –– The situation suggests that international investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing of the US current account deficit and rendering it increasingly less tenable. –– It seems persuasive that given the size of the US current account deficit, a diminished appetite for adding to the dollar balances must occur at some point. But when, through what channels, and from what level of the dollar? Regrettably no answer to these questions is convincing. This is a reason why forecasting the exchange rate for the dollar and the major currencies is problematic. It is at first sight strange to find Alan Greenspan, a one-time disciple of Ayn Rand (popular writer and philosopher who expoused an extreme anti-state liberalism), questioning whether markets could ultimately cope with huge US current account deficits. The free market apologist for Greenspan could say that he is not explicitly repudiating a market solution. Presumably when the mega current account deficit becomes untenable, due to rising financing costs, exchange rates and interest rates will shift so as to bring it down. And before the point of un-tenability, when it becomes visible to many on the horizon, the shift would already get under way. Notwithstanding this apology, the tone of the remarks definitely seemed pitched to awaken some anxiety amongst the audience, even if falling short of predicting market failure. Understandably, though, Greenspan did not fall into the trap of maintaining that a dollar decline was inevitable.

Satiation of foreign appetite for US assets? A common concern of the sceptics about sustainability (in either form of the definition) is that foreign appetite for US dollar assets may ultimately be limited. And indeed Mr. Greenspan amongst others has referred to the so-called Feldstein-Horioka research train (including the

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original paper and subsequent re-runs by later researchers) which implies that in much of the world there is a strong home bias by investors (over-weighting domestic investments compared to what simple principles of diversification would suggest), even though this (home bias) is tending to decrease somewhat (see Obstfeld and Rogoff, 2000). (In fact the rate of decrease outside the US seems to be more than in the US). The methodology of these studies is to examine empirically the correlation of savings and investment rates across countries. Strong home bias in itself would mean that savings and investment rates would be highly correlated. High domestic savings rate would tend to be invested at home rather than abroad even if domestic rates of return were relatively low. In assessing foreign appetite for US dollar assets a first point is sustainability of foreign savings surpluses. Then we can look at how much of these foreign savings surpluses would tend to go into dollar assets. The arithmetic of asset accumulation above suggests that if the main savings surplus countries were mature economies and the real rate of interest on their holdings of foreign assets were higher than the rate of domestic economic growth rate, holdings of foreign assets relative to foreign GDP would rise without limit. And so at some point a process of market adjustment would have to start – lower interest rates and higher exchange rates (of the surplus countries) so as to bring downward pressure on their trade surpluses (excluding investment income) and savings surpluses. In turn, smaller trade and savings surpluses abroad would mean that US deficits would have to narrow – with adjustment being forced via some combination of higher US interest rates and a weaker dollar. The idea, just illustrated, of there being some constraint on the US deficit path through time from foreign savings exhaustion, is not robust, at least in the short or medium-run. Some of the savings surplus countries have shrinking populations of working age and so the domestic capital stock might eventually trend down also. As the bulging population of pre-retirement age seek to boost their wealth, it is inevitable that they would find themselves with a rising share of foreign assets in their portfolio. Moreover, at prevailing low real interest rates in the mid-2000s, and given the preference of many foreign (non-US) investors for riskless or low-rate foreign assets (rather than equities), it is not clear that the rate of return on US dollar assets would be above the growth rate in the mature creditor countries. Finally, an important part of the global savings surplus can be traced anyhow to high-growth developing countries where the

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rate of return on US assets is definitely much lower than the domestic growth rate. Examples of the latter include China in particular. Smaller (in economic size) examples include Singapore and Taiwan. Moreover the group of countries in large savings surplus changes composition through time. Certain advanced economies might at some stage indeed enter an adjustment phase where their surpluses shrink. But there is a new generation of fast growth economies with large savings surpluses out there – including not just China but also oil-rich countries. Further ahead, Brazil and India might joint the high savings club. Savings surpluses in some advanced economies may in fact have further upward potential – as would be the case if the present recorded surpluses were below underlying equilibrium amounts. We have already discussed in chapter four how the underlying savings surpluses consistent with long-run international equilibrium in Germany and Japan might be much larger than what is observed. (The lower surpluses actually recorded are explained by incomes being well below full employment levels and so savings rates are depressed below where they would be in equilibrium). Some commentators suggest that there is something artificial – or out of line with equilibrium tendencies – for a large part of the savings surpluses outside the US to be in rapidly growing developing economies. Surely that is where the investment opportunity should be greatest and they should be tending to import capital. This line of argument, however, tends to understate the potential for high savings rates in economies which are growing fast, where pension provision is poor, and where resource wealth (in so far as it exists) is in the hands of a political oligarchy. (And as mentioned in previous chapter, the pre-retirement generation may be seeking to provide pensions for itself at present much higher income-equivalents than what held through most of their working life). Historically there are several examples of countries enjoying miracle periods of economic growth and yet remaining in overall savings surplus or near balance – including Germany, 1957–63 and Japan, 1965–72. In sum, the limit to the US being able to run huge current account deficits from the side of foreign savings propensities does not seem at all tight or imminent. But what about the constraint from concentration risk – that foreigners will in aggregate become concerned about the rising share of US assets in their overall portfolio and require a higher return at the margin on these to compensate for the resulting impairment of overall diversification? It is best to look at this question first without introducing currency risk – as would be the case if the

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global currency regime were a stable fixed exchange rate system (US dollar standard globally say) or an international gold standard. Currency risk is introduced into the analysis subsequently. As an arithmetic point, even if the accumulation of US assets occurred as a constant and identical proportion of each country’s net savings and current account surplus, the build-up in concentration would be slow. Typically in the advanced economies, household sector wealth as a share of GDP lies between 350 and 450%. Physical capital stock in the private sector plus government debt lies between 300 and 400%. In creditor nations, household sector wealth is typically greater than the value of the domestic physical capital with the net balance matched by net investment abroad (external assets greater than external liabilities for all sectors of the economy combined). Ten year’s accumulation of savings surpluses running at around 5% of GDP in an economy growing at 2% p.a. and with 1% real interest rates, would mean net external assets (all in the US in our present example) growing by say 55% of GDP. Out of this amount half might represent a build-up of financial and non-financial corporate assets abroad (in the US). In the case of financial corporations (mainly banks), the corresponding liabilities (for example domestic bank deposits) would be regarded as domestic by resident households, even though a fraction of the matched assets were abroad. Hence the build-up of US assets directly held in the portfolios of foreign (non-US) investors (resident in the advanced economies) might be no more than around 30% of GDP, versus overall wealth at say 400%. Another false alarm call on US concentration risk is too simple to be true! This alarm is founded on the observation that the US current account deficit is absorbing 85% of global savings – surely an unsustainable high level. The fallacy here is equating national savings surpluses with total national savings. Yes, as a matter of arithmetic, if the US savings deficit accounts for 80–90% of the identified aggregate of savings deficits in the world economy, then the US is absorbing 90% of aggregate savings surpluses. But a large part of wealth accumulation even in the savings surplus countries is in the form of domestic capital – as the physical capital stock (and national debt) grows roughly at the same rate as GDP. In the example above, Switzerland has a savings surplus of more than 10% of GDP, meaning that its net external assets grow by the same amount in any year. But if the economy is growing at 2% and the capital stock in Switzerland is around 400% of GDP, then total wealth (external and domestic) grows by around 18% of

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GDP. Hence only slightly more than half (not 90%) of the wealth increase would be going into foreign assets. Another important fallacy in the alarmist accounts of concentration risk is the failure to take account of turntables in the global flow of funds, discussed already in the first chapter of this volume (see pp. 8). Demand for US assets does not have to come from each country in the rest of the world in proportion to their present net savings surplus. In country A (outside the US) there may be a huge demand for US assets by domestic residents, far in excess of its net savings surplus, matched by inflow of capital from other countries. In country B, where resident portfolios already include a large proportion of US assets, new net outflows of capital into these might be much less than the size of the net savings surplus, with the balance going into the assets of other countries (including those where investors are rapidly accumulating US assets). In country C, which has no significant savings surplus, the inflow of foreign capital from country B (and other countries in similar position) would put upward pressure on asset prices and encourage domestic residents to switch some of their portfolios into US assets. Both C and A would be example of turntables in the global flow of capital. As an example of country A (as turntable), we could imagine a big developing economy, perhaps China or India in the long run. In both there may be a pent-up demand (in the private sector) for US assets, held back by capital flow restrictions. On top, the rapid growth of an affluent middle class is likely to mean that demand for US assets (in stock terms) could grow in absolute amounts each year by much more than the size of the savings surplus. At the same time China or India are popular destinations for direct investment. And so other countries may be light buyers of US assets (where light is measured relative to the size of savings surplus) and heavy direct investors in China (and India), whilst the latter are heavy buyers of US assets. An example of country B could be a mature creditor such as Japan, which started off its process of international diversification (back in the late 1970s) by concentrating on US assets and is now broadening out its holdings. An example of country C would be the euro-area, which in itself has no large savings surplus – but is an end-destination for East Asian or Middle East investors seeking to diversify their portfolios. So far our discussion of foreign savings propensities as a possible limit to the size of US current account deficits through time has been in the context of zero exchange risk. It is time to drop this artificial assumption. Evidently the introduction of exchange risk means that

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the limit becomes tighter than otherwise. The limit might nonetheless be very far-removed, especially if there is much scope for lifting exchange restrictions globally. As soon as we introduce substantial exchange risk, the banking sector no longer functions as an important conduit for global capital flow, except between countries in the same currency area or with respect to foreign borrowers assuming the exchange risk of taking out loans in the banking sector’s domestic currency. (An example of this latter form of transaction would be East European countries borrowing in euros from banks in the euro-area). This means there is less scope for the banking sector to overcome home bias amongst domestic investors by arbitraging in the form of issuing domestic deposits against the acquisition of foreign assets. As a general proposition, exchange risk means that foreign (non-US) investors would require higher returns sooner if the process of US asset accumulation is to continue. This general proposition, however, is subject to important qualifications. As we saw in Chapter 2, important grey and black areas of the world economy are effectively on the dollar standard. And several countries in East and South East Asia have belonged to an informal dollar bloc, with limited exchange risk between their own currencies and the US dollar. Even in the world outside these areas (grey, black, and Asian dollar bloc), the US dollar is a mainstream store of value and medium of exchange. Accumulated dollar wealth in fast growing economies might grow slowly as a proportion of GDP (the same arithmetic applies as above). And whereas the appetite for additional dollar risk might be slow growing in certain mature creditor economies, there is much scope for turntables to spread the risk in very different proportion to present net savings surpluses. In particular, investors in China and India might rapidly build up their dollar portfolios – with additions in any period far exceeding their savings surpluses, the gap being financed by inward flows of direct investment capital. And satiation of dollar appetites in some parts of the world would create its own dynamic towards turntable creation elsewhere. As illustration, if Japanese investors at the margin were underweighting the US dollar and overweighting the euro, this would trigger downward pressure on expected returns from the euro relative to the dollar which would encourage investors elsewhere (including those in the euro-area) to take on dollar risk (towards earning more). Also global borrowers would be induced by the widened expected cost spread to reduce the share of their debts in dollars and increase that in euros. Hence dollar satiation amongst some global investors would be offset by

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a reduction in non-US supplies of dollar debt, freeing up more of world savings in dollars to flow into the US. Of course dollar risk, and the extent to which appetites may become satiated for this around the world, does depend on the nature of the global currency regime. In some respects there is less competition for the dollar as the number one global investment money today (mid2000s) than in the 1970s, 80s or 90s. In these previous decades the Deutsche mark and Japanese yen were important medium-size competitors to the US dollar (as international money) even though they were never serious contenders for the number one position. The euro was meant – by its founders – to represent a serious new challenge for the dollar’s role in the global economy. But eight years on from its launch (effectively in Spring 1998), the euro’s growth as an international investment money is handicapped by issues of existential risk or regime risk (will it still be around in the long run, could the euro-area shrink in size, could the ground-rules of European Monetary Union change?). Whilst the creation of the euro has gone along with a deepening of European capital markets, this new liquidity advantage (of European currency assets) could be more than offset by a serious degree of regime or existential risk. As we have seen (see p. 95) some commentators have implied that dollar risk might increase suddenly (in a discontinuous fashion) when the US current account deficit reaches 5% of GDP or more. The rationale for this view is that a survey of historical experience suggests that all other countries (than the US) have hit a crisis at this level. For example Mann (2004) writes “for industrial countries, a current account deficit/GDP ratio of somewhere between 4 and 4.5% appears to be associated with the onset of economic forces (including a monetary policy response, a reduction in income and, in some cases, a real depreciation of the currency) that narrow the current account deficit.” An OECD research paper (Brook et al, 2004) made a similar point. “The US current account deficit has now peaked at its highest level ever recorded – around 5.2% of GDP – and remains very high by historical standard. For a large economy like the US, a deficit of this magnitude absorbs a significant proportion of total world savings and implies an increasing share of US assets in foreign investors’ portfolios. –– It is uncertain for how long foreigners will continue to accumulate debt and equity claims against US residents at the current pace.” Ex-Treasury Secretary Summers made the same point in a speech at Harvard in late 2004, “the US has never run such large current account deficits and no single nation’s deficit has ever bulked nearly as

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large relative to the global economy. At a minimum such a unique imbalance deserves careful scrutiny”. Obstfeld and Rogoff (2004) stress the relevance of benchmark experience from around the globe. “The latest end-2003 figure of US external net liabilities amounting to 23% of GDP is close to the all-time high level that the US is estimated to have reached in 1894, when assets located in the US accounted for a much smaller share of the global wealth portfolio”. The authors provide a graphic trajectory for the same ratio over the long-run and show how in the medium-term it will exceed various benchmarks reached by other much smaller countries in many cases prior to major debt problems. “We do not anticipate the US having a Latin-style debt crisis, of course, but these benchmarks are nevertheless informative”. Professor Padoa-Schioppa, then Italian board member of the ECB with special responsibility for international affairs, was much less guarded in his assessment (of the sustainability or otherwise of the US current account deficit) and quite revealing of the attitude around the council table in Frankfurt. In a November 15 (2004) interview with Reuters, Padoa-Schioppa was adamant “The US must gear its economic policy toward closing its anomalous current account deficit and it is desirable that this occur quickly. The US current account deficit is an anomaly in terms of its size and duration which no-one, even among the US authorities, believes can go on forever without correction. Our position in Europe is that this correction of policies – and not only of markets – is essential, and it is desirable that it should take place in the near future. The US should raise public and household savings by increasing taxes and lowering public spending. Very rarely in the last 100 years has one of the main economies for numerous years had a deficit of this size. It’s even rarer that this should be the case for the world’s richest economy.” The gist of all these statements, albeit well qualified, except in the case of Pado-Schioppa, is that global investors should watch out when the US current account deficit goes above the 5% of GDP benchmark – a big discontinuity may lie ahead of which a sharp dollar depreciation would be an important aspect. If indeed enough investors believe in such a discontinuity, and they demand a much larger risk premium on dollar investments (either in the form of higher interest rates or cheap currency) to continue the same pace of accumulation, then a narrowing of the current account deficit would indeed get under way once it had grown into the danger zone (of above 5% of GDP). After all, as one of Arthur Miller’s characters remarked “in the market-place if enough

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people think it is Wednesday, then it is Wednesday never mind that it is in fact Monday”. As students of global capital flows we cannot let Arthur Miller have the final word! The grounds for supposing that a discontinuity exists around the 5% of GDP level are not convincing. Indeed in 2005 the dollar was generally strong even though consensus forecasts had the current account deficit at 6.5% of GDP and rising to 7% in 2006–7. The US is not just another medium or small size OECD country. It is the largest economy in the world with a currency which is a main store of value through much of the globe. A large US savings deficit has to go along with large savings surpluses elsewhere in the world. By contrast a large UK deficit tells us nothing about the state of savings surpluses elsewhere in the world. As remarkable as the US savings deficit is the savings surplus in the world outside. The US current account deficit is not primarily a US but a global affair. The new feature in global payments during the mid 2000s is not in itself the size of the US current account deficit, but the huge divergence between savings surpluses in key parts of the world economy and the US savings deficit. There is little if any relevant historical experience to judge this against. The reference above to the US experience as a debtor in the 1890s is far far wide of the mark. Crucially, any discussion of how the US savings deficit might narrow has to go along with one of how foreign savings surpluses might also fall in step. There may indeed be a growing asymmetry in the likely direction of the dollar – up or down – as the US savings deficit reaches higher levels. When the savings deficit is at 7% of GDP, it might seem more likely that the equilibrium level of the deficit over the medium-term would fall back to 5% than rise to 9%. The 7% of GDP deficit might go along with symptoms of US household sector savings being at an unusually low level or private sector investment at an unsustainable high level – or the government deficit at too high a level. And most probably (but not inevitably) a narrowing of the equilibrium level of the US deficit does go together with dollar depreciation. Hence as the current account deficit to GDP ratio rises, the expected extent (the mean of the relevant probability distribution) of future likely dollar depreciation increases. But of course a huge US savings and current account deficit is most likely associated with real interest rates on dollars which are high by international comparison. Forward exchange rates (actual or implicit – as derived from interest rate parity conditions) build in expectations of currency depreciation to come. A bigger US deficit means most likely higher US real rates and a bigger

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discounting of future depreciation – and so there is no obvious implication for the spot exchange rate or associated feed-back to the present size of the deficit. At some stage, however, expectations might become more pessimistic regarding future possible depreciation (even though the current deficit remains unchanged) and that would bring some combination of a rise in interest rates and a fall in the spot value of the dollar, implying some downward pressure on the current account and savings deficit. That shift in expectations (due perhaps to a changing consensus about trade or income elasticities or a whole range of other factors, including foreign appetite for dollars in the long-term) could be gradual or sudden. Indeed the crux of the matter (the debate on sustainability) is the issue of discontinuity. A gradually increasing prospect of dollar depreciation (as a mathematic expectation) as the deficit expands is no intrinsic problem for well functioning mechanisms driving global capital flows. Nor is a gradual shift in consensus economic analysis behind market forecasts cause for concern. The key point is whether a discontinuity (a sudden shake of the kaleidoscope through which investors perceive the range of future possible scenarios) could provoke a shock which would maim the mechanisms. This question leads us on to the whole subject of elasticity pessimism – referred to already in previous chapters when reviewing the so-called “transfer problem”. For example, could a sudden shift (down) in the underlying savings surpluses abroad or savings deficit (down) in the US require a very big change (depreciation) in the dollar’s value to attain a new equilibrium path for the international economy? This would be the case if very large relative price changes – specifically of traded goods and services relative to non-traded – were required (along with other changes) to produce only a modest narrowing in the US trade deficit.

The elasticity pessimists Elasticity pessimism extends in both directions. Just as a large depreciation of the dollar may be necessary to reduce the current account deficit from 6.5 to 4% of GDP, a large appreciation might be needed to increase it from 6.5 to 9% (6.5% is the estimated deficit size in 2005). But let us say that markets rank the chances of underlying forces in the global economy pushing the deficit up by 2% over the next five years are significantly smaller than of pushing the deficit down by the same amount. Then elasticity pessimism would justify expectations as to

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future depreciation rising sharply as the deficit to GDP ratio moved well above 5–6% of GDP. (Expectations are derived as the mean of the probability distribution of dollar exchange rate change over the relevant time period, here assumed to be long-run). But there would still be a market solution (exchange and interest rates consistent with global capital flows equal to underlying savings surpluses and deficits). It may be that the pessimists on the US payments position, described now in supranational parlance as the “global payments imbalance problem”, are indeed making a cry from their heart about the harsh nature of economic adjustment to possible (but not inevitable) big changes ahead in savings surpluses and deficits across the globe. It is far from certain, however, that these possible changes will be sudden. And even if sudden change is a significant probability (as would be the case in the much talked about US residential real estate market crash), it does not mean that there should be pre-emptive official action so as to reduce the extent of likely swings in underlying savings deficits and surpluses. The pessimists seem sometimes to be arguing in favour of action to limit any further rise in the US savings deficit so as to reduce the probability of a subsequent big fall (in the underlying deficit) with its associated adjustment costs further down the road. The free market answer to these concerns is to stand firm against any such macro-smoothing exercise which is in any case cast in probabilistic terms. There is a significant risk that action to rein back the US savings deficit in the present might be in the opposite direction to equilibrium forces which in fact are driving the deficit to still higher levels. If changes in savings surpluses and deficits through time are sometimes sudden and sharp and produce large exchange rate changes with their associated economic costs then so be it! In any cases there are grounds for scepticism (as outlined below) about the extent of inelasticity of US trade to a changed pattern of savings surpluses and deficits around the world (and in particular to a smaller US savings deficit). Even if there is some inelasticity of US exports and imports with respect to relative price changes the role of changed propensities to spend themselves play a large role in any adjustment. A fall in the US savings deficit would be coupled with a fall in foreign savings surpluses meaning more foreign spending and thereby more US exports to the rest of the world. As we have seen (Chapter 4), failure to incorporate so-called income effects into the analysis of the transfer problem can be traced back to Keynes’s claim that Germany would have to ration beer consumption in order to pay reparations. And so today the asking

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of the question as to how much the US dollar would have to fall to bring about a given narrowing of the US current account deficit, without considering the simultaneous boost to foreign demand and fall in domestic demand taking place as part of the simultaneous global shifts in savings and investment propensities, is a false question. One eloquent exposition of elasticity pessimism has been made by Laurence Summers, in the same address already referred to above. Summers starts by noting that (in 2004), US imports accounted for 16% of GDP, vs exports at 11%. If both exports and imports were to continue to grow at their long-run historic average of 6% p.a. and GDP at 3% p.a., then the deficit widens by 1% of GDP every 5 years (see Figure 5.2). But that is too optimistic (according to Summers). “Our (US) growth sucks in imports faster than their (non-US) growth sucks in our exports”. Summers is referring to the Houthakker-Magee effect, the observed fact that the income elasticity of foreign demand for US exports is estimated to be below the income elasticity of US demand for foreign goods and services. (Income elasticity is defined as the increase in import demand for a given increase in income).

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It is possible that the Houthakker-Magee effect is a statistical artefact. The relevant income elasticities have been estimated over a long period (two decades or more) in which the US savings deficit and foreign savings surpluses have both tended to rise. Equivalently domestic demand has been rising faster relative to income in the US than in many countries abroad. The income elasticity is calculated with respect to national income levels, not to domestic demand. This divergence in itself can explain much of the Houthakker-Magee effect. In addition there may have been some tendency during the past three decades for the rapidly growing economies in East Asia to concentrate at first on developing the US market for their products – on the basis of this being an easier market to penetrate quickly than the more heterogeneous European marketplace. (France stands out as one of the European countries where the growth in penetration by Asian exports has been particularly sluggish – see Figure 5.3). But in a second stage of export development, businesses in these (East Asian) countries are likely to make the greater marketing efforts required so as to penetrate non-US markets. 3.5 US – imports from Asian developing countries* Germany – imports from Asian developing countries*

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Figure 5.3 US, Germany and France – imports from Asian developing countries*, 1980–2004 (as % of GDP) * excluding Taiwan

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A further problem with elasticity analysis in general, as an input to determining the extent of relative price adjustment necessary to accommodate a shift in savings and investment propensities globally, is its dependence on weights determined by the present relative importance of different markets and for established products and services. But the most rapid growth over the next 10–20 years might come in areas of the globe which presently receive low weights and in these new markets US goods and services might win a large share of the total. Moreover the US may now have a comparative advantage in many information technology products and services, and global demand for these could be rising much faster than the size of the global economy (see Mann, 2004). Moreover the boundary between so-called traded and non-traded goods and services is rapidly being re-drawn – in the direction of increasing the traded share. The age of information technology and lowered transport costs has made a whole range of goods and services easily exchangeable around the globe whereas previously they competed only in local markets. The pessimism of many economists about the inelasticity of US trade adjustment in line with changed savings and investment propensities in the US and abroad is based on prevailing assumptions about low rates of substitution in consumption and production between traded and non-traded goods and on a present low share of traded goods in production. Pessimism about low elasticity of US trade adjustment is prevalent amongst economists at the OECD and IMF. As illustration of the OECD viewpoint, Brook et al (2004) concludes that “even a modest narrowing of the US current account deficit would require large changes to exchange rates, fiscal policy or the non-price competitiveness of US exports”. And in a related piece published in the OECD Economic Outlook (December 2004), the authors conclude that reducing the US current account deficit by 2% of GDP over a 6-year horizon, shocks of around the following magnitudes would be required – either a 20–25% nominal effective exchange rate depreciation of the dollar, or a swing in the fiscal position of some 6% of GDP, or an improvement in non-price competitiveness of US producers corresponding to an approximate 2 percentage point increase in its share of world imports. Thoughtful pieces on US current account adjustment put the subject in the context of shifts in underlying savings surpluses and deficits around the world and the need (as part of a general equilibrium process) for matching changes in trade flows. The least thoughtful pieces start

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with the command premise that something must be done about global imbalances and in particular the US mega current account deficit must be reduced. The authors of such pieces then carry out various simulations about changes in effective exchange rates, budget balances, or other key variables which could bring about an x% reduction (in the deficit). But they ignore the specific impulses which are likely to be source of pressure to reduce the global trade imbalances – a rise in US household sector savings and a fall in private sector savings surpluses abroad. And by implication they ignore the possibility that global savings and investment patterns might move in a direction to require a larger than present US trade deficit. If there were indeed to be a world economic crisis emanating from the extent of divergences between savings and investment propensities across the globe its source would be market failure most probably rather than low elasticity in US trade patterns. The mechanisms essential to the world economy finding endogenously a general equilibrium solution where global divergences in savings surpluses and deficit are matched by trade flows might in some circumstances fail. Two of these possible failures have been examined already in the previous chapter – first, the zero rate bound preventing a fall of nominal rates to the real level which would be consistent with global and international equilibrium or second, central banks targeting a level of interest rates which is in fact out of line with neutrality.

Monetary authorities as a source of non-sustainability It is an old question of monetary economics whether central banks should in fact peg money rates or allow these to float freely and instead steer the monetary base along a targeted path. Both operating procedures can in principle be used towards aiming for the ultimate target of say price level stability. The advocates of monetary base control argue that pegging interest rates, even over short periods, mean that the bond markets are diverted from their task of forming an independent assessment of expected neutral interest rates over long periods. Instead they focus on where the central bank considers neutrality to lie. Perhaps markets would make a better job of this than central bankers. The advocates of tight rate pegging argue that the so-called money multiplier – the relationship of monetary base to wider money aggregates – is quite unstable, and the demand for broad money is itself impossible to model as a stable function of a few variables, making it inappropriate as an intermediary target for monetary policy. (For a discussion of this point, see for example Kuttner and Mosser, 2002).

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Ultimately the debate is an empirical matter – assuming that the high volatility of short-run interest rates under the monetary base control system can easily be hedged using modern techniques available. But one factor usually ignored in the empirical investigations – in part because it is so difficult to determine, but nonetheless crucial – is the extent of misalignment of exchange rates which can come about through the central bank proving to be very wrong in its assessment of neutral rate, and ignoring in many cases the international dimension of neutrality. European authorities may well have made such a mistake, as discussed below. In any case, they together with their G-7 partners have concentrated their attention publicly on an alternative third possible source of market failure (with respect to international economic equilibrium as described). This is where one or more important savings surplus countries (or deficit countries) are not playing by the rules of the game – suspending or interfering with the market forces which would bring about global equilibrium. Asian developing countries are frequently singled out for criticism (see Figure 5.4). 200

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Figure 5.4 Latin America and Asian developing countries*– current account balances, 1980–2004** (US$ bn) * excluding Taiwan ** 2005 data as forecasted by IMF Asian developing countries: Brunei Darussalam, Cambodia, China, Hong Kong, India, Indonesia, Korea, Laos, Malaysia, Myanmar, Philippines, Singapore and Thailand

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One example of that third type of induced market failure in the contemporary world economy has been the rising Chinese savings surplus. Capital export restrictions in China have meant that the government or central bank have instead acted as investor abroad (see Chapter 3, pp. 78–9). There has been widespread speculation that this public mimicking of private capital outflows is inherently unstable. Moreover the lack of clarity about China’s currency regime has induced huge perverse capital flows (mainly local companies speculating on a change of regime – involving an appreciation of the yuan – by borrowing foreign currency and repaying yuan loans). In principle markets have a better prospect of groping towards neutral interest rates and equilibrium real exchange rates where there is certainty about the currency regime. In the case of China that would mean becoming either a fully-fledged member of the dollar zone or allowing the currency (yuan) to float freely, in both cases with no exchange restrictions impeding capital flows. Until recently the China problem – of lying outside the system of market-driven global capital flows – has not loomed very large, given the historically small absolute size of the savings surplus there. The extent of the problem has become much more serious with the bulging of the Chinese savings surplus in 2005–6. According to some forecasts the Chinese surplus is set to grow much larger in coming years. (For example, the OECD secretariat in November 2005 estimated the current account surplus of China in 2005 at just under $150bn and forecast a surplus of above $200bn in 2007). Currency diplomacy in recent years has had a large focus on China and the lack of exchange rate adjustment more generally in Asia. There has been a lot of talk in international forums about the need for reducing global imbalances. The US mega current account deficit and its possible non-sustainability looms large in the G-7 discussions. Misconceptions abound as is well illustrated by a European Commission paper on the topic (October 2005). The purpose of the paper was to back the negotiating position (of the euro-area currency diplomats) that the euro-area itself could play no important part in the global adjustment process which would be the counterpart to an unavoidable large reduction in the US current account deficit over the long run. The question raised and then answered negatively by the Commission analysts was whether a big move into deficit (on current account) by the euro-area “should” be part of the adjustment process. The analysts at the Commission did not consider the hypothetical equilibrium conditions under which a euro-area deficit might emerge.

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In principle these could include heavy demand for euro-denominated assets by global investors diversifying away from the US dollar, perhaps on the basis of their appetite for further dollar risk shrinking beyond a certain point. In turn the neutral rate of interest in the euro-area would fall and the full equilibrium exchange rate of the euro rise. Investment spending in the euro-area would be at a higher level and savings most likely at a somewhat lower level than prior to the shift (in global diversification patterns). In sum, accelerated euro accumulation by global investors would have a counterpart in a swing of the euro-area net savings balance from small surplus to modest deficit and in euroarea investors putting a raised share of their portfolios into dollar assets, attracted by their now raised yield advantage (over euros). So what is there to object to in that hypothesized outcome? The Commission analysts raise five points. First, “if the euro-area contributes to a further accumulation of large negative global net asset positions, the eventual global adjustments might be only delayed rather than avoided altogether, and ultimately become more violent”. This objection raises the spectre about a modest long-run deficit for the euro-area proving to be unsustainable as the net liability position of the euro-area became ever larger. But as we have already seen in the arithmetic early in this chapter, in the case of a modest current account deficit (say 1–2% of GDP) financed at low real rates, a built-in future external debt crisis for the euro-area would be a dubious proposition. Second, “it must be considered that the euro-area starting position from which to create a current account deficit is not as comfortable as is often suggested. While the situation is clearly not as menacing as that of the US, it nevertheless limits the ability of the euro-area to borrow large sums over an extended period.” Again the critical response is the implausibility of an external debt crisis for the second largest currency area in the world starting from a small net liability position and with a modest savings deficit. Third, “in terms of global allocation of resources it is odd that poor labour abundant countries lend money to wealthy capital abundant countries (as grouped together in the euro-area)”. In practice, though, most of the savings surplus resides in either rich advanced economies (Japan, Switzerland, Norway, Singapore), or oil-rich developing countries building some reserves against revenue declines in the future, or poorer developing countries where residents out of fully rational considerations are saving hard (China, for example). Even if the euro-area were to move into savings deficit overall, Germany (together with the Netherlands and Belgium) would almost certainly remain in surplus – offset by larger

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aggregate deficits in the South (Spain, Greece, Italy) and East (assuming some of the new EU entrants in 2004 join the euro-area). Fourth, “in order to prepare for the effects of an ageing society and the foreseeable need to finance pensions, it is economically efficient to build up net assets in younger and more dynamic countries.” But it is surely possible for the euro-area, in its new hypothetical equilibrium situation of modest savings deficit induced by diversification into euros by global investors, to sustain a larger export of capital than previously on the part of euroarea investors. In effect there would be an enhanced turntable role for the euro-area, as discussed above. Euro-area investors responding to the sunken level of returns on euro money and debt instruments would allocate a larger share of their portfolios to higher yielding US assets. (And the US economy is indeed younger and more dynamic than the euro-area according to many assessments). Moreover, a counterpart to relatively high personal savings in the euro-area (reflecting fears about pension under-provision) could be a robust pace of domestic capital stock expansion (meaning a rising capital-output ratio). The fall in the neutral euro-area interest rate (in response to foreign diversification into the euro) would stimulate domestic investment – and the returns on this would be substantially above the neutral interest rate in so far as euro-area investors were ready to assume equity risk. Fifth, “the fact that only a part of a euro area current account deficit actually improves the current account in the US means that there is a risk that not only might it not prevent or significantly mitigate a disorderly unwinding of the US imbalances, but might also leave the euro area worse prepared than it otherwise would be.” This point appears to be based on a consideration of bilateral trade balances. It is true that a swing to modest deficit in the euro-area savings balance would translate into new net demand mainly for goods and services from countries other than the US. But these other countries would simultaneously be experiencing reduced net demand from the US (corresponding to the shrinking of the US savings deficit as the neutral rate rises there as a counterpart to a slower build-up of global investment in dollars). The rest of the world (nonUS, non euro-area) experiences a rise in its trade surplus with the euro area to match the decrease in its trade surplus with the US. Hence the widening of the euro-area current account deficit is a key component of the new equilibrium, even though the bilateral US-euro area trade balance might adjust only to a much smaller extent. In sum, the EU commission analysts hardly make a strong case as to why the euro-area should not eventually move into substantial savings and current account deficit (with a neutral level of rates far below

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historical norms). But as we shall see, the game of currency diplomacy is not won be economic argument. The conclusions of the EU study at least provide a script for discussion between the diplomats – some basis, however flimsy, for euro-area policy-makers to refute, for example, US demands that the ECB or European governments should play a role in stimulating growth towards reducing global imbalances. It is only possible to understand what drives the diplomats if wider political questions are tackled. The focus of many diplomats around the table is not whether market processes are functioning well and could be improved but whether loosely specified dangers which might emanate from global disequilibrium can be used to advance a political agenda. In this regard, economists employed in official capacities can become the script-writers for a geo-political drama. Currency diplomacy is the subject of our next chapter.

6 Currency Diplomacy

Currency diplomacy is defined as the conduct of international relations between governments (including inter-governmental formations, for example the EU) with regard to issues of currency policy. There are three main types of issue – the choice of currency regime (for example, fixed exchange rates vs. floating, regional currency blocs), the level of any particular exchange rate (or set of exchange rates), and the stance of monetary policy (in an international perspective). Three main methods of currency diplomacy are identifiable – unilateral (decisions taken by one government, whose diplomats then “explain” them to other governments), bilateral (one government negotiating one or more of the above issues directly with another), and multilateral (a group of governments consulting each other via an international body – for example, the IMF, or OECD – or a coalition of governments pressing a particular policy preference on another government).

Illustrative distinctions Some illustrations are useful to drawing out the distinctions just made. As examples of diplomacy concerning currency regime we could include much of the negotiations proceeding and them immediately following the break-up of the Bretton Woods International Monetary System (1970–4). Later examples include the construction of European Monetary Union and the break-up of the Asian dollar bloc. As regards exchange rate issues, there are the periodic examples of Washington seeking to lower the value of the US dollar – a process which has occasionally involved getting foreign countries to change their currency regimes. Sometimes there is no regime issue – as for example the so-called Plaza Accord (1985) (where the US successfully 146

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obtained the co-operation of Japan and Europe in lowering the value of the dollar), or the US efforts to obtain a higher value of the yen in the early 1990s (as pursued by the First Clinton Administration). Non-US examples of exchange rate diplomacy include the many examples of discreet efforts within the European Monetary System (1979–97) to obtain devaluation or revaluation of one or more member currencies. When it comes to the third type of objective for currency diplomacy – the influencing of foreign monetary policy, examples are much rarer. This might be in part because the concept is less clearly understood (especially by diplomats who are not trained economists) and in part because there is a clash of responsibility between governments and central banks on such matters. A clash makes a unified diplomacy either impractical, or impotent. The concept behind currency diplomacy directed at influencing monetary policy relates to the possibility that a particular central bank is pegging money rates at a level substantially different from neutral (where neutrality has both a domestic and global meaning, as discussed in Chapter 3). In consequence of that non-alignment (of market with neutral rates) another economy might find that its currency is driven far away from long-run equilibrium value and correspondingly its traded and non-traded goods and services sectors thrown off their long-run sustainable expansion paths. (One sector growing too fast, one too slow, from a long-run perspective). At various times US officials have pushed for monetary easing in Europe and Japan (arguing that rates are above neutral there) as a means of stimulating those economies and allowing better balanced growth in the US (faster growth of exports and more broadly of the traded goods and services sector). Implicit in most US currency diplomacy is a trade threat. If US demands are not met at least in part, then Washington will have recourse to US Trade Law to force change – generally in the direction of the given country removing impediments to US enterprises doing business in the given country. Action on trade was an integral part of the most dramatic example of unilateral diplomacy by the US – the socalled Nixon shock (August 1971). The US acted by first, slapping a temporary emergency tariff on imports into the US from other advanced economies, and second, making its removal contingent on the agreeing of an acceptable new level of exchange rates between the US dollar and the other major currencies, especially the Japanese yen. In the more recent past, Washington has negotiated both on a bilateral and multilateral basis. There has been the customary deal at

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five minutes after midnight to avert the trade threat being acted upon. Examples of bilateral diplomacy are most evident in the case of Japan-US relations. As illustration there were the so-called SakakibaraRubin negotiations culminating in the US support of a stronger dollar against the yen in summer 1995. That followed many years (from the mid-1980s onwards) in which successive US Administrations had applied strong pressure on Japan to remove barriers impeding foreign competition in its economy (see Lincoln, 1999) and in which US negotiators had been willing to accept yen appreciations as a partial substitute for real detailed progress. Then in late Spring (1995) there was the sudden climb-down by both sides in the trade negotiations. That climb-down occurred in the context of growing concern on both sides of the Pacific about the deep crisis in the Japanese financial system. It has been a familiar strategy of US negotiators to multilateralize currency diplomacy on the yen issue at various critical points. They have done so to avoid the impression of pushing its close ally into a corner. Transferring the currency diplomacy to a G-7 forum, with the IMF chiming in support of the US position, allowed Japan to make concessions to the US demands whilst saving face. In general, much of what passes for G-7 diplomacy has in effect been bilateral US-Japanese currency diplomacy, with the other five chief diplomats enjoying the sun (if lucky enough for the summit to be somewhere warm!). Occasionally though, multilateral has meant multilateral – and we return to examples (including the Dubai G-7 summit) below. In principle countries outside the US could pursue multilateral currency diplomacy by building coalitions so as to limit Washington’s power (based on implicit trade threat) in a particular currency issue. This would be a version of balance of power diplomacy, notorious in 19th century Europe (in particular). There have been weak examples of such multilateral diplomacy – but this has usually remained more hypothetical than real. For example, at the time of the Nixon shock (August 1971), there was some discussion of Japan allying with France to check US power to dictate terms, but as we shall see below there is not much substantial evidence of this having happened. During periods of large dollar decline inspired in some degree by Washington, there may have been discussions between Japan and Germany (or more recently between Japan and the Euro Group) as to how to co-ordinate a defence (against tidal waves of speculative capital pushing their currencies higher), but these have rarely if at all led anywhere.

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More recently some economic commentators have suggested that China, Japan, and other Asian countries might co-ordinate diplomacy so as to resist Washington’s pressure to impose a floating currency regime on the area. The chances of any such co-ordination taking place, however, have been slim given the frictions on other issues between Tokyo and Beijing and the primacy of the US-Japan relationship (see p. 178). There has also been some suggestion that the euroarea (as represented by euro-diplomats whether from Brussels or Frankfurt) might be seeking a role as intermediary in the at times shrill diplomacy between Beijing and Washington over currency matters. We shall see below what the trade-offs might be or have been (for Europe) in following this diplomatic route.

Trade-offs between currency diplomacy, foreign policy and other issues Trade-offs are at the core of diplomacy. These trade-offs are not confined to one particular area of diplomacy but can be made across different areas – for example gains in security co-operation in exchange for concessions on trade or currency matters. The US on occasion has scaled back demands on issues such as human rights or economic reform in return for progress (from the viewpoint of Washington) on currency policy. In other contexts, Washington has sometimes moderated its targets or aims in currency diplomacy in return for progress in other forms of diplomacy, usually in the traditional foreign policy arena of international security. One speculative example (unproven) has been Washington’s going easy on currency demands regarding the yuan. The US Treasury did not cite Beijing as a currency manipulator in its November 2005 report to Congress, despite much sabre-rattling during the year, in exchange for Beijing’s co-operation in pressing North Korea to abandon nuclear arms. Another speculative example is the possibility that Beijing might yet buy more time on the currency issue by eventually agreeing to action at the UN Security Council to deter Iran from building a nuclear bomb. More definitive evidence of trade-off was the cooling down of the currency spat between Japan and the US in Spring 1994 as the eruption of crisis surrounding North Korea’s nuclear program made Washington put greater emphasis on security co-operation with Tokyo (see Schoppa, 1997). A decade later, military support by the Koizumi government of US intervention in Iraq helped to earn Washington’s forbearance of huge

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intervention by Tokyo (through 2003 and early 2004) to hold down the yen. In a European context, there is much evidence that Germany’s willingness to go along with European monetary integration in the early 1990s was related to the EU’s endorsement of political integration between West and East Germany (see Brown, 2004). Trade-offs between currency and other forms of diplomacy requires co-ordination at the highest political level. This is difficult but not impossible to achieve in the context of the euro-area, given the lack of political union. As we shall see below, for the euro-area to effectively seek trade-offs there has to be deference within the union (EMU) to one or two countries – most plausibly France or France-Germany. Indeed, historically, the master of such trade-off has been France, where the high officials in the Treasury and Foreign Ministry are of the same stock (or more correctly, haut école). Diplomatic trade-offs are constrained in a well-functioning liberal order by the system of democratic accountability. If there is a high level of transparency, trade-offs between different branches of diplomacy might be a cause of embarrassment to the political élites. Moreover, how can the central bank, which might have to be a party to the currency diplomacy, justify a non-optimal outcome from a purely economic viewpoint, when it gets no credits (democratic) for the concession, and may even suffer a loss of reputation for independence?

Main players In modern international economic history (1960 onwards) France has indeed been the most active of the medium-sized advanced economies on the currency diplomacy stage. Not only has its method of operation been suitable to the task, but it has had clear aims to pursue. Traditionally France has been in favour of currency regime shift at a global level as a component of its geo-political vision (a world of ultimately declining US hegemony to be replaced by multi-polarity). The two bigger and more important players (in terms of global economic outcome) have been the US and Japan. The US, typically, has been interested mainly in exchange rate and occasionally monetary issues, with regime shift an intermediary and subsidiary objective. Japan has played a re-active role – responding defensively to US negotiating pressure – rather than ever formulating a preferred currency regime and making this a centrepiece of its diplomacy. Since the breakdown of the Bretton Woods international monetary system, Germany has adopted typically a low-key profile in currency

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diplomacy on the world stage (meaning in relation to Washington, Tokyo, or more recently Beijing). That is in contrast to the adroit currency diplomacy pursued by Bonn (and later Berlin) within the context of European Monetary Integration (and the associated structures, including the European Monetary System). The independent status of the Bundesbank has been a handicap to any diplomatic acrobatics. (True, the Federal Reserve also enjoys independence, but this has not stood in the way of currency diplomacy being pursued vigorously by successive administrations in Washington based on varying degrees of trade threats, as discussed below). Germany, given its lack of geo-political power (no seat at the UN Security Council and no independent nuclear deterrent, instead fully tied into NATO) does not have much scope to offer trade offs except as part of an EU-wide offer (which is notoriously difficult to frame, let alone pursue, given the absence of political union in Europe). Moreover in the three decades of the mighty Deutsche mark, Germany was quite content with the currency regime status quo. It is even possible that Germany deliberately delegated some authority for currency diplomacy on the global scene to France (which unlike Germany has a UN Security Council seat and its own independent nuclear deterrent) as a palliative for the Bundesbank having such considerable monetary power on the European stage. In similar vein Germany gave its support to a long line of French appointments to top positions at the IMF and OECD. Britain has been generally inactive in currency diplomacy – even during its brief foray into the exchange rate mechanism of the European Monetary System. London has been content with the regime of an independently floating pound and has had no interest thereby in international monetary reform. There has never been any question of London joining or helping to create alliances of countries under threat from US trade action (if they fail to change their exchange rate policy). In practice such alliances have never been considered explicitly even at an EU level, so the UK is no exception in this respect. At G-7 meetings Britain has not had sufficient weight to ever act even as intermediary between the US on the one hand, and the target of US demands (Japan or more recently China) on the other. Amongst the other G-7 countries, Italian currency diplomacy has been almost entirely concentrated on intra-European issues – in particular navigating the lira in and out of the exchange rate mechanism of the European Monetary System and then into European Monetary Union. On the global scene if Italian currency diplomats

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have been active at all it has been with respect to calming concerns about the high level of indebtedness of the Italian government. As regards Canada, its direct influence in G-7 diplomacy must surely be considered peripheral, except in one respect. The Bank for International Settlements (an important forum for central bankers and also with some influence of its own on evolving conventional wisdom) has found itself with both a Canadian head and a Canadian chief economist. Both have taken a line on the “global imbalance problem” – warning about the dangers of continuing huge US current account deficits and Asian surpluses for global stability – which is not very far from the French (see White, 2004). Indeed that is the dominant contemporary opinion (in the mid-2000s) within the Bank of Canada where there is a strong tradition of asserting monetary independence of the USA – and not bowing before US monetary hegemony. The newest player on the stage of currency diplomacy has been China. Beijing has been forced into participating (in the diplomatic game) by Washington which since 2003 has shrilly demanded an upward move of the yuan and an end to the fixed exchange rate regime under which the yuan was pegged to the US dollar. Token moves in both these directions announced (by Beijing) in Summer 2005 were hardly the end of the matter. Beijing has become an adept player within a short time-period of experience. Its UN Security Council seat and vital role in the Korean peninsula provides considerable leverage for trade-offs between currency and other forms of diplomacy. The importance of China to France’s vision of a multi-polar world has made it possible for Beijing to multilateralize the diplomacy of the yuan, rather than this issue becoming exclusively a matter of Sino-US relations. Beijing has been able to turn currency diplomacy to its own advantage by trading off democratic and human right issues, as we shall see below. In all, China’s currency diplomats have earned a reputation for consummate technical skill.

Regime shift – France’s role France’s role in the G-7 diplomacy in 2003–6 concerning the Chinese currency and more generally the future currency regime in Asia has been indirect. The head of the ECB, Claude Trichet, is an old-hand French currency diplomat. His climb up the greasy political ladder through the French finance ministry and beyond under successive Conservative, Socialist, and Conservative Administrations in the 1980s and early 1990s, has left him entrenched firmly in the French eco-

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nomic and foreign policy making establishment (see Brown, 2004). He owes his appointment (as president of the ECB) to the notorious deal between French President Chirac and German Chancellor Kohl on the eve of the EU summit launching EMU (Spring 1998). The Trichet-Chirac relationship had been cool at times, and indeed was born out of treachery (Trichet deserting his long-time backer Balladur for Chirac on the eve of a crucial electoral contest in Spring 1995 between these two leading Gaullists). It would be strange if there were no pay-back expected by the Chirac Administration and indeed rendered at least implicitly by Trichet. There is little doubt that for France one prize of European Monetary Union has been its own man at the head of the ECB able to deal on the world currency stage with little control exercised by any democratic process. If there have been any doubts about France’s valuation of the prize – it is instructive to view the reaction to Beijing’s announcement on July 22, 2005 that it was changing its currency system to an adjustable peg, guided by a basket of currencies. The first official overseas reaction came from the French Finance Ministry, welcoming the move. Trichet’s position at G-7 summits on the Chinese currency issue was fully in line with the analysis coming out of the French Finance Ministry, the Banque de France, and the French Foreign Office (Quai d’Orsay). Superficially, at least, there seems something odd about France, with its vision of a multi-polar world, and traditionally hostile to US hegemony, finding itself on the same side as Washington on the question of Chinese currency regime change. In fact M. Trichet had ostensibly been on the same side as the US through the various G-7 summit discussions and policy announcements relating to the Chinese currency question from the Dubai Summit (September 2003) onwards. Before providing possible explanations to that particular puzzle (similarity of French and US views on the Chinese currency question) it is useful to move several steps backwards in the history of currency diplomacy to the early 1960s. France entered the currency diplomacy stage in the post-war era under the presidency of General de Gaulle. The general, advised by Jacques Rueff (Mayer, 2004), saw the Bretton Woods system as operating in practice to confer considerable advantage on the US. In principle, US financial power was constrained by the obligation (under Bretton Woods) of the US Treasury to convert foreign official dollar balances on demand into gold at the fixed rate of US$35 per ounce. In practice, such conversions were rarely made (until the mid-late 1960s)

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and were constrained by wider political considerations. The US, meanwhile, (according to Gaullist propaganda) was buying up Europe and living beyond its means by printing dollars. Rueff warned of a coming global financial crisis due to the global accumulation of dollars – and advised that the solution to the problem was a return to a system more based on gold and less on dollars (meaning that central banks around the world should hold less of their reserves in the US currency). The purpose of the present chapter on currency diplomacy is not to offer a detailed critique of de Gaulle’s view on the international monetary system. Rather the object is to look at methods of French diplomacy. Initially diplomacy was by unilateral declaration, or thinking aloud. In February 1965 the General made his famous speech. “We consider that international exchanges must be established – as was the case before the great worldwide disasters – on an unquestionable monetary basis that does not bear the mark of any individual country. What basis? Actually it is difficult to envision, in this regard, any other criterion or any other standard, than gold”. In fact the historical record shows that much earlier, already in 1961, de Gaulle had alarmed the newly elected President Kennedy, who told his advisers that the “two things which scared him most were nuclear weapons and the payments deficit” (Gavin, 2002). Kennedy entertained seriously (before provisionally but not finally rejecting) a proposal from his Secretary of State that the US would help France develop its independent nuclear deterrent (which up until then the US had opposed) in return for France desisting from its pro-gold policy. (Provisional rejection was based on Washington’s concern not to upset Germany by furthering French nuclear unilateralism). Even so, Paris had a rare opportunity to pursue bilateral currency diplomacy with Washington There is no evidence, however, that de Gaulle was interested in any deal which would restrict his pursuance of an increased role for gold. The scope for France to pursue bilateral or multilateral diplomacy on the gold issue in the early and mid-1960s was quite small. The FrenchGerman friendship treaty (January 1963) – the so-called Elysée Treaty – had been the high water mark of the close relationship between Chancellor Adenauer and General de Gaulle. But the Chancellor had been unable to carry through on his pledges given the strong pro-US sentiment in his party (the CDU). His successor, Ludwig Erhardt, a committed Atlanticist, turned his back on further overtures from France The powerful Bundesbank had no interest in a greater international role for gold. Leading Bundesbank officials were concerned with

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a different problem – how to stem the inflationary tide from the US that was bound to wash up in Germany if the mark remained pegged to the dollar at an unchanged rate. Opinion amongst German officials – both within the Bundesbank and outside – was slowly swinging towards the view that a floating Deutsche mark, cut loose from the dollar – might be the most effective way of insulating the German currency from US-made inflation. In any case, French potential influence in the international monetary arena took a big setback with the social and economic turmoil which erupted in May 1968. General de Gaulle resigned the following year. Already in late 1967 de Gaulle had seen the way of the future for French currency diplomacy by sending Raymond Barre to Brussels and endorsing his work there on blueprints for European Monetary Union. Europe, led by France, would defy US monetary hegemony. This strategy looked increasingly fragile in 1971 as the Bretton Woods System entered its death-throes. In May of that year Germany set the mark free to float rather than accept further huge speculative money inflows from the dollar. French policy-makers were quick to realize the new parameters of international monetary choice. First, there was the possibility of re-vamping Bretton Woods, based on a higher gold price (in terms of US dollars). Second, there could be a freely floating exchange rate system between the major currencies, which would mean that the Deutsche mark would emerge as the world’s powerful no. 2 money after the US dollar. Or third, the dollar could indeed break its link to gold (as in the second scenario), but Europe would form a regional fixed exchange rate system as a forerunner to eventual monetary union. The French policy-making establishment was adamantly opposed to scenario 2 or anything which smacked of Deutsche mark “nationalism”. Scenario 3 was not without risk, in that Germany could flex its economic and monetary muscle to still come out effectively at the top of the new arrangement. Hence in August 1971, when the US closed the gold window and imposed a “temporary” import tax, France aimed first at turning scenario 1 into reality. Paris remained steadfastly opposed to floating the French franc. A free float of the French franc – according to the viewpoint of French policymakers – would have meant the Deutsche mark (itself floating) gaining dominance in the European stage. Instead the French government imposed a barrage of exchange restrictions (on capital inflows) so as to maintain an unchanged parity against the US dollar. Paris bargained hard for a rise in the official gold

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price and a return to a global system of fixed exchange rates. But surprisingly there is no evidence of France forming an alliance for this purpose with Japan – the other major country which was then set against a generalized float. (A negotiating alliance might have taken the form of Japan joining with France in insisting on a change in the gold price in return for France backing Japan’s claim that the revaluation of the yen should be only modest.) Perhaps the perspectives of French diplomacy had simply not evolved far beyond de Gaulle’s disdainful description of visiting Japanese Prime Minister Hayato Ikeda as “that transistor salesman”. France persevered in its efforts to re-build a gold-based international monetary order through the transitional Smithsonian Accord (December 1971), but when that burst apart in early 1973, Paris switched focus to option three – a joint European float as a prelude to European Monetary Union. In the following quarter century European Monetary Union was the end-destination of French currency diplomacy. Of course there were periods in the desert when French monetary affairs were in such a poor state that Paris could hardly hope to make progress on its ultimate aim. And in reaching the final destination, Paris had to make many concessions to Bonn (and subsequently Berlin) – in particular giving up any realistic prospect of an overweight French influence over monetary policy in the soon-to-be-created monetary union. During all this time France participated in G-7 currency diplomacy. The strength of French-German ties did allow France at times to act as a principal negotiator with German acquiescence – under strict oversight. That was the case with respect to the Louvre Accord in Spring 1987 (Brown, 2002). The French finance minister, E´douard Balladur, as host to the G-7 finance ministers and central bankers meeting, helped to broker a deal in which Washington would co-operate with Europe and Japan in stabilizing the dollar after its sharp fall-back (of the preceding 18 months). Unannounced target ranges were agreed for the exchange rates between the US dollar, Deutsche mark, and Japanese yen (the French franc was tied to the Deutsche mark within the European Monetary System). It was only after the birth of European Monetary Union, and the succession of Claude Trichet to the presidency of the ECB (Autumn 2003), that a grander and less constrained period of French currency diplomacy on the global scene blossomed. The immediate focus was on China and the looming “threat” to world economic prosperity from the huge international payments “imbalances” (in particular the mega US current account deficit and the huge current account sur-

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pluses in East and South East Asia). The aims of the new involvement of Europe in currency diplomacy were limited to two out of three possible objectives – currency regime change (in Asia) and steering exchange rates (between the US dollar, euro, and Asian currencies). The third possible aim – influencing monetary policy decisions outside the euro-area – was largely rejected in that the ECB itself had no inclination to receive advice from outside or even acknowledge foreign influences on the determination of neutral interest rates in the euro-area. Europe’s new assertiveness in G-7 currency diplomacy was all part of the new soft euro-nationalism as described by Claude Trichet in a somewhat loquacious answer to a question at a press conference (July 1, 2004) regarding the possible influence of US money rate decisions on ECB monetary policy). “We all have responsibility, all over the world. Certainly across the Atlantic the Federal Reserve has a very important responsibility, and it is not my responsibility to elaborate on that. We have our own responsibility – the US in the US and the euro-area in the euro-area. We are in different universes with different fundamentals and different episodes in the business cycle. Furthermore, we are both responsible for price stability in these different universes. So we are not influenced in any way by what has been decided across the Atlantic or what has been decided in the past across the Channel, or what has been decided elsewhere in the world. Because of our own analysis of the present situation in the euro-area, we have not changed our monetary policy stance. Again, on the basis of European judgement and diagnosis we have no bias and we remain vigilant.” The blindness of Jean-Claude Trichet and his colleagues to the fact that neutral interest rates are interdependent in a global economy would have been a serious handicap to foreign currency diplomats, especially US, seeking to bring about a better alignment (closer to equilibrium) of monetary conditions internationally. As we shall see, however, contemporary US policy-makers had no inclination to pursue such negotiations.

For Washington, currency diplomacy = trade diplomacy? Any student of US currency diplomacy finds pretty quickly that the dominating theme has been the highlighting of foreign unfair trade practices and the use of exchange rate change as a substitute for or compliment to reforming these. All the other sub-themes, such as international monetary reform or global monetary co-ordination are

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largely background buzz, unless taken up forcefully by key foreign governments. For example, back in the 1960s the question was largely unasked in Washington about whether the US could gain from a grand deal to salvage a dollar standard, albeit with some residual nominal link to gold. The contours of a deal would have been the US making a more explicit and credible commitment to hold down inflation – meaning that the US price level was indeed an anchor to low inflation globally. Other countries – in particular Japan and Germany – would have had to accept that during long periods their own inflation rate would be persistently above or below the US inflation rate so that real exchange rates between their own currencies and the US dollar would move in line with equilibrium tendencies. As illustration, in the 1960s very rapid productivity growth in the Japanese traded goods sector meant that the equilibrium real exchange value of the yen in terms of the dollar was on a rising trend. If the nominal exchange rate between the yen and the US dollar was to stay at an unchanged parity, then Japanese inflation would have to remain well above US inflation (as indeed occurred in the first half of the 1960s but not the second half). That might have been a small price to pay (especially from a Japanese but also a US perspective) so as to avoid the costs of much larger and more volatile currency swings (certainly in nominal and most probably also in real terms). Convertibility of dollars into gold at a fixed price (defined within a narrow range) could in principle have been the external discipline forcing the US to follow a policy of low inflation. But so far had the real price of gold fallen (in terms of say US purchasing power) since its official nominal price had been fixed around 30 years earlier (1934) by the Roosevelt Administration (at $35 per ounce) that a big revaluation (rise of the official price) would have been essential to making full convertibility of dollars into gold feasible. Such a large devaluation of the dollar against gold, however, could have shaken confidence fatally in the international monetary system (based on the dollar and a fixed gold link). Hence a fully restored and operating gold link for the dollar was a largely implausible option. What was in it for Washington to offer its allies a re-vamped dollar standard with a new commitment to low inflation? For a start, low inflation might have been desirable from a domestic viewpoint. But in the world of the late 1960s and early 1970s the conventional wisdom was that some trade-off existed in the long-run between inflation and unemployment. US policy-makers might have had a tough job per-

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suading their electorates that lower inflation was to their advantage overall. As part of a grand deal, however, Washington might have sought to extract progress on international trade liberalization which would help sweeten the overall deal to be sold (to Congress and the US voters)? Yes – US diplomats could have argued – we will make the dollar standard more acceptable to you (in terms of low inflation) but you must accelerate the dismantling of trade barriers in the way of US exports. As a matter of counterfactual history it may be doubted whether Germany or France would have gone along with such a deal. Germany may already have been too distrustful of US commitments on inflation and France may not have been ready to jettison its aim of a fuller role for gold in the international monetary system. And as we shall see below, Japanese currency diplomacy was still in a stage of underdevelopment, where a grand deal was hardly likely to be proposed or even negotiated by Tokyo. In fact US currency diplomacy in the 1960s focussed on the terms which Washington might demand for keeping the semblance of convertibility between the dollar and gold, even though its substance was draining away (for example, voluntary restraint by foreign central banks with respect to converting dollar balances into gold, and from 1968 a two-tier gold market). US currency diplomats (and policy-makers) talked much about the so-called US balance of payments problem (Treaster, 2004). In modern terms the problem did not lie with the trade balance (which in any case was in surplus or small deficit) but with US interest rates falling below their neutral level (as the Federal Reserve and bond markets miscalculated). In consequence capital inflows were not sufficiently strong to balance the external accounts, and so foreign governments had to pile up official dollar holdings. The evident symptom of US interest rates being below neutral was rising inflation pressure. A succession of US Administrations saw the US balance of payments deficit “problem” as an opportunity to demand trade reforms or increased foreign payments for US military services. Yes, US diplomats told their opposite numbers, we will keep the gold window open, but you must help towards to solving of our balance of payments problem by paying for our forces in Europe or accelerating trade liberalization. These may have been laudable aims in themselves, either from a domestic or global viewpoint or both, but they were not a substitute for the grand system thinking which might have salvaged the existing currency regime in the long-run.

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Once the regime collapsed – with the immediate catalyst being the Nixon shock – US currency diplomacy soon embraced the system of floating exchange rates between the dollar, Deutsche mark and Japanese yen, with intra-European exchange rate fixing being left to the Europeans amidst benign neglect from Washington. Currency diplomacy now was largely intertwined with bursts of trade policy activism and occasional demands for more pro-cyclical economic policies abroad. The latter did not have to mean cutting interest rates towards or even below what the US officials regarded as neutral (not a term then widely in use but nonetheless the underlying concept was familiar) but could involve fiscal policy stimulus. A few examples illustrate the characteristics of US currency diplomacy through the first thirty years of floating exchange rates. In the late mid 1970s (1977–8) as the US dollar came under serious downward pressure and the US current account deficit widened (hardly far in modern terms!) the Carter Administration piled the pressure on Germany and Japan to take stimulatory action. (In effect, Washington blamed Europe and Japan for the US dollar’s problems). The emphasis was not on any demands for easing of German or Japanese monetary policy, but rather for budgetary stimulus. Almost instinctively US currency diplomats kept away from recommending monetary policy changes to their allies – perhaps seeing this as likely to strengthen the dollar and making US deficits sustainable (hardly likely to appeal to those powerful lobbies in Washington calling for trade action). In fact, with the benefit of hindsight, the main source of disequilibrium in the global economy in the mid-late 1970s was not German or Japanese economic policies, but over-expansionary US monetary policy. That was not a diagnosis made by economists close to the seat of power whether in Washington or abroad. There were no strong voices from Japan or Germany demanding US monetary tightening. Even if some economists there made the correct diagnosis of the weak dollar (for example within the Deutsche Bundesbank), currency diplomats (in Europe or Japan) realized that the independent Federal Reserve under Chairman Arthur Burns would hardly be taking or welcoming their friendly advice. In the mid-1980s there was a new round of US currency diplomacy. The Reaganomics boom coupled with abnormally high US interest rates (engendered in part by powerful disinflationary policies administered by the Volcker Federal Reserve) had fueled huge capital inflows to the US and these were matched by a correspondingly wide US trade and current account deficit. The losers in the US traded goods sector

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demanded action and their growingly vociferous Congressional representatives piled up legislative initiatives (vetoed in the main part by the President) against “unfair” foreign competition. The Second Reagan Administration embarked on hectic currency diplomacy aimed at lowering the international value of the dollar and thereby diffusing the protectionist bombshell. The Plaza Accord was the diplomatic coup. Japan agreed to temporarily tighten monetary policy so as to raise the international value of the yen and there was a commitment to joint foreign exchange intervention by the US, Japanese, and European central banks (under instruction of their respective Finance Ministries) so as to push the dollar lower. In fact, the Plaza Accord is the most over-sold accomplishment in the history of currency diplomacy. The US economy had already entered a serious growth recession, and the coming sharp decline of US interest rates would have meant a much weaker US dollar with or without Plaza. The Reagan Administration if indeed concerned to take the sting out of the protectionists in Congress should have concentrated its assault on inappropriately tight US monetary policy rather than leaning on Japan to make a wholly inappropriate tightening of monetary policy (not justified by contemporary Japanese economic situation). Foreign governments and central banks should similarly have been arguing for easier US monetary policies as essential to global economic equilibrium. But high inflation was sufficiently recent and the record of the Volcker Federal Reserve so impressive in its defeat, that scope for diplomacy concerning US monetary policy was at best very limited. Indeed the Reagan Administration was quietly encouraging a rebellion against Chairman Volcker within the FOMC aimed at securing bigger rate cuts. The Reagan appointees (increasing in number) on the Board of the Federal Reserve were increasingly restive. Foreign pressure on the FOMC might have had only perverse results (on monetary policy). That situation had changed already into 1986 as the dollar fell more sharpy than anyone at the Plaza had expected or intended. Volcker pressed for foreign rate cuts, particularly from the Bundesbank, tracking down its then President (Karl Otto Pöhl) on a visit to Israel to make a personal appeal by telephone for a rate cut. In a rare example of monetary diplomacy, the US was pressing another country to shift its monetary policy with part of the bargain being that the Federal Reserve would follow suit. Volcker feared that a unilateral easing by the FOMC would trigger unwanted further dollar weakness. A year later (February 1977), within the framework of G-7 negotiations at the Louvre, the US

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agreed to participate in a stabilization of the US dollar after its recent steep fall (which went far beyond what had been envisaged at Plaza). It was not spelt out (in the Louvre Accord) where the responsibility for stabilization action lay, but critically Federal Reserve Chairman Volcker was a party to the deal. Treasury Secretary Baker’s motive in supporting a stabilization of the dollar at this juncture remains largely speculative. Perhaps he was convinced that a halt to the dollar’s slide would reduce the risk of an inflation shock and thereby of higher US rates, a worthwhile prize given that the next Presidential elections (at which his close friend George Bush Senior would be the likely Republican candidate to succeed Ronald Reagan) was barely 18 months down the road. Volcker, an old hand at currency diplomacy through the crises of the late 1960s and early 1970s, may have welcomed dollar stabilization as providing ammunition against the growingly powerful opposition within the FOMC which was seeking to block monetary tightening even though signs of the economy pulling out of its growth recession were now multiplying. Volcker could now present rate rises if needed as essential towards meeting the currency commitments made at the Louvre. Both Volcker and Baker could not be right. As events unfolded in the following months (Spring 1987 onwards), Volcker’s assumption (not disclosed to the Administration during the negotiations leading up to the Louvre Accord!) that US monetary tightening would be required to prevent a new fall of the dollar proved to be correct, and Baker’s hopes that stabilization would mean less reason for interest rates to rise were dashed. Frustrated US currency diplomats under the command of Baker used the Louvre Accord to beat on the door of the Bundesbank and the Bank of Japan to ease monetary policy or at least desist from tightening. Volcker’s hiking of rates in Summer 1987 (despite serious divisions within the FOMC) may have been the final factor tipping Baker to recommend that he be replaced as Federal Reserve Chairman. Baker did not mince his words about the backwoodsmen at the Bundesbank who insisted in proceeding to raise interest rates in early Autumn 1987, not withstanding the Louvre Accord. Meanwhile a change of personnel in Baker’s team of advisers (crucially Richard Darman had resigned to take a job on Wall Street in April) had left him now leaning on an official (Charles Dallara) who was in tune with the weak dollar ideas of James Tobin and his protégé Fred Bergsten. All of this demonstrates the difficulties in the way of any serious international diplomacy with solely the benign aim of edging interest rates in the major centres closer to an ideal concept of mutually consistent neutral levels.

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In any case, the chosen successor as Federal Reserve Chairman, Alan Greenspan, had no interest in currency diplomacy. As a professional economist back in the mid-1960s he had written an article for Ayn Rand’s “The Objectivist” in favour of the gold standard (see Rand et al, 1966; Greenspan, 1966 and Walker, 1998). He had described efforts at international monetary co-operation as flawed, quoting (in the same article) the notorious example of 1927 when the US Federal Reserve had been persuaded to ease policy by the Bank of England as part of an effort to stabilize the foreign exchanges (and in particular to prop up Sterling) and had so contributed to the speculative build-up of 1928–9 in the US economy and stock market. He took no time to de-bunk the Louvre Accord, and in an interview with Sylvia Nasar of Fortune Magazine (the only interview he ever gave as Federal Reserve chairman on currency matters) stated that he did not believe that there was a floor to the dollar. (Earlier in the year, as an economic consultant, Greenspan had sent an advisory note to his clients saying that the dollar should fall to 10% below the level at the time of the Louvre Accord). One vocal critic of Alan Greenspan, Jude Wanniski, (see Wanniski, 2000) has written extensively on this episode as a very black mark in the illustrious Chairman’s career. In effectively announcing the end of the Louvre Accord – and the Fortune article appeared on the eve (Friday, October 16) of the Great Crash (October 19, 1987) – Greenspan effectively scared investors about the inflationary outlook and thereby about the effective rate at which real gains would be taxed (given the lack of indexation in tax liability calculation). Was the new Chairman about to embark on a similar path to the now notorious Arthur Burns, who appointed by Nixon in early 1969 proceeded to create the greatest peacetime inflation, all towards the re-election of the President or of his chosen successor? Wanniski may be over-stretching a point. But throughout his long term of office Greenspan would have little truck with currency diplomacy – neither giving advice to the leading foreign central banks nor entertaining discussion on a so-called globally consistent level of interest rates. (Right at the end of his last term, however, Greenspan did participate in the Administration jawboning of China, as discussed below – see p. 173). On balance at critical periods of dollar weakness the Federal Reserve Chairman was tight-lipped, offering little or no comment (other than the mantra that currency policy is the responsibility of the US Treasury) or any offer of monetary support (a temporary tightening of monetary policy for example). The exception was during early days of the so-called strong dollar policy in Summer 1995, which coincided with the looming decision

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of the Clinton Administration as to whether to re-appoint him. Treasury Secretary Rubin who had just negotiated an accord with Japanese chief currency diplomat Sakakibara would have a big say in the re-appointment decision. The Greenspan Fed arrested its rate-cutting initiated in Spring 1995 (the easing of monetary policy had been in response to an emerging economic slowdown which proved to be short-lived). During the Greenspan era (1987–2005) the main two episodes of US currency diplomacy were first, the bilateral trade negotiations with Japan (1988–95), which spilt over at critical junctions into exchange rate discussions and second, the assault on the Asian dollar bloc, especially China, from 2003 onwards. In both of those episodes the Federal Reserve was not an active participant in the diplomacy (with the possible exception of Greenspan’s one-day visit to Beijing in October 2005). But its chairman was sufficiently astute politically to realize that his smooth path through the Washington political forest with its many potential trip-wires required that he make the appropriate nods, winks, and speeches with suitable innuendoes. The two episodes are taken up below under our discussion of Japanese currency diplomacy and the Chinese currency question.

Tokyo-Washington dialogues Tokyo was a comparative late-comer to international currency diplomacy. During the miracle years of the late 1950s and 1960s (continuing to 1973 on most accounts), Japan had pegged its currency at the unchanged 360 level to the US dollar, whilst allowing considerable real exchange rate appreciation to take place in the first half of the 1960s through tolerating a much higher rate of inflation than in the US. Tokyo was not prepared for the assault of the Nixon shock, not fully realizing that as now the world’s second largest economy with a sudden bulge in its trade surplus (previously the tendency had been towards deficit at cyclical peaks) it had become prime target of a new force in post-war US politics – neo-mercantilism. It is certainly possible to argue in retrospect that Japan might at least have reviewed a diplomatic strategy aimed at salvaging the yen’s attachment to the dollar standard at an unchanged rate, even if the gold window were closed. Indeed that was the knee-jerk response of Japanese policy-makers to the Nixon shock – to continue unchanged. But they were forced to change tack within days by the flood of hot money inflows. What would have been the main elements of a diplomatic plan to salvage the dollar standard?

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The core elements would have been some bold proposals likely to appeal to the Nixon Administration plus some re-adjustment of domestic policies to serve the priority of currency stability. The bold proposals could have included first, a package of economic reforms likely to mean much improved access of US exporters to the Japanese market. Second there would have been a commitment to aggressive monetary ease towards helping to jump-start the US economy out of its weak cyclical phase (1970 was a recession year and the recovery in 1971 appeared weak to contemporary observers). The Bank of Japan would have had to swallow its concerns about inflation for now, accepting that it had little choice in the matter if a dollar standard were to be sustained, and offered impressive rate-cuts up front. Capital export controls would have been scrapped to have allowed Japanese savings to move into US assets – helping to alleviate the so-called US balance of payments financing problems. None of this occurred in time. Eventually, the Bank of Japan did aggressively ease monetary policy, but only following the Nixon shock and a big appreciation of the yen. Monetary overkill ushered in a period of spectacularly high inflation. Passing through a series of shortrun stabilizations, the yen by the mid-1970s had becoming a fully flexible currency. (In-between 1971 and 1976 there had been long periods of stability versus the dollar, first under the Smithsonian Agreement, and then, de facto stability from mid-1974 to mid-1976 following the First Oil Shock). In 1977–8, Tokyo conceded a promise of fiscal reflation as part of the G-7 deal with the Carter Administration (see pp. 160–1). The Bank of Japan, still trying to bring inflation down from its disturbingly high levels of the mid-1970s, was unwilling to make concessions as part of the deal. The Ministry of Finance had to give way very reluctantly (given that they were just restoring order after the bombshell of the Tanaka fiscal policy excesses). Why did Japan concede rather than laying the blame (for the weak dollar and US “balance of payments problem”) at the door of the Arthur Burns Federal Reserve? The presumption is that Japan by saying No might have risked a repeat of the Nixon imposed import tariffs or equivalent. At least that was the view of Japan’s currency diplomats. Meanwhile, to be better prepared for future events, Japan moved full speed ahead in the dismantling of its exchange restrictions, meaning a potential – and indeed actual – surge in private capital outflows largely to the US. There followed a golden period during which US disinflation (under the Volcker Federal Reserve in the first half of the 1980s) went along

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with huge private capital outflows from Japan to the US. The Ministry of Finance managed to claw back its concessions and indeed the budget balance moved towards surplus. And the Bank of Japan finally brought inflation down to low levels (still positive). The dollar-yen rate settled at a level where the Japanese economy could generate large current account surpluses in line with its private capital exports and now overall large underlying savings surplus. The main criticism of Japanese diplomacy at this point was its lack of preparedness for what was to follow and which should have been seen at least as a risk scenario. The rising tide of protectionism in the US Congress through the mid-1980s – a reflection of the manufacturing sector’s decimation by the strong dollar – was there for all to see. What was to be Japan Inc’s response? One possibility was that Tokyo would seek to persuade Washington that the present high valuation of the dollar was in part temporary – due to the policy of disinflation meaning that US interest rates were above long-run neutral level – and in part structural (a reflection of buoyant US investment opportunity created by Reaganomics and of savings surpluses in Japan and Germany). No fix was possible through macro-economic tinkering on the part of Japan. Tokyo, however, would be willing to fully participate in monetary talks with Washington so as to mutually review estimates of consistent neutral interest rates in the US and Japan (and other G-7 countries). Meanwhile Tokyo would offer up-front a long-run program of economic reforms under which US (and other non-Japanese) enterprises could hope to gain considerable access to Japanese markets and overcome the so-called many invisible barriers. Instead, Japanese currency diplomacy was driven by special interest (domestic) politics and short-run placating of US demands, gaining a reputation for never giving as much as had been promised, but nevertheless inflicting substantial harm on the Japanese economy overall. One unfortunate component of the bad outcome was a lack of vision or faulty vision on the part of the Bank of Japan, meaning that international diplomacy on monetary matters was either ineffective or went totally in the wrong direction. As we have seen, at Plaza itself (Autumn 1985), Japan agreed to tighten monetary policy towards playing its part in lowering the value of the dollar. That was a totally bizarre offer, given that the Japanese economy at the time had no serious inflationary symptoms and was growing at a below-par pace. Anyhow the tightening was soon reversed as US monetary easing in the context of US growth cycle downturn

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brought a sharp decline of the US currency. At that stage the obvious monetary response would have been continued aggressive interest rate cuts by the Bank of Japan – if necessary all the way down to zero. The international case for such action centred on the large private sector savings surplus in Japan. The neutral level of interest rates there was likely well below that in the US. But Japanese monetary policy did not take that aggressive course. The Japanese call money rate was still at 4% p.a. in late 1986. Instead the Ministry of Finance sought to stimulate directly (not via the interest rate mechanism) a credit boom – accelerating the liberalization of the Japanese banking system and encouraging an incipient construction sector upswing. That choice of credit stimulation at a higher-than-otherwise level of interest rates (meaning a higher-than-otherwise international value of the yen) may have been induced in part by wariness (amongst Japanese officials) about the resurgence of US trade pressures on Japan which came to a head during the Bush (Senior) Administration. Towards stopping Congress from mandating trade sanctions against Japan, the Bush Administration entered into the socalled Strategic Impediment talks with Tokyo. A stronger-than-otherwise yen would be helpful to keeping protectionist pressures at bay and smoothing the talks. Concessions on Japanese fiscal policy (Washington demanded an easing) would be helpful. (In principle, easier fiscal policy would mean a higher equilibrium value for the yen, in that it lowered the national savings surplus). From the viewpoint of the ruling Liberal Democratic Party, overturning Ministry of Finance guidelines on fiscal authority towards the greater purpose of reaching agreement with the US offered immediate vote gains. (The recipients of public spending largesse tended to be the backbone of LDP support, whether the construction companies, or more generally the non-metropolitan regions which are over-represented in the Japanese electoral system and which have benefited from the highways and dam developments fittingly described as “cathedrals in the desert”). In general, Japanese negotiators were willing to give ground on public spending and on a stronger yen but were most resistant when it came to removing impediments from which their special interest groups derived advantage. Perhaps even without Ministry of Finance prodding a real estate bubble would eventually have got under way in Tokyo. Then the yen would have strengthened as the private sector savings surplus fell and interest rates in Japan started to move higher from their depressed level. We cannot be sure. But we can be certain that once the bubble

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burst, the ensuing rounds of currency diplomacy which followed helped to dig Japan into the hole commonly described as the Lost Decade. As the US economy floundered in a long growth recession (including a period of actual recession) from late 1989 to early 1992, Congress and the Administration saw the political advantage of turning the trade pressure up on Japan, even though that country’s huge financial contribution to the Gulf War (early 1991) was a tempering influence. As Japan’s current account surplus bulged in the aftermath of the Tokyo market crash (January 1990), US Congress members and Administration officials thumped the table and demanded action from Japan to reduce its trade surplus and open up its markets to greater US participation. In principle Japan had a strong and pervasive counter-case to make. In the post-bubble situation, the savings and current account surpluses were bound to rise, especially given the severity of the emerging real estate market downturn. Japan would be acting in its own best interests and fully in line with global economic equilibrium principles by aggressively easing monetary policy and allowing rates to fall to their very low post-bubble neutral levels. Huge capital exports from Japan would absorb the savings and current account surpluses. Japan’s contribution to US and world economic recovery would come through its depressing influence on global interest rates and bond yields. Japan’s failure to make that case can be blamed at least in part on the then Bank of Japan Governor, Yasushi Mieno, who seriously misunderstood the economics of the new situation. Educated in the old principles of current account balances determining equilibrium exchange rates, Mieno viewed the rising post-bubble current account surplus as implying a higher equilibrium value for the yen. He was an enthusiast of a hard yen, in any case. US officials were certainly not inclined to make the argument just outlined for a weaker yen by default. From Washington’s perspective a stronger yen, helped along by massive fiscal easing, would sway the most number of votes by the key election date of November 1992. (In principle, according to the Mundell-Fleming analysis, an easing of fiscal policy for a given monetary policy means a higher equilibrium real exchange rate. A bigger fiscal deficit sustains a higher neutral interest rate and a stronger capital account in the balance of payments). Bill Clinton, the winner of that election, had fought the campaign under the slogan “it’s the economy, stupid”. A get tough trade agenda, especially versus Japan, was a main point of his international economic program. In principle the Japanese government could have met the

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new Administration in Washington head on with a counter-program. The Bank of Japan, still ultimately under the control of the Government, could have been ordered to shed its qualms about a new bubble appearing and engage in aggressive monetary expansion. The US, Japanese negotiators could have pleaded, would surely gain from rapid Japanese economic recovery. Japanese diplomats might have gained some ground from rallying wider support within G-7 for their action. (The IMF, however, was hostile to the large and growing Japanese current account surpluses). Towards meeting US demands, Tokyo could have offered a list of accelerated market-opening measures, and demonstrated how they would be introduced effectively and promptly. Japanese officials might also have hinted that any unilateral trade action by Washington against Tokyo would be met with determined response – referral to GATT and counter-action by Tokyo. Instead Japanese negotiators re-trod past paths. They offered massive fiscal reflation which the LDP party bosses welcomed. The yen was talked up from time – often just around the time of a crucial Japan-US summit and there was sporadic G-7 intervention helping to underpin its rising trend. In return for the stronger yen, Washington became less insistent on the extent of required economic reform, leaving special interest groups close to the LDP substantially unscathed. The tide of Tokyo-Washington currency diplomacy came to a turning point in mid-1995 as the full extent of the deflationary hole into which Japan was falling and the associated banking sector risks became evident. Moreover key changes in the diplomatic ranks on both sides were important – MoF careerist Matsushita replacing Mieno at the BoJ, Eisuke Sakakibara becoming the top yen diplomat, and Rubin taking over from Bentsen (a Texan, close to the neo-mercantilist current) as US Treasury Secretary. The new deal in Summer 1995 was a further monetary easing by the Bank of Japan, a permanent truce in the trade conflict (with the US side being able to claim some sort of victory in time for elections the following year) and G-7 intervention to bolster the US currency. Federal Reserve Chairman Greenspan made some rare pro-dollar strength remarks and desisted from any further rate cuts (see p. 163). (Cynics might argue that early evidence of the US economy emerging from its brief growth recession might have argued against additional monetary easing anyhow). A new powerful card had come forward for Japan to play in the game of currency diplomacy – deflation – and the need to overcome this not only from a domestic economic standpoint but also for the sake of the global economy. Unfortunately the card was not to be used to its

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maximum effectiveness and was indeed sometimes lost from view in the following years. Part of the problem again was a change of guard at the BoJ, from Matsushita to Hayami in early 1998. (The hast change was related to a corruption scandal within that institution). Hayami was a throw-back to Mieno in terms of his enthusiasm for a strong yen and miscomprehension of how equilibrium exchange rates are influenced by huge underlying savings surpluses. Moreover also in 1998 the BoJ gained independence from the Government, and Hayami was determined to demonstrate that independence in practice even if in consequence there was some non-optimality in macro-economic policy-making. Hayami was concerned that participation of the BoJ in the framing and implementation of currency policy would dilute the new independence. BoJ officials argued strenuously that currency policy had nothing to do with their institution, even though there was a growing literature that under conditions of deflation where the zero rate boundary prevented rates falling to their neutral level, the only type of monetary policy was currency policy. In any event, the slide of the yen through 2001 and early 2002 in the aftermath of Japan’s brief equity market bubble of 2000 (and subsequent crash) met no resistance in Tokyo or Washington. Japanese currency diplomats had an amiable reception in Washington where the economic supremo under the new Bush Administration, Lawrence Lindsey, understood fully the grounds for yen weakness, despite the US itself being in an economic downturn (see Lindsey, 1999). Indeed media accounts stated that Lindsey had given the green light to yen depreciation in excess of what actually occurred, but Tokyo diplomats failed to force the window of opportunity further open. The next chapter in Tokyo-Washington currency diplomacy opened with the enunciation of the so-called Bernanke doctrine in early 2003, when the Federal Reserve launched its new policy of “breathing low inflation” back into the US economy, where the concern had now become that inflation had fallen so far as to mean that conventional monetary policy might not be usable in the next economic downturn. The implementation of the new US monetary policy meant that the dollar slid in global currency markets – and also against the yen. In response the government of Japan embarked on a massive program of foreign exchange market intervention, defending successfully its actions in Washington on the special grounds of persistent deflation and the need to overcome this. That is why it came as such a bolt from the blue when the G-7 Finance Ministers meeting at Dubai in September 2003 issued a com-

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muniqué to the effect that there was now a preference for “more flexibility in exchange rates for major countries or economic areas to promote smooth and widespread adjustments in the international financial system based on market mechanisms”. Parallel statements left little doubt that the target for increased flexibility was both the yen and the yuan. Again, a change in the diplomatic cast played a role. Treasury Secretary O’Neil (not amenable to taking orders from the White House) and Lawrence Lindsey were out (sacked or resigned in December 2002), and Snow, an ex-railroad company CEO with a prior public service record in transportation, was in. The ailing Japanese Finance Minister, Masajuro Shiokawa, was due to be replaced the following Monday in a Cabinet re-shuffle (Prime Minister Koizumi was concentrating his attentions on an LDP leadership election taking place the same day as the Dubai Summit). The euro-area was represented by the anointed ECB President-elect, Jean-Claude Trichet (the retiring president Duisenberg taking a back-seat).

Washington-Paris-Beijing-Tokyo diplomacy The emergence of the euro-area as a serious element in currency diplomacy was a key new fact revealed by the Dubai Summit (September 2003). Also striking was the fact that the euro-diplomats, led by ECB President-elect Trichet, appeared to be siding directly with Washington in demanding a change of currency regime in Asia. Was this an unholy alliance? After all, relations between “old Europe” and the US had become seriously strained by the US-led regime shift in Baghdad (Spring 2003). How could the same governments be so close on the currency issue especially given the lead role (albeit not explicit) of Paris in the new euro diplomacy? Of course this was not the first time in history in which a surprise alliance emerged suddenly between governments which had previously been on bad terms with each other. What was the catalyst on this occasion? In fact, was the new friendship between Washington and Old Europe in matters of currency based on a mutual feeling that each had got the better of the other in the unfolding bargain? How important anyhow was euro-support at G-7 for the new US currency policy towards Asia? Did the euro diplomats simply have an inflated idea of their collective importance? The sudden attack by Washington on the Asian dollar bloc was indeed puzzling. With the US in huge savings deficit and the Asian countries in large savings surplus, there were surely considerable advantages for the US in a currency regime where exchange risk was

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only a small impediment at most to the flow of capital between the two. Low exchange risk meant lower-than-otherwise US interest rates and a higher-than-otherwise US dollar. From the viewpoint of the Asian countries in large savings surplus, low exchange risk with the dollar meant that they could reach external equilibrium with a higherthan-otherwise level of interest rates. This was important if indeed the neutral level of rates under a floating currency regime would be below zero meaning a deflationary disequilibrium situation could develop. The lower-than-otherwise real exchange rate for the Asian countries’ currencies (under a continuing dollar bloc rather than a free float) could be important in itself to maintaining the dynamism of their export sector. (This last point is controversial, see p. 75). The country targeted foremost at Dubai was China, and as yet that country was in only small savings surplus. Many long-run projections, however, suggested that the saving surplus would become huge over coming years and indeed that was already apparent in 2005. If China were to break its link with the dollar, some of the other Asian countries (excluding Japan, considered separately), themselves in huge surplus relative to economic size (Hong Kong, Taiwan, Singapore), might be forced out of the quasi-dollar bloc to which they belonged. (Speculative flows and policy action would contribute to that outcome). The G-7 statement (at Dubai) appeared to welcome that possibility. As regards Japan, that country was not in a dollar bloc anyhow, but because of its deflationary situation, had been long seen as a special case (see p. 169), in which heavy intervention rather than free floating was often the appropriate currency mix. Surely Washington was not really about to abandon that view? The predominant view amongst analysts was that the Bush Administration and its political advisers had seized upon the Chinese currency issue out of purely domestic political calculation – with Congressional and Presidential elections looming within a year and where the state of Ohio with its rust-belt industries subject to Asian competition, could crucially affect the electoral outcome. Banging the drum against unfair Asian competition and getting China in particular to make a move could all be good politics. On a balance of electoral risks, the gains in Ohio from tough action on China and “unfair” Asian competition apparently outweighed the loss of votes from any rise of US interest rates attributable to a break-up of the Asian dollar bloc. That cynical view carried considerable plausibility, but did not explain why the Bush Administration persevered with the policy into 2005 well after the election had been won. Again there may have been a

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new range of primarily political considerations. In particular there was strong support in the Senate for trade moves penalizing China. The Bush Administration had already suffered serious setbacks to its legislative programme on the Senate floor, with key appointments and initiatives blocked. The attempt to move the Administration’s agenda on by offering up the fig-leaf of long-run currency adjustment had obvious appeal to the White House. The Bush Administration collected some surprising support (in Spring 2005) along the way for its Asian currency policy from Federal Reserve Chairman Greenspan and Governor Bernanke. The intervention of Alan Greenspan – in the form of remarks to Congress during testimony (April 21, 2005) – was all the more remarkable given his usual silence on currency topics. Cynics suggested that the intervention in the case of Greenspan was to help gain him influence in the selection of a successor (his retirement fixed for January 2006) by establishing good will with the Administration. In the case of Ben Bernanke, his remarks came in the context of a Senate Hearing (April 25) on his appointment as chairman of the Council of Economic Advisers. It was understandable that he would reach out to the neomercantilist Senators, especially as a whole series of Bush nominees to various offices were having a hard time of winning Senate approval. The ostensible case for a change in Chinese currency regime presented by these Federal Reserve officials was that an independent monetary policy in Beijing would be beneficial both for China and the world economy. For China, breaking the peg to the dollar would allow the Bank of China to tighten monetary policy to prevent a build-up of inflation. The present combination of a large and growing current account surplus and upward pressure on prices suggested that the yuan was undervalued. A real appreciation could be obtained without high inflation through a currency adjustment. In broad terms, the officials suggested that the Chinese economy would follow a more stable path if monetary policy were anchored to a domestic variable – whether the price level or money supply – rather than to the yuan-dollar parity. The world economy would surely gain from a more rather than less stable Chinese economy, now that it had reached the same size as France (using nominal exchange rates as converter) and would be the same size as Germany within 5–10 years. At his Senate Budget Committee hearing (April 21, 2005), Alan Greenspan took the opportunity to give Beijing some unasked for advice on currency policy.

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“The sooner they (China) move off this fixed (rate), the better off for China’s economy ––. Their present policy of sterilizing monetary inflows is creating imbalances which suggests, sooner rather than later, they’re going to have to, for stability purposes, move their currency. –– As far as I’m concerned, it’s very much in their interest to move. –– And as you can well imagine, we in the US government have been in conversations with them to indicate that in our judgement and in our experience they should be moving sooner rather than later.” At best it was ingenuous for Messrs. Greenspan and Bernanke to suggest that the object of Bush Administration currency policy was to make the Chinese economy better for the Chinese and its business cycle less violent (with benefits for the world economy). In any case, with no knowledge on how an independent monetary policy would operate or on how stable it could be, it was a stretch for these Federal Reserve officials to suggest strongly that this would provide the most stable outcome. Both ignored the latest evidence that inflation in China had fallen to barely 1% year-on-year, suggesting that the rising current account surplus was symptomatic of an underlying savings surplus rather than a disequilibrium situation. Neither official put emphasis on the severe exchange restrictions in place and the case for removing these. Then the savings surplus could flow out to the global economy in a smooth fashion rather than in the form of eye-catching reserve accumulation by the Bank of China, likely in itself to inflame neo-mercantilist opinion in Congress and elsewhere. Both officials were silent on the bigger question of whether US pressure on Beijing over currency policy might not in fact mean less pressure on the political regime there with respect to a range of alternative issues – slave and prison labour, general abuse of human rights, non-fulfilment of ILO standards as required by the WTO access agreement, and piracy of intellectual property rights. In fact there was an alternative policy which Washington could have been following altogether with respect to the Chinese currency issue. Yes, if you (Beijing) want to keep the yuan at an unchanged parity to the dollar, so be it. But you must play according to the rules of the game of the dollar standard. Remove exchange restrictions. Stop sterilizing money inflows or outflows and so permit real exchange rates to move in line with the requirements of global economic equilibrium. There should be no presumption that the real exchange rate of the yuan will indeed rise, given the emerging huge savings surplus and probable surge in private capital outflows. If there are differences of view concerning trade matters, these should not be solved or appeased

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through currency moves but by direct action, if necessary through multilateral agencies (the WTO, or ILO for example). And when it comes to issues of human rights, use of prison labour, infringement of intellectual property rights, we (Washington) will negotiate hard on these and take retaliatory action as consistent with domestic and international law. We do not intend to accept the sop of an exchange rate change as a substitute for progress on these issues. It seems unlikely – and there is no public evidence of the fact – that the Bush Administration (including the US Treasury) or the Federal Reserve ever explicitly considered the full alternative scenarios for Chinese currency policy including the continuation of a dollar bloc in revised form as just described. Perhaps there was an awareness amongst some foreign policy officials that by pressing for currency regime change, Washington had lost leverage on other issues. Perhaps in terms of the political calculus of the Bush Administration there seemed more prospect of measurable progress and votes to be gained from scoring a success in currency diplomacy than from insistence on wideranging human rights and labour conditions reform. Indeed the Bush Administration seemed to be offering an implicit deal to Beijing in the form of you make us concessions on our currency demands, and we will go easy on taking trade action against you or making referrals to the WTO and ILO. (The partial analogy was in the yen diplomacy of the 1990s where the currency rate became a trade-off for general economic reform). We will also co-operate with you to block the efforts at the UN of the “coalition of four” (Japan, Germany, Brazil and India) to gain seats in the Security Council, even though we believe that this body should be expanded by two members to include Japan. But we realize that you cannot accept Japan in the Security Council. In any case we appreciate your support at the UN as a member of the Security Council for our Iraq policy, albeit that you could do a lot more to help resolve the nuclear crisis in North Korea and desist from preventing a referral (to the Security Council) of the Iranian nuclear programme. The French government presumably also conducted a review of the issues and alternative strategies for dealing with the Chinese currency question before endorsing Trichet’s entry on to the stage of currency diplomacy at Dubai. At one extreme, the euro-area (represented by the Jean-Claude Trichet and by Finance Ministers from France, Germany and Italy) could have refused to go along with the US initiative on Asian currency policy at Dubai, and there would have been no joint communiqué. That would not in itself have prevented the US pursuing

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its currency objectives in Asia (and in China especially). Instead there would have been harder bilateral bargaining (between Washington and Beijing). The intervention of the euro-area in support of the US at G-7 in fact made the bargaining process softer on China. Some direct evidence on this point comes from an interview of the IMF Managing Director, Rodrigo Rato with Reuters on July 29, 2005. This senior IMF official, an ex-Spanish Finance Minister, stated “we were insisting all along through the summer and the winter that China should change its currency system, but we never accepted the argument that there was a case for retaliation against Chinese exports. I know some groups and people thought otherwise. I think there was no case for that and action would have been unfair and a mistake”. Historically the IMF has been headed by a Continental European and sensitive to the current of French-German thinking on currency matters. (Indeed French has been the dominant nationality of IMF managing directors – including Pierre-Paul Schweitzer (63–73), Jacques de Larosiere (78–87) and Michel Camdessus (87–00)). The outcome of the Dubai summit meant that euro-area diplomats were part of the negotiating process (with respect to the Chinese currency issue) and could press Washington to give multilateral diplomacy space and time. It would surely be best (so the euro diplomats could argue) if the IMF gave its blessing to the change in currency regime. In turn the euro-area diplomats presented themselves to Beijing as mediators between the hard-liners in Washington and themselves (the Chinese diplomats). The euro-area diplomats could impress upon Beijing the case for compromise. Anyhow this should mean fewer problems (with Washington) on other fronts (human rights, etc.). Moreover the French contingent (of euro-area diplomats) would have hinted at their country’s interest in increased military equipment business once Paris could succeed in getting the EU arms embargo lifted (imposed in the aftermath of the Tiananmen Square massacre) or even before. For France, the driving force behind the diplomacy, cosying up to China was consistent with the advancement of its grand aim of multi-polarity rather than US hegemony. France and the euro-nationalists saw clear advantage for themselves in the break-up of the Asian dollar bloc. After all, a principal purpose behind the formation of European Monetary Union was to challenge US monetary hegemony and gain increased independence (of the US) for Europe in particular. A break-up of the dollar bloc would surely mean just that – a decrease of US monetary power in Asia and an increased global role for the euro. Economists at the Bank of France

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trumpeted the view that the US mega current account deficit was a serious long-run menace to the global economy. So as to avoid much greater trouble down the road, balance of adjustment should start early. So long, however, as Asia remained on a dollar standard, Europe would bear an unfair share of the adjustment cost. Burden sharing required that Asia revalue their currencies. The same line of argument was broadcast by ECB officials from President Trichet downwards. Implicitly, euro diplomats were working with a command-type model of balance of payments adjustment. The stated problem was to reduce the US current account deficit by say X% of (US) GDP. For that to occur there had to be a y% real effective exchange rate depreciation of the US dollar. If the Asian countries remained on a dollar standard and somehow prevented a real appreciation of their currencies (via sterilized intervention) from taking place, then European currencies would have to adjust upwards by a very large amount. If, by contrast, the Asian currencies were forced to appreciate, then the European currency appreciation could be less. The argument was deeply flawed but nonetheless it was repeated forcefully and apparently with some success in the world of currency diplomacy. Whether the US deficit had to fall by X% of GDP depended not on command but on the evolution of savings surpluses and deficits throughout the globe (especially in the US, Europe, and East Asia). Where the offsetting changes in surpluses had to take place to match any reduction in the deficit would be determined by market forces and depended on how savings propensity and investment opportunity changed relative to one another in Europe, Asia, and the Middle East. The extent of exchange rate change which accompanied the fall in the US deficit would turn on whether the downward shift in savings surpluses abroad (outside the US) occurred autonomously (for example due to a sudden flourishing of investment opportunity) or had to be induced (via interest rate falls). Induced falls would mean larger exchange rate change (see Chapter 8, p. 224 for a discussion of the various exchange rate scenarios possible). Moreover, just because the Asian countries were on a dollar standard did not mean that they could not experience considerable real exchange rate change over the long run. This could stem from cumulative differential inflation. Finally, forcing the dollar bloc to break up might stimulate diversification out of the dollar by Asian investors which could push the euro to a higher level than it might otherwise have reached. In principle the break-up of the dollar bloc would mean in the long run smaller Asian savings surpluses, lower Asian interest rates, smaller

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US savings deficits and higher US interest rates. That would be a direct consequence of an increased barrier in the form of exchange risk between the savings surplus countries in Asia and the savings deficit countries, principally the US. The impact on the euro-area savings balance (small at present) and equilibrium exchange rate would be ambiguous, depending on a number of factors, including the elasticity of capital flows from the euro into the dollar in response to a widening rate spread between the two currencies (higher US interest rates) and the extent to which Asian investors would see benefit in diversification into euros now that they were no longer much riskier than dollars (from an Asian perspective). This diversification by investors would be offset at least partially (in its effect on the euro) by diversification on the part of borrowers (away from dollars and towards euros). One country which might have been expected to have a strong view on whether the Asian dollar bloc should continue and what its breakup might mean for currency movements was Japan. In practice though, Tokyo largely followed Washington’s line, albeit winking to Beijing that somewhat smaller gestures than those demanded, and at a slower pace, might be sufficient. Even if some Japanese policy-makers might have sympathized with the view that an Asian dollar bloc was in Japan’s interest (providing stability of trading conditions for Japanese direct investment in these countries and reducing the likelihood of Tokyo’s own intervention tactics coming under attack), they could hardly reckon that a Japan-China coalition would be any stronger than Beijing on its own in protecting the status quo. What had Tokyo to gain from introducing a point of tension (Asian currency policy) into a generally close relationship to Washington, when Chinese-Japanese relations were themselves in near-crisis state (the proximate cause being Prime Minister Koizumi’s continuing annual visits to the Yasukuni Shrine)? After all, long deflation had made Japan a special case when it came to currency policy.

The outlook for currency diplomacy In sum, the diplomacy of the yuan became very murky – and the main players had fairly cloudy vision concerning both their strategy and where it would all end. Certainly it was significant that the euro-area, driven by France, had entered the game. Not for the first time its diplomats had lost sight of the forest for the trees. Are there lessons from the China example – and other recent history – for how diplomacy might or should evolve in coming years?

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A first point is a disturbing lack of quality or democratic check even with respect to US currency diplomacy. Could there not have been a higher quality debate in Congress on the issues? In particular why were there not more probing questions concerning the economic consequences of currency regime choice in China and other broader related questions, such as the impact of the chosen path of currency diplomacy on human rights, labour practices, and indeed any potential conflict over Taiwan. (For example, perhaps the building up of massive holdings of US dollars by Beijing might increase its potential to wage psychological or actual war against Taiwan). Secondly, European currency diplomacy was made with even less democratic check than in the US, unless we treat France as speaking for Europe. Chinese currency policy was a subject which the French Finance Minister sometimes had to address at press conference. But there is no record of parliamentary questions concerning this. Going forward, euro-area members have yet to address how currency policy is to be formed and how it is to be vetted. Presumably it is not a long-run stable situation for this to be sub-contracted to France. In any case the next President of the ECB (Trichet’s term expires in 2011) is hardly likely to be French. Without any progress towards political integration in the euro-area it is open to doubt whether currency diplomacy should be undertaken at all (from the viewpoint of democratic legitimacy). That might mean some loss of potential advantage for Europe in some situations – but in much of the currency diplomatic game the sum is zero or negative, and it is not obvious Europe should expect to be on the winning side. Third, currency diplomacy concerning monetary policy alignment from a global standpoint (discussing whether perceptions of neutral rate levels as held by the major central banks for their own money are globally consistent) remains highly underdeveloped and intermittent. In a world in which interest rates as pegged by central banks can stray far from neutral levels where these are defined in a global sense, could there not be a better mechanism for exchanging views – for the US to influence Europe and Japan, and conversely. It is a farce for G-7 central bankers to meet twice a year simply to discuss generalities or exchange rates, but without reviewing the global consistency of their monetary policies (in the sense of their groping towards estimated neutral rate levels which would stimulate sufficient capital flows to match underlying savings surpluses and deficits). Monetary diplomacy as just described has got a bad reputation in the past due to its having been linked to specific episodes of exchange rate

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targeting (as under the Louvre Accord) which were untenable. In fact monetary diplomacy need not be related to specific exchange rate targets – even though the determination of neutral rate levels globally does assume that exchange rates are on an equilibrium path (see Chapter 3, p. 69). Most of the time it would not be unreasonable for central banks to assume that the market perceptions of the equilibrium path as reflected (not necessarily 100%, due to the possibility of market interest rates being above or below neutral level) in actual market rates are as good as any likely to emerge from supranational institutions. The present isolationist standpoint of the Federal Reserve and ECB, where any interference from outside would be ill-regarded, is surely sub-optimal. If indeed monetary diplomacy is impossible to implement or of essentially poor quality, then that would be an argument for allowing markets a greater role (and national – including currency area – bureaucracies, such as the Federal Reserve or ECB, less) in the setting of market interest rates (as outlined in Chapter 5, p. 141). Markets in making their assessment of neutrality have no qualms about introducing global elements of consistency into their analysis – but are discouraged from doing so if the game has become predicting where the national bureaucracies will guide their pegs to short-term money rates. Fourth, Japanese currency diplomacy has remained typically myopic – focussed on agreeing at times of stress an unofficial acceptable range of foreign exchange market intervention with their US opposite number. There has been no big picture. Indeed there might be considerable advantage from both the Japanese and global perspective in Japan moving away from a fix-it approach to currency diplomacy to a contingency approach. According to this, Japan would explain that when short circuits develop in the global flow of funds, possibly because of the zero-rate barrier in Japan preventing an equilibrium outcome from emerging, then large-scale official intervention in the currency markets is a stabilizing necessity. Rather than Japanese diplomats agreeing a target range for the yen/dollar rate with Washington, they would state a likely amount of reserve accumulation over a period of time. US and Japanese diplomats would review those targets for reserve accumulation in line with the progress of deflation and the duration of any short-circuit. Markets would be left to set the currency rates but with the knowledge that a given volume of official operations would be taking place over a given time period. From the perspective of early 2006, when Japanese deflation is widely seen as fading away, the need for any re-vamping of the framework of currency diplomacy vis-à-vis the US might seem

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remote. All the talk (and eventually action, March 2006) coming out of the BoJ has been about preparations for a reversion to conventional monetary policy and a scrapping of the exceptional arrangements in place since 2002. As we have seen, however, earlier in this book (Chapter 4), it is plausible that in the next global or Japanese economic downturn the zero rate barrier could again become effective. It would be a pity if Tokyo had meanwhile scrapped its special status enjoyed in G-7 whereby it can pursue substantial intervention as a non-conventional tool under situations of deflation. Instead, pro-active currency diplomacy by Tokyo would have ensured that termination of the present abnormal ease was accompanied by a new framework of policy agreed with Washington. In this, contingency use of unconventional tools including foreign exchange intervention would be possible should the deflation threat return. Fifth, there is the question of new players. As we have seen, Beijing, through no choice of its own, has had to enter the game of currency diplomacy, and as a player has been able to take advantages of its geopolitical position and euro-ambitions (for a multi-polar world) in Paris. Could there be further new players in coming years? India, Brazil and Russia are all possible candidates, especially if they achieve the continuing rapid economic growth rates which optimists on those countries project. The other new game of currency diplomacy is likely to be within the European Monetary Union, as national governments claw back the power which has been delegated to technocrats in Frankfurt, or by default to France. The flow of capital within a monetary union and between the union and the world outside, together with its implications for international relations within Europe, are the subjects of the next chapter.

7 Dysfunctional Union

Throughout this volume a recurrent theme has been the power of divergences in savings propensities and investment opportunities between countries to drive global capital flows. A key line of inquiry has been how neutral interest rates vary relative to each other (across currency frontiers) and how equilibrium exchange rates shift in response to the power source (international divergences between savings or investment propensities) being turned up or down. Within a monetary union the power source driving capital flows between the member countries and between them (the union as a whole) and the rest of the world is the same (as for the case of sovereign monetary areas). The possibility of virtually riskless arbitrage, however, keeps nominal interest rates (measured with respect to assets of identical credit risk) at identical levels to each other in all member countries (of the monetary union). The analyst of capital flows focuses on how the underlying divergences (in savings propensities and investment opportunities) influence the determination of the neutral interest rate for the whole union and the movement of national price levels relative to each other (within the union). Within the monetary union international trade and capital flows are unimpeded by exchange rate risk or currency transactions costs. There is one common (to all member countries) credit and capital market. Though in principle the same nominal interest rate (for a given maturity and credit risk) throughout the union can translate into distinct (and different) expected real rates for each member country in line with divergent expectations regarding national price level trends, there is no sense in which these real rate spreads become a driving force behind capital flows. The real rate spreads are wholly dependent on the residence of the investor (or more exactly on where the investor 182

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intends to purchase goods and services), not on any national differentiation of the particular money and bond market instruments. As illustration, take the situation of a long-run expectation that the price level in Spain will rise faster than in the rest of the euro-area, on average. That expectation might be based on the so-called Balassa effect, found where productivity growth in the traded goods and services sector of a converging economy is running far ahead of that in the non-traded sector (see Chapter 3, p. 80). (Convergence refers to the process of an economy catching up with more advanced economies). Real interest rates on euros (or indeed on any other money) would be lower from the viewpoint of Spaniards or any other euro-area investors intending to spend their money in say, Spain, than from the viewpoint of investors who concentrate their spending in Germany. This spread of real rates (dependent on where in the union the spending is to occur) does not create any type of arbitrage opportunity, risk free or risky, in the form of exporting capital from one member country to another (Spain to Germany in the illustration given). Equivalently, real interest rate spreads between member countries in monetary union play no role in bringing about external balance – defined as the situation where the underlying savings surplus (or deficit) equals net capital outflows (or inflows) for each and every country. They do however play a role (not always constructive as we shall see below!) in the achievement of internal balance (where aggregate demand, including net exports, is equal to productive potential). In fact, one criticism of the operation of monetary unions is that they may give rise sometimes to a spread of real interest rates (measured according to the perceptions of investors in each member country) which is more out of line with neutrality than what would occur under a regime of sovereign monies (for each country). As illustration, if the underlying savings surplus increases in Germany at the same time as falling in France, a process of adjustment would get under way in which the German price level would tend to fall relative to that in France. During this adjustment period, likely to stretch over a period of years, real interest rates as perceived by German investors (or borrowers) would be greater than as perceived by their French counterparts – a perverse situation, given that higher savings in Germany should mean lower real interest rates there in the long run. Under a regime of sovereign monies, German real interest rates (and nominal) would have fallen at the same time as the savings surplus was recognized by markets (and the relevant central bank) to have moved on to a rising path. (The lags in recognition might of course be long!).

184 What Drives Global Capital Flows?

The relative price level adjustment in France and Germany (accomplished by nominal exchange rate change) would indeed have been more rapid (under the case of sovereign monies) and cumulatively less. It is not always the case that the process of relative price level adjustment in a monetary union pushes real interest rates as perceived by residents in the given countries (where adjustment is occurring) in the opposite direction to neutral (during the adjustment phase). Take the example of where one member economy is enjoying a productivity surge in its export sector (or a buoyant market for one of its main exports, perhaps a primary commodity). Its price level would adjust upwards, and during the period of adjustment, real interest rates (as perceived by domestic residents) would fall. The same (in different degrees) would happen under a regime of floating exchange rates (see Chapter 3, p. 80). The national currency would jump (in international value) in anticipation of rising export revenues, and interest rates would fall to offset the dampening influence on aggregate demand (on the assumption that the rising revenues are some considerable time off in arriving). The lower real interest rates in both cases (monetary union and sovereign money) induce some bringing forward of domestic demand (and so a widening of the savings deficit or narrowing of the savings surplus) ahead of the future rise in export revenues. The issue of possible perverse movements in real interest rates is relevant to the assessment of the benefits and costs which flow from monetary union. But that is not the aim of this chapter. Rather, the purpose here is to analyze the mechanisms which facilitate the flow of capital both between member countries (in monetary union) and with the world outside. Are these (mechanisms) well-functioning enough to allow full equilibrium to be achieved in all countries of the union even where there are widely divergent socio-political, economic, or demographic conditions prevailing? Finally we take a look at how these same mechanisms might be maimed by the outbreak of speculation on the survival of monetary union itself.

How big is divergent price level risk? The creation of monetary union extinguishes exchange rate risk as a factor in trade or capital flows between the participating countries. But relative price risk – the possibility that the price level in one member country might move far up or down relative to in another member (or members) – might loom large when cumulated over long periods of time and be more serious than the exchange risk which has been dispelled.

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As illustration, if Germany were still a sovereign monetary area, the emergence of a large underlying savings surplus (in that country) would go along with interest rates there (in Deutsche marks) falling in nominal and real terms relative to elsewhere. A new equilibrium would come about, where lower German interest rates contained the widening of the savings surplus and at the same time stimulated the outflow of capital. The lowered level of interest rates would mean that the price level in Germany would not have to fall by as much relative to foreign price levels (or its exchange rate fall by as much) so as to sustain internal balance (characterized by aggregate demand, including net external demand, being equal to productive potential). By contrast, in a monetary union, the whole offsetting stimulus to aggregate demand (to match the initial fall in domestic demand stemming from a rise in underlying savings surplus) has to come from relative price level change (and its influence on net external demand). Furthermore, the process of relative price level change without the help of nominal exchange rate shifts might be intrinsically more economically painful than where sovereign monies at adjustable or fully flexible exchange rates to each other still exist. As illustration, suppose the flourishing of investment opportunity in Spain coupled with a rising savings in Germany means that for both countries to reach a new equilibrium the Spanish price level must increase cumulatively by 10% and the German price level fall by 4% compared to the euro-area average (which increases by say just under 2% in line with the ECB’s objective). In the context of monetary union, there is no financial instrument which provides a means for Spanish households to hedge their monetary savings (in euros) against high inflation (in Spain) over an interim period. And for foreign corporations which have made direct investments in Spain there is no instrument for protecting their economic exposure to a big rise in relative labour and other costs there. In fact, for both households and enterprises the obvious hedge might be Spanish real estate – but the extent of basis risk (ups and downs of Spanish property in real terms where the Spanish price level is used as deflator) should not be underestimated. By contrast, where relative price level change takes place mainly through the swings of exchange rates, both the household sector and enterprise sector might be less at risk over long periods of time (than where the change occurs via price levels themselves adjusting). In the Spanish example, a jump in its currency (the peseta) would compensate for the lack of cumulative rise in the price level, but leave many (Spanish) investors better off (especially small and medium-size savers

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in whose portfolios money, bonds, and other nominal claims – including pension funds – rank high). Enterprises could hedge in part by taking forward exchange positions and rolling these over (short foreign currency and long pesetas). Rolling over short-maturity forward contracts provides a hedge against unanticipated real exchange rate movements (identical to relative price level changes) at the cost of assuming some inflation risk (on both sides of the deal). Cumulative inflation risk (inflation different from expectations as reflected in nominal short-maturity rates) tends to diminish when summed over long time horizons as the market’s errors even out. The extent of relative price level change over time (whether in the context of a monetary union or floating exchange rate system) can depend on the mobility of labour. In some examples, labour mobility adds to the potential size of relative price change. For example, suppose one country in the union is enjoying an investment boom. If the labour supply (in that country) is fixed, then rising real wages might soon erode the profit opportunities and so the marginal rate of return on new investment falls to the average level across the entire monetary union. By contrast, if labour inflows are highly elastic in response to real wage gains, the profit opportunities would persist for considerably longer – and the amount of cumulative capital inflow could be much larger (meaning a more substantial relative price level change). As a general point, the extent of relative price level change, and the consequential risks (for economic agents) are larger in the case of a small member of the monetary union than large. For changes in the underlying savings surplus position of a large country are reflected to a greater extent (than is the case for a small country) in the common interest rate level (for the union as a whole), meaning that less relative price change is required (than for a small country) in the process of restoring internal balance. The amount of cumulative real effective exchange rate change and the potential shifts in the underlying savings surplus (of deficit) for the monetary union as a whole are not obviously larger, when considered over long periods of time, than would be the case where sovereign monies still existed for each member country. By contrast, the size of notional real effective exchange rate change for each member country considered on its own (where this is defined to mean a shift in the domestic price level relative to the say trade-weighted average of those in foreign countries, including union and non-union) and swings in its underlying savings surplus (or deficit) are potentially enlarged.

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As illustration, suppose there is an autonomous rise in the underlying German savings surplus (due to some combination of rising household sector savings and of falling investment propensities – perhaps linked to the increased availability of cheap labour resources across the border into Eastern Europe). In the context of European Monetary Union, that increased level of German savings surplus means a downward pressure on the euro interest rate – greater than the downward pressure which would have borne on non-German interest rates within the boundaries of the present euro-area if each member nation still issued its sovereign independent money. Hence the German savings surplus remains at a higher level, and the deficits (surpluses) in the other euro-area countries at a higher (lower) level, than would be the case under the sovereign money alternative. As a corollary the real effective decline in the German price level relative to those abroad (including union and non-union countries) would be greater than the real effective exchange rate decline of the mark in the case of monetary union. But the overall level of the euroarea savings surplus and the average level of euro-area interest rates (equal to the euro-rate in the case of monetary union) might be little different in the two cases.

The German problem in EMU The hypothetical discussion of a rise in the underlying German savings surplus corresponds in some degree to the reality of the situation within European Monetary Union. Already at its formation, perhaps with the benefit of hindsight, the underlying German savings surplus was tending to increase. The construction boom which got under way following German political unification (1990) had already started to go into reverse (from the mid-1990s onwards) (see Figure 7.1). And growing concerns about the long-run solvency of public sector pension provision (meaning that present commitments would have to be scaled back) was tending to put upward pressure on the savings rate – especially given the bulge in the pre-retirement decade of workers in Germany’s rapidly ageing population. Into the early years of the next decade (2000–10) there were new downward influences on the business investment spending rate. These came from the growing perceived burdens (from the viewpoint of entrepreneurs) of Germany’s Rhenish capitalist model (high degree of worker protection, meaning inflexible labour markets) in a world where it had become much easier (by virtue of the information

188 What Drives Global Capital Flows? 15 savings 14

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technology revolution) to shift production abroad to locations where labour was cheaper and less protected. Several of these new locations were just across the frontier (in Central and Eastern Europe) and were particularly easy for German (as compared to say French) entrepreneurs to utilize. This comparative advantage of German entrepreneurs (in taking advantage of the integration of ex-communist countries into the EU) stemmed in part from geography and in part from longestablished commercial relationships. Simultaneously with the rise of the underlying German savings surplus was a tendency for savings deficits (surpluses) in other important parts of the euro-area to increase (decrease) due to the structural financial changes which accompanied European Monetary Union. In particular, the traditional high interest rate countries of the EU, where the old sovereign monies had been of low quality (subject to high inflation risks), found themselves with a new low rate international money (the euro) and financial market innovation simultaneously bounded ahead.

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It was hardly surprising that these countries (Spain, Italy, Portugal, Greece, Ireland) experienced a plunge in their savings surpluses or a widening of their savings (and current account) deficits as the household sector in particular took advantage of the new consumer borrowing or real estate mortgaging possibilities (see Figures 7.4 and 7.5). It could not be clear whether in aggregate the downward forces on aggregate savings in these countries matched in amount the upward forces in Germany – in which case the average neutral interest rate level across all member countries would have been unchanged. It was certain, however, that a substantial relative price level adjustment would have to take place (down in Germany, and up in Spain, Portugal etc.) (see Figures 7.2 and 7.3). The attitude of the ECB towards all this was to focus on the average price level for the whole of the euro-area and how this was evolving relative to target. ECB officials cited the example of the US, where the Federal Reserve monitors the inflation rate for the whole of the US and is not greatly concerned by the process of relative price adjustment between the regions or states. That nonchalant attitude (on the part of the ECB) was open to question. The extent of relative price adjustment

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190 What Drives Global Capital Flows? 135

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under way in the euro area at the start of the new union was surely beyond the normal experience within the US. The extent of political tolerance for the costs of relative price level adjustment might well be less in the group of sovereign states that made up European Monetary Union than in the United States of America, bound together in a federal political union with an extensive system of fiscal burdensharing between the states. Moreover there was no big theme behind relative price level adjustment in the US to which the Federal Reserve could pay attention. There were no forecasts of big relative price adjustment say between New York and California. In the case of the euro-area, a key issue was whether the ECB, in its formulation and conduct of policy, should take account in any way of the big projected relative price level movements within the union, particularly vis-à-vis Germany? The issue was in some respects blurred in the policy discussions. The blurring occurred in consequence of a tendency of policy-makers focussing on past measures of relative price levels (before the union was formed) and present measures (according to national income data) of savings surplus, rather than searching for appropriate new benchmarks (of relative prices) and for estimates

192 What Drives Global Capital Flows?

of the underlying savings surplus. In particular, econometricians working in the ECB or Bundesbank quoted data to show that with the price level adjustment which had occurred so far, Germany was now (2003) as competitive as before unification. But the question went unasked as to whether under present circumstances, and within the context of monetary union, Germany had to be much more competitive than in the past so as to generate an export surplus equal to its underlying savings surplus, which might now be much larger than in past periods (of surplus). The grounds for suspecting that the underlying surplus was indeed larger than in the past and than the actual realized surplus (whether taken from the national income data or as proxied by the current account in the balance of payments) included first, the creation of monetary union itself (which as we have seen means that interest rate differentials between the countries participating in union can no longer emerge and play a role in moderating savings imbalances). Second, the recessionary or near recessionary conditions in the German economy – explained in part by the rigidity of prices and wages and hence the slowness of relative price level adjustment to take place – went along with savings being depressed below their equilibrium level (as households to some extent would maintain their living standards by saving less than they would in a situation of normal prosperity). Despite ignoring these sophistications, the ECB was still aware of the substantial relative price level adjustment within the monetary union which most likely was under way and in line with equilibrium tendencies. Some monetary critics argued that the ECB should have used that knowledge to be somewhat more tolerant of near-term overshoots of its inflation target. The above-average rates of inflation in Spain, Portugal, Ireland, and Greece, which were adding to the euro-area wide CPI inflation rate, would come down of their own accord once the process of relative price level change within the union was complete. (The sources of downward pressure on inflation in those countries would include an eventual weakening net external demand which would stem from the erosion of price competitiveness. In addition real estate markets might cool down after their buoyancy in the early years of monetary union). The German rate of inflation would most likely not come under coincident upward pressure, given the extent of inflexibility of prices there (Germany) in a downward direction during the period of relative price adjustment and the large amount of slack which had developed. Once the process of relative price level adjust-

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ment was complete, there could be a long period during which the German price level would remain stable, even though the German economy had pulled out of its period of sub-par growth.

National socio-economic choice – is it suppressed by monetary union? One theme to emerge – not totally new – from the German experience in monetary union is whether individual countries can pursue their own distinctive socio-economic model. Is it possible for Germany to stick with its Rhenish capitalist model, reinforced at first in some respects by the SPD-Green government which came into power at end1998, and then gradually modified, in the new world of European Monetary Union? If we were to listen to the clamouring from the Bundesbank, the ECB, and the OECD secretariat, the obvious answer would be negative. There is no alternative (according to this chorus) in the context of union to discarding Rhenish capitalism. On closer examination, however, the “third way” does still exist as an option, even if the cost-benefit analysis in favour of or against its adoption or retention has been altered by the reality of monetary union. By “Rhenish capitalism” we mean a system of protection for labour against shock – most importantly redundancy or sudden changes in terms of employment. The system comes at a cost which bears on enterprises. That cost has most probably increased in recent years due to the information technology revolution. The harnessing of the new technology to goods and services production is easier to achieve where there is considerable flexibility in labour inputs. In principle, there is an equilibrium solution – in which Germany would be in full internal and external balance. The German wage level would have fallen to a level (relative to that abroad, on average) such that the increased cost of labour protection was largely shifted to employees, and the rate of return to capital (taking off the implicit cost to enterprises of complying with the Rhenish model) was the same in Germany as elsewhere in the union. In the case of Germany’s experience so far with European Monetary Union an impediment in the way of reaching such an equilibrium solution has been the inflexibility of nominal wages in a downward direction – meaning that the process of relative labour cost adjustment (to take account of the increased burden of the Rhenish capitalist model) has been painfully slow. In some respects, though, German labour has more scope to shift some of the cost of the Rhenish model to owners of capital throughout the

194 What Drives Global Capital Flows?

euro-area (instead of this being paid for fully by labour in Germany) than would be the case for labour in a small country in the euro-area. This greater scope stems from the fact that the neutral level of interest rate in the euro-area as a whole reflects investment opportunity and savings rates across all member countries and Germany is an important part of the (weighted) average. Hence the adoption or reinforcing of the Rhenish model in Germany would tend to depress the neutral rate of interest in the euro-area (and more broadly the marginal rate of return to capital in the euro-area). As long as the euro is freely floating against outside currencies, and there is a significant impediment in the form of exchange risk to global equalization of rates of return, it is possible for an equilibrium solution to emerge in which expected rates of return on euro assets are somewhat low (reflecting costs of the Rhenish model) by international comparison. As part of the process (of reaching the equilibrium outcome), real wages in the union countries not applying the Rhenish model would tend to rise somewhat (compared to those in Germany). That follows from an increased capital intensity of production there (relative to in Germany) as capital costs fell (in line with the neutral interest rate). In the long-run, growth of labour earnings could be retarded in Germany by a lowering in the rate of domestic investment (the corollary to greater net capital exports) and so eventually in the capital-output ratio – relative to the hypothetical level of these aggregates (domestic investment and capital-output ratio) if the Rhenish capitalist model had been discarded. (See Chapter 3, p. 86, for a related discussion of the (cheap labour” “neighbour next door problem.”). If Germany were not part of monetary union, but retained and even reinforced its Rhenish model, then the equilibrium solution would be characterized by interest rates (and marginal rates of return generally) in Germany falling to a lower level (than in the case of monetary union), real wages sustaining a higher level (at least in the early years before the depressing influence of a continuing lower-than-otherwise level of capital investment sets in) and net capital exports from Germany to the rest of the world running at a greater pace. German savings would be somewhat lower in response to lower rates of return, and the domestic rate of capital spending more sluggish (by a larger margin), than in the case of Germany belonging to monetary union. (We are comparing here full equilibrium outcomes). So far we have been considering the Rhenish model only in terms of the labour market regime (the extent of protection there against shock). There may also be other attributes, however, more generally

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associated with a “third way” socio-economic model, including fairly onerous taxation of capital compared to the low-tax regimes in other parts of the union or elsewhere. This would result in some increased momentum of capital flight as domestic investors sought to put an increased share of their portfolios in offshore centres and other low-tax jurisdictions (protected by effective bank secrecy or non-co-operation in tax matters). Under a floating currency regime (in which Germany would issue its own sovereign money, the Deutsche mark), the veering of taxation towards the “third way” would mean higher-than-otherwise interest rates (on marks) and a lower exchange rate (for the Deutsche mark against other currencies). The extent of the rise could be moderated, as we saw in Chapter 3 (p. 73), by foreign inflows of capital, if indeed foreign investors are exempted from the new higher tax regime. Another moderating influence would come from any tendency of German investors to buy Deutsche mark-denominated assets in the selected foreign centre (rather than foreign currency assets, including non-German equities). The higher rates (on Deutsche marks) would be consistent with a lowered rate of capital spending in Germany, increased net exports (of goods and services), and a larger overall savings surplus. (The latter would correspond to a fall in capital spending offset only in part by a possible decrease in savings – if indeed some households reacted to the increased taxation of income by reducing their propensity to save and if this influence were not wholly balanced by the influence of higher rates). In the new long-run equilibrium path the capital-output ratio in Germany would be increasingly below the alternative path which would have been followed without the socialist tax measures, meaning some depression in real wage growth. (In turn, if labour is mobile, that decrease in wage growth might give rise to net emigration, which in turn would arrest the fall of wages relative to abroad). How does that equilibrium outcome differ from what would occur under a currency union? Here there would be no rise in union interest rates unless for some reason the capital flight went to a large extent into assets denominated in foreign currencies. This would be unlikely, given the large range of assets available in the union currency. By contrast, in the case of Germany with its own sovereign money, the range of assets available offshore in the German currency (Deutsche mark) is smaller and so the incentive for the fleeing capital to move into foreign currency assets is correspondingly greater. The outflow of domestic (German) capital into union (euro) currency assets in foreign banks (outside Germany) would not have any

196 What Drives Global Capital Flows?

consequence for relative prices between Germany and the rest of the union, as there would be perfect round-tripping. With no exchange risk as impediment, foreign capital (from other countries in the union) would flow into Germany to offset any capital flight, all at the same level of interest rates (as prior to the increase in taxation). This would be on the assumption (in line with present prevailing practice) that foreign investors in Germany would not be subject to the higher tax regime (at least with respect to their placement in money and bond market instruments). And so a shift in tax regime – towards penal taxation, say, on wealth – should have little or no effect on exchange rates or the growth of real wages and the capital output ratio (in the German economy) through time. Before the creation of monetary union in Europe, tax flight did have an influence on the equilibrium solution for the affected country. An illustration comes from the brief socialist experience in France during 1981–3, ushered in by the election of Francois Mitterrand as President, and the victory in parliamentary elections of his socialist-communist coalition. Interest rates rose in France as the counterpart to a massive export of private capital. Domestic investment by French enterprises plummeted. Through a succession of devaluations the franc’s international value reached a new record level of cheapness in real terms (vis-à-vis foreign currencies). In Spring 1983 came the turn, when the Mitterrand Administration ditched socialism in favour of “Europe”. Mitterrand had been convinced by his advisers that even with a floating exchange rate for the French franc (if it had been pulled fully out of the European Monetary System), socialism was not possible in France alone (see Brown, 2004). Jacques Delors, his finance minister, announced that socialism in France could only be advanced as part of a European-wide movement. First there had to be economic and monetary integration. Then the European Union with France as an integral part could embrace the social market economy. In fact, Delors was wrong on both scores. France could have pursued the social market alternative on its own with a floating exchange rate regime (as we have discussed above for the case of Germany). If instead the choice were made to pursue European monetary integration first, and the end-goal were reached, France could still embrace socialism on its own, without other union members following suit. Delors would have had a point if he argued that unilateral socialism (but not Rhenish capitalism) would be less costly for France in the context of monetary union than under continued national monetary sovereignty. The basis of that hypothesis, as in the German example, is that capital flight

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would not push up interest rates and the capital-output ratio should continue along the same path, rather than falling. In consequence real wage growth should not suffer over the long run. In sum, the economic logic of monetary union points to considerable diversity being possible between socio-economic choices in the member countries. In monetary union capital flight from France would largely return in another form. Indeed, if the French socialist state were attractive to fellow Europeans, an increased pace of intra-European labour migration into France could pull in capital alongside. (Some transitory downward pressure on the real wage rate, in consequence of the increased foreign supply of labour, would bring some upward pressure on the rate of profit in French industry. And the extinguishing of currency risk within monetary union might in itself spur intra-union labour migration).

Real estate market speculation as driver of capital flow within union Germany rather than France provided the first testing ground for whether a unilateral lurch towards the “social market economic model” carries an extra or lesser price tag within the context of monetary union (rather than monetary sovereignty). The problem – as with any test of economic principle – is that much else has been occurring at the same time! Disappointing German economic performance in 2001–5 could be explained in large part by the very different condition of its real estate market and construction sector from elsewhere in the union (see Figure 7.6). Flat or declining real estate prices in Germany contrasted with a hot real estate market in France and even a possible bubble in the case of Spain and previously Holland. Indeed the divergence of real estate market behaviour across the euro-area has been one of the surprise features of experience with European monetary union to date, and certainly not discussed in clear terms by academic economists or economic commentators in the runup to its launch. Perhaps the assumption was that monetary union would bring a closer correlation of asset markets, including real estate markets, across intra-union political frontiers. That might indeed be the case in so far as divergences (across the European countries) in the basis of valuation (risk premium on real estate versus other assets, benchmark yields on bonds or equities) were the main factor behind previously observed (prior to union) differences in real estate market behaviour. For now, in the context of monetary union, there is no

198 What Drives Global Capital Flows? 300 280 260 France 240 Spain 220 Germany

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currency risk impediment to the arbitraging of real estate risk premiums. The bond yield benchmarks used in valuations are the same in each member country. And the relevant equity yield (to be used in assessing the level of the real estate market) is most probably that derived from a euro-area wide index (of stock) rather than a national index. In order to derive lessons from experience so far (of real estate market behaviour in the European Monetary Union) it is necessary to start by reviewing the process of price formation in residential real estate markets. There are two components to the expected rate of return on residential real estate. First there is the net rental return, which can be imputed (in the case of the owner occupier) or contracted (between owner and tenant) and second, expected capital gain. The net rental return should be calculated net of costs (these include maintenance costs, expressed as an annual equivalent of normally lumpy outgoings,

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and in the case of rental properties, agency costs). Expected capital gain should take account of an obsolescence rate for even well maintained properties. As an alternative formulation we can say that the present value of residential real estate is the discounted stream of present and future net rents, where the growth rate (of rents) takes account of the expected obsolescence rate. Let us say, as illustration, that the long-run expected rate of real capital gain in an economy growing at say 2% p.a. is around 0–1% p.a. (explained by some upward trend in real land prices even though building costs in real terms might be flat or even falling, taking account of technological progress in the construction sector). Obsolescence should not be underestimated as a factor in calculating expected capital gain. For example, many old properties are not suitable for the incorporation of air-conditioning, or are badly designed to incorporate other new technological features. Also tastes in design are likely to shift. And suppose the total expected return, to be consistent with expected returns on other asset classes (in particular a total real rate of return on equities of say, 6% p.a.), would have to be around 5% p.a. Then the net imputed rental yield would be approximately around 4.5% (allowing for the 0.5% p.a. contribution from capital gain). The heterogeneous tax position of different categories of real estate owner adds some complexity to the price formation process. Owneroccupiers usually enjoy tax-free imputed rent, but they typically pay large taxes on the purchase of their home. Even if that tax is spread over the average holding period (say seven years), the net annual imputed rent would be reduced by a significant amount (say, 10% in the case of the UK). Investor-owners pay a similar purchase tax to owner-occupiers (albeit that they might be able to spread it over a much longer holding period in that their ownership is not tied to individual work or life cycles) but in addition they pay tax on the rental income (net of property maintenance costs). The investor-owner could nonetheless enjoy a similar overall rate of return to the owner-occupier if rents in the contract market are substantially higher than the imputed rental levels in the owner-occupier market. Alternatively it could be that the total expected rate of return in the owner-occupier market is somewhat elevated to compensate most households (owneroccupiers) for the poor diversification of their portfolios once they include their home. Institutional investors holding residential real estate to let would normally be able to achieve a superior level of diversification in their portfolios and might therefore be ready to accept a lower level of overall yield (than the owner occupier).

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In any case the imputed rental levels and contract rent markets cannot be fully arbitraged. Households, in deciding whether to rent or buy the space which they occupy, consider first of all whether to put favourably taxed real estate into their portfolio at the expense of other assets (some of which, for example holdings in the black or grey areas of the global economy, might also enjoy a specially low or zero rate of taxation). Then they assess as consumer whether the rent which they would pay in a lease contract would be less or greater than their estimate of imputed rent. If greater, they may nonetheless take the option of contract renting if their expected period of occupation is short (meaning purchase tax weighs heavily on the arithmetic). A particularly strong aversion to real estate risk (perhaps because their portfolio would become very undiversified and indeed highly leveraged), or pessimism on real estate market prospects would be reflected in a high estimate of imputed rent. By the same token, some potential investorowners might be ready to hold real estate and collect rent, even with contract rents at or below imputed rents, because they have a particularly optimistic view about prospective rental (or equivalently capital value) growth. One symptom of an overheated residential real estate market is a large overhang of space in the rental market due to the supply from investor-buyers having very optimistic views about growth and overestimating imputed rents (held down by expectations of capital gain). The fall in contract rents encourages some households who would normally be owner-occupiers to switch into the rental sector, perhaps because they can find such a good deal, perhaps because they are wary of a bubble. There are practical problems in applying the above framework of analysis to real estate market values. We cannot observe imputed rents. There is no accepted benchmark for normal risk premium in the real estate sector (how much more should the normal total expected rate of return on real estate be than on indexed government bonds, and how much less than on equities?). It is difficult or impossible to obtain consensus views on rental (or capital) growth, unlike for the equity markets where the investor can turn to surveys of expectations for corporate earnings growth and relate these in the long run to views on profits share in GDP and the growth of GDP. As illustration of the problem consider the situation in the overheated central London residential real estate market of 2003–4. Net rental yields for investor-owners of prime property were said to be 2%, compared to say 5–6% in the mid and late 1990s. It is surely likely that general expectation of real (inflation-adjusted) rental or capital growth

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had moved above the normal say 1% p.a. It is also possible that investors (home-owners) in their collective wisdom had decided that real estate should be moved into a lower risk class relative to equities (having just experienced the bubble-and-burst of 1999–2001). All of this would suggest that imputed rental yields had also moved down albeit most probably by a smaller amount. As illustration, mainstream estimates of imputed rental yields might have fallen to 2.5% (from the normal 4.5%) and capital growth estimates risen to 2%, meaning that total expected returns in residential real estate (to the owner occupier) were now down to 4.5% (from the normal 5.5%). Would such a fall in expected yields (and total rate of returns) in the real estate sector of one country in a monetary union trigger a greater flow of capital towards less heated sectors in other countries of the union than if each country had its own sovereign money? As a first point it should be noted that risk-arbitrage between residential real estate markets in different countries is the preserve of a small number of large international institutional investors or a few footloose wealthy households. There may also be some direct contagion effects – illustrated by French investors becoming persuaded by prevailing practice in the UK or US to insert a lower risk premium than previously into their valuation arithmetic. It is implausible that such contagion effects should be stronger within a monetary union than between the union and the outside world. In particular, French investors in real estate are surely not likely to adopt valuation arithmetic used in Madrid or Amsterdam without regard to what occurs in London or New York. In principle a fall in expected total rates of return to real estate investment in one part of the union would trigger some capital flow into higher yielding alternatives within the union. Such flows are likely to be stronger in the case of commercial than residential real estate, given the wider span of potential arbitragers (which would include multinational companies deciding where to locate industrial plant or offices). Real estate transactions are inherently long-term in nature, and so over the likely horizon of the investor relative price level risk (between union countries) could be an impediment to arbitrage, even though exchange risk or relative price level risk over short periods is now zero or much less (in the case of relative prices) than under a floating regime. The Spanish investor (whose own local market might appear to be overheated), for example, in looking at the depressed German real estate market, has to reckon that when eventually a recovery phase sets

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in there, the German price level might still be falling relative to that in Spain. And how can he be so sure that the expected total rate of return obtainable in the German real estate market is indeed now higher than in Spain? The low rental yields in Spain might be symptomatic of high growth expectations, and so the total rate of return likely still larger in Spain than Germany. In the actual experience so far of European Monetary Union there is little evidence if any of arbitrage capital flows between overheated real estate markets (whether in Holland or Spain or even France) into cooler or even recessionary real estate markets, as in Germany. Indeed, the direction of flow has been in the opposite direction – Germans buying second homes in Spain! The fact that the German real estate market failed to attract capital inflows could be explained by contemporary pessimism about the economic outlook (in Germany) and the extent of previous over-building. Higher net rental yields obtainable on German real estate evidently did not translate into higher overall expected rates of return, but reflected expectations of zero or negative capital gains. Divergent real estate market conditions across the monetary union apparently did not reflect valuation differences that could be arbitraged away but fundamental economic factors. The divergence of real estate market conditions has been a factor driving broadly defined capital flows within the European Monetary Union, even though not between the real estate sectors. Booming residential real estate markets tend to go along with downward pressure on the national savings surplus whilst weak residential real estate markets have the opposite influence. As illustration, the hot Spanish real estate has been widely seen as one force pushing Spain’s savings deficit to new peaks (an estimated 9–10% of GDP in 2006–7). The boom of the Dutch real estate market in the late 1990s and early 2000s caused that country’s traditional savings surplus to shrink. There were the corresponding large relative price level movements – with the price level in the countries with the booming real estate markets and falling savings surpluses rising relative to elsewhere. The relation between real estate market conditions and savings surpluses or deficits is not, however, as strong theoretically as it might have seemed in practice. Moreover, there has been a tendency amongst commentators to use labels such as overheated or bubble-like, without convincing foundation, for describing real estate market conditions. There are two broadly used definitions of a bubble which do not always overlap. The first is the economist definition. According to this a bubble exists when the price level in a given market reflects a near

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100% certainty being given to one highly optimistic scenario (relevant to the particular asset or commodity) about the future, when in normal rational mode a probability of much less than 100% would be attached. Apply the economists’ definition of bubble to the residential real estate market that would describe a situation where prices were determined on the basis of a highly optimistic scenario for rental growth having almost 100% likelihood of becoming reality. That situation cannot be demonstrated without question even in London’s experience, as we have seen above. The second definition (of bubble) stems from behavioural theorists (see Schiller, 2000). The trend is creating the trend. Investors expect to see large capital gains and rental growth in the near and long-term future just these have been realized in the recent past. Such behaviour is of course inconsistent with rational expectations, and the problem for behavioural psychologists and economists is to provide sufficient evidence in favour of their hypothesis. In any case, let us assume provisionally that periods of overheating or speculative excess, even bubbles, do occasionally characterize real estate market conditions (see McCarthy and Peach, 2004, for a general discussion of real estate bubbles). What are the links between this and the overall savings surplus of the economy? The usually cited connexions are credit market effects (rising home values allow households to borrow more against their total wealth including human capital, given that real estate is readily usable as collateral) and wealth effects (the rise in wealth relative to income means that households can save less out of current income – and spend correspondingly more – and still achieve their given eventual wealth target). The second channel (wealth effects) is perhaps more questionable than the first (credit effects), as owner occupiers are also payers of rent (to themselves). A rise in residential real estate values due to a fall in the risk premium (used in the valuation arithmetic) would add to wealth unambiguously. If, however, the rise in real estate values is related to an upward revision of expectations regarding future rent levels, then many households would suffer an offsetting loss as longtime consumers of space. In broad terms, owner-occupiers who intended soon to slim down their present space requirements (or move them to a cheaper location) would be unambiguously better off. But those who would maintain their space requirements unchanged for a long time, or even add to them, might even lose out (in terms of overall economic welfare).

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Population ageing and relative price change The high and rising German savings surplus and the associated adjustment problems within EMU have also been related by commentators to the question of population ageing (see Bloom and Canning, 2004). It is possible that the growing concerns about pension provision – whether the public sector can keep to its present scale of payouts in the face of a big rise in the share of the postretirement population over coming decades – have been an upward influence on the German household sector savings rate. Those still in the labour force and working could be raising their savings rates to make more provision for old age, and this tendency could be more than offsetting the downward influence on the aggregate savings rate from the rising number of retired households (the retired population is overall a net dissaver). In Italy and Japan – the two other G-7 economies where ageing is occurring on a similar but more severe profile to in Germany (immigration provides the greatest relief to the ageing trend in the German case) – the consensus economic view is that dissaving by the retired population is more than offsetting additional saving by the working population. Any view about Italian trends, however, is highly tentative, given the extent of other simultaneous changes, especially the transition to the low interest rate environment of the euro from the high-interest rates of the lira. There are some general principles that can be stated for the relationship between population ageing and net capital flows, albeit that how these are applied in any particular example can lead to differing results as above (see Bryant, 2004). The hypothetical conclusions can be seen to depend in part on the nature of the currency regime in place – whether floating rates for sovereign currencies or a monetary union. For example take the often quoted case of Japan, which faces the most acute pattern of ageing (rise in the share of the postretirement population) in the next two decades. It is possible that depletion of savings by the old will be less than expected, and retirement-related saving by the working population more than expected. In any case, Japanese data on household savings has been distorted by a growing surplus in the financial corporate sector – which in other countries would be attributed to the household sector. Moreover, household and corporate sector saving have to be considered together. Some of the fall in household savings recorded in recent years in Japan could well have been due most of all to the

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increase in corporate wealth, matching large-scale debt repayment out of retained profits (see Chapter 8, p. 229). Even staying with the hypothesis of Japanese household sector savings, correctly measured, falling under demographic influence, the question is whether that fall would be more or less than the decline of the investment rate (also under demographic influence). A declining population of working age would go along with a slower growth in the capital stock (as there are fewer work-places which have to be equipped with capital). So it is possible for the underlying savings surplus to increase or decrease depending on whether the investment rate (investment spending as a share of GDP) falls by more or less than the savings rate. A more complete analysis would include trends in non-business investment – in particular public and residential investment. Here the demographic influence, however, is less obviously in one direction or another (than is the case for business investment). If we take the case of a rising savings surplus, that would tend to put downward pressure on the neutral level of interest rates in Japan, mean a higher momentum of capital exports, and an increased capital intensity (capital-output ratio rising) in the Japanese economy (which would be reflected in turn in enhanced labour productivity and real wages). By contrast in the case of a falling savings surplus, there would be upward pressure on the neutral level of interest rates in Japan, a decreased momentum of capital exports, and a decreased capital intensity (meaning slower productivity growth and a lower-than-otherwise path of real wage growth). These conclusions about demographic influences depend on the neutral rate of interest in Japan moving significantly in one direction or another relative to the neutral rate (on average) in the world outside. Within the context of a monetary union, the cost of capital is the same throughout all the member countries (subject to the qualification made earlier for the situation where there are strong expectations of a long-run trend change in relative price levels) – irrespective of whether a particular country is in a special situation with respect to population ageing. Suppose demographic influences are indeed imparting an upward influence on the overall German savings surplus. Then there would be some downward pressure on the euro-area neutral rate, but less (as the influence of higher German savings would be diluted throughout the monetary union) than what there would have been on the German neutral rate if the Deutsche mark had still existed. A bigger

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part of the adjustment to the rising German savings surplus would come through relative price change (a decline in the German price level relative to that elsewhere on average in the monetary union). Productivity and real wage gains in Germany induced by ageing would be less under the regime of monetary union than under a sovereign Deutsche mark. (There would be some spill-over, however, of real wage and productivity gains to other members of monetary union as a corollary to the lowering of the euro-area wide cost of capital or equivalently neutral rate level). In any overall consideration of demographics and capital flows, the question of immigration is important. In the analysis presented so far, immigration is a given amount – determined presumably by quota, and not affected by the choice of currency regime (monetary union or independent sovereign monies). In principle labour migration can be incorporated into the analysis. In the Japanese illustration, if indeed the demographic influences are bolstering the saving surplus and so real wage growth – then there would likely be increased political demands (from business leaders) for restrictions on immigration to be eased. The rationale for these calls would be to ease upward pressure on wage costs and downward pressure on profitability. By contrast if the demographic influence were to decrease the savings surplus – then the political pressure to ease immigration restrictions would be less. In the case of Germany, there is a virtually unrestricted inflow of labour from other EU countries (subject to transitional limitations in the case of new EU entrants in 2004). In so far as the rising savings surplus puts upward pressure on wage levels and downward pressure on profit margins that would induce increased inward flow of labour (from other EU countries). As we have seen however, the fact of monetary union reduces those pressures (in that there is a greater tendency for an emerging savings surplus to seep out as capital exports). And so the German savings surplus could induce less immigration in the case of monetary union than in that of an independently floating Deutsche mark. Further, under either currency regime, whether the inflow of labour would add to or subtract from the underlying savings surplus is ambiguous. The investment rate would rise as enterprises tooled up the new additions to the labour force. The new immigrants, however, might themselves be intensive savers. Changes in the profits rate and cost of capital are only one element in the combination of economic forces affecting immigration into the rapidly ageing society. Another element is the price of land. A downward trend in the working population would most likely go along with

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falling rents on many types of commercial real estate – whether warehouses or offices. Some long-term fixed business capital in the form of machinery or other installations would become underutilized. The marginal cost of bringing them back into operation would be small. In so far as there were rational pricing in the public sector, charges (to the public) for under-subscribed schools and universities would be cut (perhaps in a tailored fashion, taking account of price-discrimination possibilities between different categories of student) and congestion taxes would fall. The fall in rents and charges as described would provide incentive for greater immigration.

Energy bonanza – Alberta, Canada, Holland and UK compared The influence of demographic trends on capital flows – whether within the context of monetary union or more broadly – is inherently slow. It is quite different with respect to energy bonanza. Here an economy experiences a big new gain in comparative advantage in the form of discovered energy resources or previously known energy resources which now become highly profitable to exploit due to an upward jump in energy prices. A recent example of energy bonanza in the context of a floating exchange rate is Canada, where vast tar-sand deposits in Northern Alberta became commercially viable as the oil price spiralled higher in the years 2003–2005. Some analysts project that non-conventional energy output in Canada could reach as much as 5–10 million barrels per day (bpd) over the next 20 years. That compares to stable conventional oil output of around 1.25 million bpd. In fact, the case of non-conventional energy production in the Canadian province of Alberta incorporates some aspects of both a monetary union and floating currency case. Alberta belongs to the federal political union and monetary union called Canada. But the Canadian dollar is itself floating against other currencies. It is that latter aspect on which we concentrate first, rather than looking at relative price level adjustment between the province of Alberta and the other Canadian provinces. Let us take the scenario of another 3.5mbpd of tar-sand oil output at $60 per barrel coming on-stream within 10 years. That translates into around US$70bn of extra energy exports, or around 10% of Canadian GDP. This is not all a bonanza. The cost of extracting nonconventional energy in this form is very high, $40 per barrel, according to some estimates. The actual bonanza (pure rent element) might,

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as illustration, amount to around 22% of present GDP. The rest is an investment opportunity with normal returns. The fact that this new investment opportunity is in Canada in itself means a big swing of its savings balance over the medium-run from surplus (as in the early mid 2000s) to large deficit – though this (swing) may be offset in some degree by increased savings out of the rental element of the energy bonanza. (Canadians would save some share of their increased wealth corresponding to the discounted value of future rents). The fact that the investment opportunity has emerged in the traded goods sector of the Canadian economy could mean that its currency comes under long-run pressure upwards on account of the socalled Balassa effect (see Chapter 3, p. 80). (This describes the long-run shift upwards in the national price level relative to foreign price levels necessary to maintain economic balance in a situation of much more rapid productivity growth in the traded than non-traded sector). The extent of the Balassa effect in the Canadian case would depend on the import-intensity of the extraction process of oil from the tar-sands. If the process is very import intensive – then there would be less of a Balassa effect. In total, what can we say about the influence of the Alberta oil bonanza on the equilibrium level of the Canadian real exchange rate and Canadian interest rates? In itself, the flourishing of investment opportunity, substantial relative to the size of the Canadian economy, puts upward pressure on the neutral interest rate. This (pressure) could be offset by increased savings out of enhanced wealth and by speculative inflows of capital. (Anticipations of a long-run real exchange rate appreciation in line with the Balassa effect could be reflected in an immediate up-front jump of the Canadian dollar, itself putting downward pressure on the neutral rate level – see p. 82). It is not possible in principle to say whether the balance of forces described would amount to net upward pressure on the neutral rate. In any case the extent of any net upward shift in the neutral rate would itself be tempered by a corresponding gain in momentum of foreign capital inflows. That gain in momentum would depend on the degree of risk aversion towards the Canadian currency on the part of foreign investors. As regards the Canadian currency, the influence of all the factors considered is almost certainly upwards – with some dampening influences coming from an increased propensity to save out of increased oil wealth, from very long-run expectations of a bulging deficit on Canada’s investment income account as dividends and interest payments are made to the foreign investors who financed the

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energy extraction, and from expectations of eventually a diminishing inflow of capital (the extraction process would presumably involve heavy up-front capital spending). In fact we could project a profile for the equilibrium real exchange rate which is at first sharply higher and then tends to fall as the savings deficit decreases in the very long run. Indeed eventually (as capital spending winds down and rental income reaches peak levels) the savings balance would move into large surplus. At that stage, the neutral interest rate in Canada could fall relative to that abroad. How different would these conclusions be if Canada were in a monetary union with the US? The scope for the neutral interest rate level (in real terms) to rise in Canada would be less – but it is not clear how much of a rise would occur under the floating currency regime in any case. All of any real exchange rate appreciation would have to come through a rise in the Canadian price level relative to the US price level. The total real exchange rate change might indeed be greater in the case of monetary union than under a floating currency regime. That would be so if indeed the (real) neutral rate level would rise in the floating currency case (as against remaining unchanged under monetary union), meaning that less of the adjustment to the energy bonanza would have to be borne by the real exchange rate. In the eventual payback period, when Canada moves into large savings surplus, the real exchange rate decline would be more under monetary union if similarly the real neutral rate level would shift downwards in the floating case (but would remain constant under monetary union). It is the hypothetical experience of Canada within a North American Monetary Union (with the US) which is partly relevant to the direction of change for Alberta’s price level relative to the price level in Canada’s other provinces. The extent of upward relative price movement in Alberta’s case, however, may be very modest. Much, indeed most, of the equipment and labour resources to extract the oil from tar sands has to be imported from other Canadian provinces, the US, or elsewhere. Hence the Albertan underlying savings and current account deficits might increase pretty well in line with each other, without much requirement for neutral interest rate or relative price level changes. Most of the increased spending by Albertans out of their energy bonanza is likely to be directed towards imports from other Canadian provinces or from the rest of the world rather than from within Alberta. Overall the Balassa effect in the case of Alberta (upward pressure on its price level relative to elsewhere in Canada) might indeed be small. Moreover, the rental element from the energy

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extraction has to be shared to some degree with the other Canadian provinces. Canada’s experience with energy bonanza is but the latest of a historical record. Previous examples amongst the advanced economies have included the UK, the Netherlands and Norway. The UK stands out as having achieved the various stages of adjustment (to energy bonanza) under a floating exchange regime. The Netherlands operated for most of the time under a fixed exchange rate regime (vis-à-vis Germany and later within the European Monetary System). Norway has been under a controlled floating regime with its government pursuing a vast capital export policy – a public pension fund which allocates a share of the oil revenues to foreign assets. In the UK’s case, the currency rose powerfully during the second oil shock (1978–9) and beyond into the early years of rapidly rising output. But as in so many other real world examples of economic phenomena, many other changes were going on at the same time (a huge monetary squeeze from 1980–1, the Thatcher economic revolution, the abolition of exchange restrictions). In the case of the Netherlands, there was an unmistakable tendency for Dutch costs and price level to rise relative to that in Germany (and other countries in the ERM) during the first two energy shocks (1973–80) – explained by the huge indigenous production of natural gas (whose price was closely indexed to the oil price). The tendency of rising costs to erode competitiveness of traditional exports from Holland came to be described as the “Dutch disease”. The extent of relative price adjustment between Holland and Germany was less than the huge swings in the floating pound. And the inflation experience of the UK was worse than that of the Netherlands. Those two facts on their own do not in themselves support the hypothesis that energy bonanza can be more smoothly accommodated within a monetary union or fixed exchange rate system than a floating currency regime. There were so many important other developments occurring alongside.

Divorce of monetary union In principle energy shock combined with the new potential in one country of a monetary union to produce huge amounts of natural gas or oil at sky-high prices could threaten the survival of a monetary union. The given country might see so much inflation danger from remaining inside (a big rise in its price level relative to that outside), that it would opt to restore its independent sovereign money. Such a

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course of action might well be politically popular if the electorate becomes fully aware that a significant share of their monetary savings and pension entitlements could be wiped out within the context of a monetary union. In practice, according to the present state of geological knowledge, there is not much chance of such an energy-induced shock to European Monetary Union (EMU). Much more discussed, as a possible scenario, is a forced withdrawal of Italy. If this scenario were to move into the centre of the screen of probabilistic vision, what would be the influence on capital flows within EMU and between the euro-area and the outside world? Towards answering this question, it is necessary first to hypothesize how an Italian withdrawal from EMU would take place. General scenarios for shrinkage or total break-up of EMU have already been sketched in Brown (2004), but a more precise version can be sketched for the case of an Italian separation. There are two main possible triggers to an Italian withdrawal. The first is the spectre of default on the public debt, already projected by some estimates in 2005 to reach 110% of GDP by end-2007, with the budget deficit in 2006 at 5% of GDP. The second is electoral revulsion against the economic costs of a long period of price decline (in Italy). This decline might be necessary towards establishing a new relative price relationship between Italy and the rest of the euro-area which would be in line with full equilibrium, taking account of the growing competition faced by the Italian export sector in its traditional areas of comparative advantage from low cost suppliers in Asian developing countries (see Ciocca, 2004). Corresponding to these two main triggers are the scenarios of forced withdrawal (debt crisis) and voluntary withdrawal (deflation). A forced withdrawal is where the Italian government has no choice but to make an immediate exit from EMU – or else the banking system would collapse. This could be the situation if Italian government debt prices spiral downwards (in a default crisis) and in turn funds flee Italian banks (given their huge holdings of Italian government bonds). The only way out would be for the government of Italy to re-gain control of the money-printing press – albeit with the inevitable consequence of emitting inflation shock. A voluntary withdrawal is where an economic policy debate takes place about the benefits and costs to the Italian economy of exiting from EMU and an action program is decided upon. In principle, voluntary withdrawal could take a slow staged form or a sudden form. In practice when the rationale for withdrawal is to bring down sharply the relative price

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level in Italy (compared to the rest of the euro-area), meaning that it is totally clear that the reincarnated sovereign money will start off at a much cheaper level than the euro, only a sudden form withdrawal is possible – similar in mechanical form to what takes place under the forced exit. Indeed what begins as a process of voluntary withdrawal could turn into a forced withdrawal – if speculative outflows of capital threaten to engulf the national banking system in bankruptcy. The mechanics of a sudden withdrawal, whether voluntary or forced, would be as follows. The Italian government would freeze euro deposits held by Italian banks with the Italian central bank (Banca d’Italia) – except for that part which represents reserves against nonresident euro deposits with Italian banks. Italian banks could no longer transfer resident euro deposits (now called “Italian euros”) on a 1:1 basis into euro deposits outside Italy or non-resident euro deposits in Italy. The 1:1 convertibility of euro banknotes into resident euro deposits (“Italian euros”) or conversely (deposits into banknotes) would be suspended. Italian euros could be used freely to fulfil eurodenominated contracts between Italian residents (for example, invoices for goods and services, wage agreements) and to repay euro loans by Italian banks to Italian residents. There would be a new category of euro deposits, termed “free”, which Italian residents could open. Funds from these could be transferred on a 1:1 basis into non-resident euro deposits and foreign euro deposits (outside Italy). Euro banknotes would remain convertible on a 1:1 basis against free euro deposits (but not Italian euro deposits). An exchange market could start up between Italian euros and free or foreign euros. In this case of Italian euros opening at a much depreciated level against free and foreign euros, euro banknotes would go to an immediate premium against Italian euros, only available so far in the form of bank deposits (no banknotes). The premium would be determined by the exchange rate between Italian and free or foreign euros. Italian residents in obtaining cash (still euros) from automatic teller machines would be levied extra charges based on the rate of premium. In the retail economy, dual pricing would occur – one price for payment by check or card and a lower price for payment by cash. Eventually the Italian euro deposits would be re-denominated as Italian lira deposits and euro loans by Italian banks to Italian residents as lira loans. (Free and foreign euro deposits would become again simply euro deposits). Newly printed lira banknotes would be obtainable on a 1:1 basis against the lira deposits. Italian residents would freely determine when to dispose of their euro banknote holdings and acquire lira banknotes.

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As this process got underway, central banks in the euro-system would find themselves with a flotsam of euro notes and this would have to be dealt with under a seigniorage agreement between Italy and the other countries still in EMU (otherwise Italy would have reaped a fiscal advantage at the cost of the others). In general terms, the switch to the new currency (liras) would occur largely by decrees, but these would not apply to non-residents of Italy. Thus bank deposits and other debts outstanding to non-residents in euros would not in general be subject to forced conversion. (The rationale for this exemption would be to prevent a wholesale withdrawal of foreign business from the Italian banking system during the inevitable period of uncertainty preceding the decrees. Up front there would be a commitment that whatever happened foreign deposits and loans would not be affected). Italian government bonds, however, and other bonds issued in the Italian domestic market, would be payable in Italian euros and later liras, even if held by non-residents. Exit by sudden decree would create windfall losses or gains most particularly for Italian financial intermediaries. Italian resident deposits in euros with Italian banks and Italian bank loans (in euros) to Italian residents would not have been in balance except by chance at the time of exiting EMU. If deposits are well below loans and the Italian euro falls immediately against the euro, then the banks would experience net loss. There is also the question of interest rate exposure. Long-term interest rates might jump immediately on Italian euros and inflict loss on banks’ holdings of long-maturity loans at fixed interest rates. The loss would be diminished by the presence of longmaturity fixed-rate liabilities also transformed into Italian liras (for example Italian bank bonds or long-term deposits/savings plans outstanding). Some prior interest rate hedges, however, would be ineffective. For example, euro interest rate swaps entered into originally to protect profits against unexpected euro rate rises would not be helpful in the case of a change in monetary regime, on the assumption that the decrees did not include a re-denomination of swap contracts. As part of the exit plan, the Italian government would compensate Italian financial intermediaries for windfall losses in excess of a stipulated percentage of capital. There might also be a windfall profits tax on more fortunate institutions. (There could not be 100% compensation, as this would set up moral hazard, meaning that Italian institutions would take no prudential steps to minimize their exposure to loss from a change in monetary regime). It is likely that the financial intermediaries would also have suffered some loss in the inevitable period

214 What Drives Global Capital Flows?

of speculation ahead of the exit from EMU. At that time, Italian banks would have scrambled to retain Italian resident euro deposits fleeing for safety into foreign euro accounts (where they could not be forcibly transformed into Italian euros). The premium interest rate that the Italian banks would have then offered might have been offset only in part by loan rate surcharges passable on to some Italian borrowers. Indeed, rising losses for the banks during periods of speculation on exit might force an emergency withdrawal, which in principle could be reversed later if indeed the democratic process brought a decision in favour of continued Italian membership in EMU. In practice, reversal would depend on the goodwill of Italy’s EMU partners. At best they would accept Italy back as a full EMU member almost immediately with Italian liras re-converted into ordinary euros at a 1:1 rate. In sum, within monetary union large hot money flows are indeed possible if its future ever came into serious doubt. In the example given, and in particular given the announced exemption of nonresident deposits from compulsory re-denomination, there would be huge round-tripping. Resident deposits would flee Italy and be replaced by non-resident deposits, probably largely from the international interbank market. The pressure of speculation on a change of monetary regime would be evident in a spread between interest rates of resident Italian euro-business and in the global euro markets (outside Italy). The growing un-hedged position of the Italian banking system to risk of regime change (from EMU back to a sovereign lira) and rising interest rates on domestic lira loans (putting Italian corporations at a competitive disadvantage so long as the feared change in regime did not take place) would be one factor tending to accelerate the decision of whether or not to stay in EMU. So far, despite much talk in the marketplace and in market-commentaries about a possible eventual Italian withdrawal from EMU, neither phenomenon – a flight of domestic deposits and the emergence of a risk premium on Italian rates – has become evident.

8 Currency Speculation

Capital flows between countries or areas with independent monies occur in the context of exchange risk. A key issue in the study of global capital flows is how rational investors (and borrowers) deal with such risk. Currency risk is not always a source of friction (or in economics jargon, disutility). In some cases investors can gain protection against specific bad “states of the world” by deliberately assuming currency risks. An illustration is the once renowned role of the Swiss franc as safe haven – rising at times of global financial distress or raised international tension. In other cases, investors can expect to bolster their returns considerably by increasing their exchange risk exposure even without possessing the proverbial crystal ball. Borrowers might similarly expect to reduce their financing costs (by assuming currency risk). Finally there are a range of players who believe that for some reason they possess special insight which will enable them to make profits at the expense of less skilful players in the game of currency speculation (or at the expense of non-players who have embraced a so-called passive strategy, discussed below). Players in the game deliberately assume exchange risk beyond what could be justified on the basis of normal balancing of risk and return where there is no special knowledge or skill (including market intuition) on the part of the investor or borrower. As illustration take the situation at end-2005. Looking at the 5-year swap rates in various currencies – 5.1% in US dollars, 0.9% in Japanese yen, 3.1% in euros, and 2.2% in Swiss francs – these could be translated into real rates (subtracting expected core inflation in each respective country or currency area) of around 3.3%, 0.8%, 1.6%, and 1.4% p.a. respectively. The investor or borrower, on the basis of generally available knowledge, could determine that none of the given currencies were far away from 215

130

Euro real effective exchange rate 150 EURO real effective exchange rate

120

US dollar real effective exchange rate

140

130 110 120 100 110 90

100

80

90 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

Yen real effective exchange rate 120

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

Swiss Franc real effective exchange rate 120

110 110

100 90

100

80 70

90 60 50

80 Swiss franc real effective exchange rate

40 Yen real effective exchange rate 30

70 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

Figure 8.1 Real effective exchange rates – US$, euro, yen and Swiss franc, 1971–2005

216

USD real effective exchange rate

Currency Speculation 217

their long-run average level of the previous 20 years in real effective exchange rate terms (see Figure 8.1). It would also be reasonable to assume that the US dollar had somewhat greater likelihood of moving down than up over the long run (in real effective exchange rate terms). This asymmetry was related to the substantial probability that the underlying huge US savings deficit would tend to diminish (through endogenous influences emanating from within the US economy), most likely bringing downward pressure on US neutral interest rates relative to those abroad. But allowing for a part of that depreciation in real terms of the dollar to take place via high inflation in some dollar-zone emerging market-economies (especially in East and South-East Asia), it could be that the trend real depreciation of the dollar versus the yen and euro would be very gradual (say, no more than 1% p.a. on average). That would leave a significant real income advantage (cumulated over five years) in favour of holding US dollars compared to yen, and an only slightly smaller advantage compared to euros and Swiss francs. Risk over a 5-year period is much less in annualized terms than over short periods given the tendency of white noise around the trend to diminish as an influence on performance the further ahead is the horizon date. Hence investors worldwide at end-2005 would hold a larger proportion of dollars in their portfolio and a lower proportion of yen, euros, and francs than in earlier periods (for example 2002) when there had been a much smaller (if any) real income advantage (in the dollar’s favour) and when the dollar had been considerably higher in real effective exchange rate terms. Precision in strategy formulation (what share to award the dollar for example in the overall portfolio) is not possible given the lack of an objective probability distribution of possible exchange rate changes over the next 5-year period. But purchasing power parity (the hypothesis that real effective exchange rate movements are constrained by arbitrage in goods and services trade), diminishing white noise over time, and the concept of some tendency for reversion towards the mean (overshoots to be corrected) , form the foundations, albeit fragile, to the building of portfolio strategy (whether as borrower or lender). In a world of constant rate of return differences between currencies (adjusted for expected exchange rate change) and unchanging risk parameters, there would be little occasion for the passive investor or borrower to review the neutral weights used in portfolio composition. (Passive means unguided by any strong view on market prices – spot or forward – being out of line with those which would hold in a general

218 What Drives Global Capital Flows?

equilibrium solution). Once, however, we introduce the real world assumptions that rate of return differentials between currencies, adjusted for expected exchange rate change, vary through time, and that these (differentials) are apparent even to investors or borrowers without special knowledge, then so-called passive portfolio strategy should be reviewed on a continuous basis. This has nothing to do with the end-of-year bonus for the biggest currency trading profit, or coming top of the survey of foreign exchange rate forecasters, but judiciously altering portfolio weights (for the different currencies) so as to better balance risk and return over the long-run. An analogy can be drawn from equity market portfolio balancing. Once we drop the convenient assumption made by some researchers in the early years of modern portfolio theory that expected rates of return (on equities and on so-called riskless assets) are constant through time and that the various probability distributions (of possible returns in each period) are stationary, then the efficient passive investor should reappraise continually the portfolio weights for equities versus bonds. (In the context of equity markets, the passive investor is not trying to out-guess the market as to where its level will be at given date or in a given time period in the future). The investor should seek to estimate where the equity risk premium now lies (the spread of the expected return on the market portfolio over the riskless rate of return) and the extent of risk. The estimation of risk premium is superficially easier in the case of equity markets than currencies, in that there is a direct comparison possible between earnings yields and the riskless rate (usually taken as the yield on inflation indexed government bonds). That comparison, however, is misleading in its simplicity. Only in a special – albeit useful – benchmark situation does earnings yield (estimated on the basis of analysts’ forecasts of corporate earnings for the next 12 months) correspond to the overall expected rate of return (dividends plus capital gains). This is where capital gain in any period equals the newly retained earnings per share, as would be the case if all growth in earnings per share in fact comes from returns (within the corporation) on the new internally generated capital (retained earnings). More generally, estimation of equity risk premium is a rough-andready process – similar in some respects to that of currency risk premium. As illustration, the 1-year forward earnings yield on the S&P 500 (based on consensus estimates of earnings 12 months from now and assuming the market would then be at the same level as now) at end-2005 was at just under 7%. That compared to a 10-year yield on

Currency Speculation 219

US inflation indexed Treasury bonds of just above 2%. But the true risk premium could have been substantially less than the difference between the two (say 4.75%), often taken as a crude basis of measurement. With corporate profits at end 2005 above the peak level relative to GDP of early 1998 there could well have been a long-run expectation (in the market-place) of profits growth beyond the next year falling behind economic growth. Indeed there were widespread forecasts of a cyclical slowdown in the US economy, led by a deflating residential real estate market, starting within a year or so. And so earnings per share excluding returns on reinvested profits might well shrink at some point over the next few years. On that basis, the risk premium derived from just considering the next 12 months would be inflated. The investor seeking to balance his or her portfolio through time in response to first, the evolving estimates of risk premiums (adjusted to take account of longer-term considerations as just described) for equities or other asset-categories and second, the shifting parameters of the human condition (in particular age and health) is not aiming to win the annual beauty contest amongst fund managers. Rather, the investor accepts that even without special trading ability, judicious shifts in weights are optimal. These (the shifts) are necessary towards a better balancing of risk and return through time. The investor, though, has grounds for caution, not least because the estimation procession for risk premiums is so imprecise. It is quite a different set of calculations guiding the speculator. The speculator is seeking to profit from a supposed special talent in investing. In terms of the currency markets this talent might consist of skill in economic analysis (concerning such topics as business cycles, global flow of funds, monetary trends, savings surpluses and deficits), or an ability to tear away from the strong consensuses which build about the economic and market outlook and not be blinded by the conventional wisdom from using his critical faculties, or a special insight based on contemporary and possibly historical knowledge into how policy, including international currency diplomacy, is likely to evolve. Another form of talent could be special intuition or expertise in assessing or modelling market psychology (this would include so-called technical analysis, so long as a relationship can be drawn between the esoteric price pattern and investor behaviour). It is very difficult to ascertain by results whether the particular investor in fact possesses the supposed skills. For quarter-by-quarter or even year-on-year outcomes will bear the large imprint of white noise. The investor’s analysis of available information might have been the

220 What Drives Global Capital Flows?

best around, but new information pushed the recommended or actual positions into loss. Over long periods of time, bad and good luck should tend to cancel out, and skill shine through. That is true across a large number of speculators with genuine talent, but it may not be the case for one unfortunate skilful speculator! All of this is not totally different from other examples drawn from economic life. Only the balance between luck and skill and the difficulty of providing objective measures of talent are qualitatively different. In general skill and training or entrepreneurial gifts tend to be associated with higher-than-otherwise earnings. But there is an element of luck or fortune as to whether the training or gifts can be used to big advantage – or to any advantage at all. In practice measurements to reveal whether a particular individual has talent include training, job history, and record of success (or failure) to date. In the case of speculative talent, training and employment history reveal a little but not much (this is also the case with entrepreneurship). Past performance is more heavily influenced by luck in the case of speculation than of entrepreneurship (albeit that even for the latter luck looms large). A careful in-depth examination of past speculative strategies can provide, nonetheless, some insight into the degree of talent. The hindsight investigation might also help focus the particular speculator on the possibilities of self-improvement. Take for example John Maynard Keynes’s huge bet against the mark in Spring 1920 (see Brown, 1986). Keynes had grounds to be pessimistic about the long-run future of the German currency – which indeed ended worthless in 1923. In early 1920, however, a powerful recovery of the mark got underway (from an already very cheap level in real terms) as some optimism spread that the Allies would provide Germany with credits to help finance reparation payments. Keynes could be faulted for assuming that market opinion was bound to agree with his own diagnosis – that Germany could not pay the reparations bill and would be forced into bankruptcy – and for failing to realize the huge potential volatility of the mark albeit around a downward trend. There were other respectable views (later presented formally by Ohlin and Rueff, see p. 97) “out there”, after all, that Germany could indeed pay if it could re-gain access to international credit markets. Undoubtedly Keynes did learn from the mistake, but seems to have resolved not to speculate on currencies again! One example of successful speculative calculation comes from the profits reaped by contrarian traders (provided they kept to their course into 2005 rather than losing their nerve) during the episode of serious

Currency Speculation 221

weakness of the US dollar in 2004. It was obvious then to most market participants that huge speculative positions against the US currency had built up – not least of which was the widely reported short position of the renowned stock market investor, Warren Buffet. A chorus of wailing comments about the dollar emanated from an array of editorial writers, and from a wide span of officialdom, including the G-7, the IMF, OECD, BIS, the US Treasury and eventually, albeit in muted form, from Alan Greenspan himself (see Greenspan, 2004). Yet any self-disciplined market-practitioner should have realized that the dollar could not have become a one-way bet. Unless there was some type of market failure, it must be the case that prospective returns on the dollar, taking account of expected exchange loss or gain, were not far out of line with those on other currencies – indeed probably somewhat superior given the likelihood that the US mega savings deficit originated to some degree from forces (low savings propensity in the household sector, in particular) within the US (rather than just being a response to global demand for US assets). Even though real interest rates on dollars were not yet obviously well above those in other currencies, the dollar had surely sunk to such a low level that a rebound was more likely than a further fall.

Speculation on the US dollar The illustrative speculator, reviewing the dollar in late 2004 (then at 1.33 and 105 against the euro and yen respectively) and estimating its equilibrium path through time could have proceeded usefully by constructing a range of scenarios. The construction process would have helped to highlight under what circumstances the full equilibrium value of the dollar, consistent with interest rates at neutral levels in the US and elsewhere, could rise or fall. The equilibrium path of the dollar, which joins up those estimates of full equilibrium value for different points in time, is itself a probabilistic concept (see p. 69) calculated as a weighted average over the full range of possible scenarios. The speculator, drawing upon the constructed scenarios, would have undertaken a comprehensive analysis of first, how far present interest rates were out of line with neutral; second, how far the dollar exchange rate now or at various dates in the future (as reflected in actual or implicit forward rates) diverged from the equilibrium path (due to factors other than present market interest rates being different from neutral level); third the likelihood of various divergences (actual vs. neutral interest rates, actual exchange rate vs. equilibrium path –

222 What Drives Global Capital Flows?

adjusted for differences explained by interest rates out-of-line with neutral) widening or narrowing by the time the bet matures. (In Autumn 2004, the dollar may well have been judged by some speculators as being well below its equilibrium path, especially as it was near the lower end of its 30-year range in real effective exchange rate terms). Fourth, the speculator would have the job of assigning probabilities to each scenario used in the analysis. The key details to be filled in for each scenario would be whether underlying savings surpluses in and outside the US would tend to rise or fall from present levels (opposite tendencies possible) and the implications for the full equilibrium value of the US dollar. Of course in an accounting sense the movements of savings deficits in the US and surpluses in the world outside would have to be in equal and opposite directions, but from the viewpoint of analysing currency direction it is crucial to assess where the primary shifts in savings or investment propensities will most probably take place (and how those shifts would in turn induce via exchange and interest rate changes offsetting changes if required in the rest of the world). Scenario 1 is where savings surpluses in the world outside the US rise. In particular, with faster economic expansion, could the savings surpluses in Germany and Japan rise (as households there attempted to build up savings after the years of economic stagnation) and could a bursting of the speculative bubble in the Chinese economy bring a big rise in China’s savings surplus (primarily from a decline in its ratio of capital spending to GDP)? Already in the first four years of the decade (2000–4), the German overall savings surplus had risen from near zero to almost 4% of GDP, as business investment (especially construction) had fallen sharply. Given the lure of cheap wage costs across the borders to the East and the rigid structure of the German labour market, it was not difficult to imagine further trend declines in the German investment spending ratio (see p. 188). And with mounting concerns about public and private cut-backs in pension benefits, a further big rise in the German savings surplus was feasible – perhaps even to the 10% of GDP level which characterized the UK economy in the two decades before World War One. One counterpart to a rising German savings surplus could be an increased investment spending ratio in the cheap labour economies to the East (or South East). But those same economies are likely to be experiencing a tightening of fiscal policy in coming years and there is scope for their household savings rates to rise under demographic pressures in particular. Elsewhere, within the euro-area, a further decline in

Currency Speculation 223

the French household savings surplus is unlikely if the real estate market there were indeed to cool and the socio-political malaise to increase. Spain’s huge savings deficit would narrow sharply if its estate market eventually cooled. Hence a doubling of the German savings surplus would mean most probably a large increase in the overall savings surplus of the euro-area. As regards the Japanese savings surplus, upward pressure could come also from fiscal tightening (on the assumption that the so-called Ricardo effect – whereby public savings promotes private dissaving – is less than perfect) – given the long-run likelihood of serious efforts being made to bring down the structural general government deficit from 6–7% of GDP and so arrest a snowballing net government debt to GDP ratio already at an estimated 83% of GDP in 2006. If the rise in savings surpluses outside the US came about, as described, then there would be further downward pressure on the neutral level of global real interest rates – most of all in the savings surplus countries and least in the savings deficit countries. In principle, so long as market rates move in line with neutral rates, and so long as the fall in neutral rates had not already been discounted in the term structure of market rates, a stronger US dollar would be the result, brought about by a gain in the momentum of capital inflows to the US. But in practice, as we have seen already in this volume (see Chapter 4), market rates may well be out of line with neutral rates (where these are defined with respect to two dimensions, national and international). In particular, in some savings surplus countries there are barriers to market rates falling to the neutral level, if indeed the zero rate barrier is effective. (For example in the case of Japan where rates were already at zero and underlying deflation evident, it would be impossible for market rates to fall to neutral level if this were indeed sub-zero). In this case the rate spread in favour of the US dollar might not rise significantly and there might be no gain in its international value. In the second scenario, foreign (non-US) savings surpluses decrease. For example, consumerism takes greater hold in the main present savings surplus countries – both the advanced economies and the emerging market economies. In addition, demographic influences in Japan and Germany might put net downward pressure on national savings – if indeed dissaving by the post-retirement generation more than outweighs any downward shift in capital spending (related to shrinking labour forces) and increased saving by those still working (see Chapter 7, p. 206). That would put upward pressure on the neutral level of global interest rates, most of all in the savings surplus countries. In consequence the full

224 What Drives Global Capital Flows?

equilibrium value of the dollar would fall (again subject to the condition that the shift in neutral rates were not already discounted in the term structure of market rates at the point in time when the speculative strategy was considered, meaning that the equilibrium path of the dollar would not shift). Suppose instead the starting level of market rates in the savings surplus countries were well above neutral (meaning that the actual exchange rate of the dollar would be below its “full equilibrium value”). Then as the savings and current account surpluses fell in the world outside the US and the US savings and current account deficits contracted in line (under the influence of higher US rates), the interest rate differential between the US and foreign countries would not shrink. Indeed it would be possible that the rate spread in favour of the US rose – as higher export demand pushed US rates higher with no corresponding rise in foreign rates. And so a fall in foreign savings surpluses could mean a lower US current account deficit, higher US interest rates, a wider rate differential in favour of the US and a stronger dollar. In scenario 3 an autonomous (not interest rate induced) narrowing of the US savings and current account deficits takes place. This puts downward pressure on the global level of neutral interest rates, most of all in the US. Hence the full equilibrium value of the dollar would fall (again on the assumption that this pattern of fall in neutral rates is not already discounted in the term structure of market rates). But suppose the starting level of market rates in the US were below neutral and so they did not decline. Then the dollar might rise as a consequence of the narrowed current account deficit coupled with an unchanged or improved rate differential in the dollar’s favour. (An in improved rate spread would be the consequence of foreign rates falling whilst US rates stayed still). Alternatively, however, market rates abroad might be blocked from falling by a zero rate boundary under conditions of deflation, whilst US market rates fall in line with neutral. Then the decline of the dollar could be particularly severe, whilst some foreign countries (where interest rate adjustment is blocked) would fall into deflationary disequilibrium as their currencies spiralled upwards. (The upward spiral would bring about a lowering of the current account surpluses but not the underlying savings surpluses consistent with full employment). Scenario 4 is where an autonomous (not interest rate induced) widening of the US savings and current account deficits takes place. (Most likely this would come about through a flourishing of invest-

Currency Speculation 225

ment opportunity in the US economy or a reduction in the required risk premiums there on new investment). This puts upward pressure on the global level of neutral interest rates, most of all in the US. Hence the full equilibrium value of the dollar would rise (subject to these rate moves not already being discounted). Suppose, however, that the starting level of foreign market rates were above neutral. Then they might not go up. And so the market rate spread in favour of the dollar would rise by more than the neutral rate spread. The dollar could climb far (by more than the full equilibrium value). The only sub-scenarios in which the dollar could fall in consequence of a widening of the US savings deficit would be where US rates (across the term structure) started above the neutral level or where the sheer size of prospective capital flows into the US triggered anxiety amongst international investors about “sustainability” (meaning whether markets could cope with flows on the given scale). Then there are four further scenarios in which there is a simultaneous shift in the savings deficit in the US and savings surplus outside the US. In scenario 5, the US savings deficit decreases and the foreign savings surplus decreases (both autonomously). The neutral level of US rates falls, whilst that of foreign rates rises. In principle that means a fall in the full equilibrium level of the US dollar. But suppose that at the start US market rates are below neutral whilst foreign rates are above neutral. Then there may be no change in the market rate spread between the US and foreign countries, whilst the size of the US current account deficit narrows. That could mean a stronger dollar. In scenario 6, the US savings deficit decreases and the foreign savings surplus increases (autonomously). Under this scenario, the neutral level of US and foreign rates both fall. Whether the full equilibrium value of the US dollar falls or rises depends on which shift is greater. If the shifts are equal, there is no significant influence (on the full equilibrium value). At a lower level of interest rates globally, the savings deficit of the US and the foreign savings surplus would remain unchanged. But suppose instead that interest rates abroad cannot fall to the new lower neutral level. Then only US interest rates fall, and so does the dollar. Non-US currencies rise sharply in value and the US current account deficit shrinks. The world outside the US falls into a deflationary disequilibrium. In scenario 7, the US savings deficit increases and the foreign savings surplus increases (autonomously). In this case, the neutral level of interest rates in the US rises and that abroad falls. The full equilibrium value of the dollar rises. In principle, only if foreign market rates cannot fall

226 What Drives Global Capital Flows?

(in line with neutral) and US market rates are already above neutral (and so they do not rise further) would a depreciation of the dollar take place. But in practice if there is an actual or feared market failure (inability of markets to cope with net global capital flows beyond a certain scale), then the dollar could also fall. In scenario 8, the US savings deficit increases and foreign savings surplus decreases (autonomously). Under this scenario, the neutral level of interest rates rises both in the US and abroad. If the shifts in the savings deficits and surpluses (underlying) are equal, then the neutral level of rates moves up by a similar amount (in the US and outside) and there is no implication for the full equilibrium value of the dollar. However, it could be that market rates abroad were above neutral levels at the start. And so the dollar would come under some upward pressure. We can see from the range of scenarios, and the imprecision of estimates concerning the present divergence between market and neutral interest rates or between market exchange rates and full equilibrium exchange rates (whether at the start or end of the speculative trade), that speculation is very much a shot in the dark. (Note in particular that the illustrative speculator has been focussing on changes in savings balances as a possible catalyst to shifts in the equilibrium path of the exchange rate. But there are other catalysts – for example new information on or reassessments of trade elasticities or currency preferences and appetites). The more the potential speculator realizes the extent of the darkness, the less likely he or she is to take big bold positions – or any position at all. In fact the most serious basis for taking a speculative position in late 2004 was as first, a market critic and second, a prophet of US monetary policy. A weight of current evidence suggested that huge negative sentiment had built up against the US currency based on two or three of the scenarios (negative for the dollar) above only, with the others (in which the dollar would rise) virtually excluded from consideration. It was reasonable to assume that there was a substantial probability of one or more of the positive scenarios coming into view before long, as market frenzy faded. Alternatively it could become apparent that US interest rates had been well below neutral and were now moving up or that foreign rates had been far above neutral and were now moving down (or some combination of the two).

Tools of currency speculation and examples of their use Given the key (but far from exclusive) role of how the global pattern of savings surpluses and deficits evolves in the determination of full

Currency Speculation 227

equilibrium exchange rates, an obvious question is what tools can the speculator use to grasp whether a shift (in the pattern) is taking place. The main data set is indeed the savings and investment tables produced by large and some small advanced economies. As illustration we can take the US savings-investment table, re-produced below (see Table 8.1). This is a snapshot of realized savings and investment during the specified time periods. It cannot reveal directly the underlying equilibrium amounts of savings and investment (where equilibrium is determined globally). The table could include a variety of unintended savings or investment and of course at a level of output which is not consistent with non-inflationary production at full capacity throughout most of the globe.

Table 8.1

US Savings and Investments, 2001–5

(US$ bn)

2001

2002

2003

2004

2005 H1*

Gross Saving

1658

1489

1474

1572

1651

Gross Private Saving

1400

1560

1661

1755

1705

132

185

173

152

36

192

295

376

397

456

903

894

911

973

982

172

187

201

233

231

Personal Saving Undistributed Corporate Profits Business Consumption of Fixed Capital Household Consumption of Fixed Capital Gross Government Saving

256

–71

–187

–182

–26

Federal (net) State and Local (net) Government Consumption of Fixed Capital

46 4 206

–248 –34 211

–382 –23 218

–406 –5 229

–285 21 238

Gross Investment

1931

1926

2028

2308

2448

Gross Private Domestic Investment

1614

1582

1670

1928

2056 392

Gross Government Investment Net Lending or Net Borrowings (–) Statistical Discrepancy Memo: S-I Private Sector S-I Government * Annualized rate

317

347

358

380

–371

–459

–507

–653

–89

–21

47

67

–214 –60

–22 –418

–9 –547

–173 –562

–351 –418

228 What Drives Global Capital Flows?

Anyhow, subject to these imperfections, Table 8.1 reveals that between 2002 and 2005 (H1), the private sector saving deficit in the US economy widened by over $300bn, whilst the public sector deficit widened by $100bn. In looking at the sub-components of the private sector deficit, what stands out is the decline in personal savings and rise in private investment. A key component of the increase in private investment – not shown in the table – was private residential construction, which increased by around 1.5% of GDP ($170bn) during the years in question, evidently related to the boom in the residential real estate market. The advantage of this breakdown is to help shine light on what forces could bring about a shift in the US savings-investment balance. In the situation of late 2005 the obvious elements which could be in transition were construction spending (related to the cooling of the residential real estate market), personal savings (surely not to stay so low in the long-run). On the other hand, business investment as a share of GDP in 2005 was no higher than in 1995 and still well below the peaks reached in the 1997–2000 information technology boom. The speculative investor in currency markets should not become preocupied with the exact sectoral breakdown of the savings-investment balance. The division of this between the personal sector (household savings) and the corporate sector (undistributed corporate profits) is in large part devoid of economic meaning (see Chapter 7, p. 204) Savings in the corporate sector should add to underlying equity value – and capital gains (realized or unrealized) are a form of household sector saving (albeit not registered as such in the traditional breakdown which lies behind the compilation of the savings-investment tables). The equation of corporate savings and rising personal equity value is most obvious in the case of small and medium-sized corporations. The owner-manager who utilizes cash flow to repay debt adds to his or her overall wealth. In general terms we have already seen that the market value of equity is not always closely related to the accumulation of profits inside the corporation (see p. 218). Other factors, such as changed assessment of earnings growth, or shifts in risk premiums, might be much more important. Everything else the same, however, a higher rate of profits retention means a higher equity value (for the given corporation) and thereby higher savings in the economy as a whole (corporate and household sectors combined). This equivalence of personal and corporate sector saving is especially important in the context of the Japanese economy where in the early years of the 21st century the savings surplus of the corporate sector

Currency Speculation 229

ballooned at the same time as the household sector savings surplus (as recorded by the national income statisticians) dwindled (see Table 8.2). Quite simply if the Japanese corporate sector had not in these years been applying its higher earnings to the repayment of debt, Japanese equity values would have been lower than otherwise. In turn, Japanese household sector saving would surely have been larger (as measured in the national income accounts) as there would have been less capital gain accumulating towards providing an adequate nest egg for retirement and other purposes. Analyzing the savings surplus has been a key part of yen currency analysis through the more than three decades of a floating exchange rate. In principle, periods of time when the underlying savings surplus in Japan was increasing (due to a rising propensity to save or a shrinking frontier of investment opportunity) should have been accompanied by a downward pressure on yen neutral interest rates and on the yen itself (assuming that similar developments were not happening in the global economy – and especially in the US). That was the case through the early years of the 1980s – and indeed at that time the US savings deficit was simultaneously ballooning under the influence of Reaganomics (dramatic widening of budget deficit and buoyant investment spending). Many yen analysts became unstuck by the sudden fall in the Japanese savings surplus in the late 1980s as a boom in investment spending emerged and household savings fell in part as a reflection of buoyant equity and real estate markets. (The role of the Japanese authorities in promoting the boom has been discussed already in Chapter 6, see pp. 167–8). All of this occurred at a time when the US savings deficit was contracting (a serious growth recession in the

Table 8.2

Japan Savings and Investments, 2000–8

(¥100 bn)

2000

2003

2008

Non-Financial Corporates Financial Corporates Households (& Non-Corporate Business) General Government Net Capital Exports (to areas (taken as equal to C/A surplus)

–38 182 313 –382 –129

99 167 238 –382 –158

50 150 300 –330 –190

+53

+36

+20

Statistical Error (Missed savings surplus = +)

230 What Drives Global Capital Flows?

mid-1980s and some early action at reducing the budget deficit). Correspondingly the yen rose sharply. The big challenge for analysts of the yen familiar with using a savings-investment framework in currency economics came during the early 1990s, after the Tokyo equity market bubble burst. Real estate markets started their long ascent downwards. All of this would have been expected normally to translate into a weaker yen (via considerable downward adjustment in the neutral rate of interest in the Japanese economy). But instead of falling, the yen rode sky-high (see Chapter 4, p. 104 and Chapter 6, p. 168, for a discussion of this episode). In the second half of the 1990s and beyond, the saving-investment balance framework has become more reliable in application to yen currency analysts. The fact that the zero rate boundary has prevented market rates falling to neutral level during much of the time has been an important point to incorporate (in the analysis) (see Chapter 6, p. 167–70). The combination of a falling Japanese investment ratio (business investment as a share of GDP) in the mid-late 1990s and a business investment boom in the US, coupled with a reversal in monetary stance (Japanese money rates eventually falling to zero whilst in the US the FOMC moves rates sharply higher), went along with a weaker yen. That trend, however, was broken by an implosion of the so-called carry trade in yen (in autumn 1998) followed by a short-lived equity and capital spending boom (1999–2000). Foreign capital poured into the Japanese equity market. The periodic importance of equity flows in Japan’s currency markets raises the issue – already examined in the context of Chinese capital flows – as to whether any insight is to be gained from the traditional concept of the basic balance of payments. In the Chinese context (see pp. 90–2) we have seen that the concept is of little use. The same applies, as we shall see below, in the Japanese context, and indeed more generally. The basic balance of payments should not be in the main compartment of the currency analyst’s toolbox, even though it still sometimes receives fleeting attention in market commentaries. (The basic balance of payments is defined as the current account balance plus long-term flows in the capital account – meaning direct investment and portfolio capital). The monthly statistical statements from Japan or US about portfolio flows (equity and bonds, in and out) do sometimes provide the market talking point for 24 hours at most. A main flaw of capital account data in providing insights to underlying currency flows has already been highlighted (see Chapter 1, pp. 16–18). An important part of the end-investor or end-borrower flows may be

Currency Speculation 231

taking place in the offshore markets, with only the intermediary flows showing up in the traditional balance of payments, where they would be registered as short-term capital transactions (largely via the banking sector) not forming part of the basic balance. A further flaw, related in particular to our discussion here about equity inflows into Japan, stems from an emphasis on partial rather than general equilibrium analysis and a neglect of the time frame over which expectations influence the process of exchange rate determination. And there is the familiar problem that actual flows may tell us little about the desired changes in stocks which are the key element in price action. On any particular day, or in any particular week or month, a big flow of foreign buying of Tokyo equities, for example, would mean an extra source of buyers of yen in the currency markets. But the level of the yen is not settled by the short-term composition of currency business. Rather, the dominating factors are long-run expectations regarding equilibrium values, and divergences from these caused by money interest rates diverging from neutral. A transitory rise in foreign purchases of Tokyo equities – even if amounting to say a cumulative total of $45bn over 3 months (as from August to October 2005) – should have little influence. Much the same as for sterilized foreign exchange intervention, offsetting flows would be triggered (other investors in yen, including domestic residents, deciding that this was a good opportunity to move into non-yen assets). If, on the other hand, the buying of equities from abroad is long-run (stretching out over years) and seen as such, then it might go along with a core surplus in the so-called longterm capital account. This would have to be matched by a deficit (or shrunken surplus) in the current account. A further aspect of the link – or lack of link – between equity flows and the equilibrium value of the yen (or any other currency example) is illustrated by the experience of Autumn 2005. Unusually this episode of massive foreign inflows to the Tokyo equity market was accompanied by a big growth of the carry trade in yen (borrowing of the Japanese currency to match foreign currency assets). The foreign buyers of Japanese equities were said to have “hedged” almost all their purchases. The idea behind these hedges was that profit (or loss) from the carry trade position would be negatively correlated with returns on Japanese equities (expressed in foreign currency terms). For example if a fall in the Tokyo market in dollar terms tends to go along with a fall of the yen against the dollar, then a joint position in the carry trade (short yen, long dollars) and equity market could appear to be less risky from the viewpoint of a say US hedge investor than a simple unhedged

232 What Drives Global Capital Flows?

position. In practice a substantial correlation as described is only likely to be found over short holding periods and would depend on Japanese equities (in yen terms) not bouncing up in response to yen declines and conversely. (A weaker yen could in principle bolster Japanese equities by countering pessimism on deflation and improving profits prospects for the key export sector). From a longer term standpoint, the so-called hedging strategy looked more like a passing trade idea rather than a new departure in portfolio management. Assuming the huge purchases of Japanese equities made in Autumn 2005 found their way into passive portfolios of global investors, the key issue would be whether they could gain an improvement in the overall balance of return and risk by maintaining a large short position in yen. This would be the case if cumulative income from the carry trade (rolling over positions every say three months) tended to reduce the overall variability of returns (expressed in the investor’s base currency or currency mix) measured over a normal holding period of say several years. There is no empirical research or theoretical consideration to make the passive investor confident about any such risk-reduction potential (of currency hedging). Perhaps some foreigner investors have been lured, nonetheless, into the strategy of “hedging” yen risk by the resulting apparent access to zero rate financing. Instead of funding the Japanese equity portion of their portfolio with dollars, they fund it with zero rate yen (the result of borrowing yen and lending dollars or an equivalent forward exchange position). Hence it might appear that the foreign investor could enjoy the same risk premium (expected returns on Tokyo market less the real riskless rate of return in Japan) as Japanese investors, rather than the smaller apparent risk premium calculated as prospective earnings yields in Tokyo less the real riskless rate of return on dollars. (As we saw at the start of this chapter, real 10-year swap rates on dollars at end-2005 were more than 200bp higher than on yen). That attempt, however, to “lock in” a higher risk premium was based on illusion. Foreigners could expect to earn the same risk premium as Japanese investors without “hedging” if they correctly took account of the likely trend real appreciation of the yen. On top of the gains over time on their holdings of Japanese equities as calculated in yen there would be an expected translation gain into dollars stemming from the real appreciation (of the yen against the dollar). That real appreciation was one element built into the forward structure of exchange rates (either explicit or as derived implicitly from rate spreads) for the yen against the dollar and corresponded to the fact that real yen rates were well

Currency Speculation 233

below real dollar rates. The real gains on the yen, however, could not be totally isolated from equity risk by entering the yen carry trade (see below). Even if the gains could be locked in, it is not clear that the overall risk-return parameters of the well-diversified global portfolio measured in a particular currency (or currency mix) would improve. Rolling over short-maturity forward contracts in the yen/dollar exchange market (or equivalently borrowing yen and lending dollars on a short-maturity basis) does not secure the real appreciation (for the foreign investor) as the nominal rate spread between dollars and yen (or forward premium on the yen against the dollar) is a joint estimate also of inflation differences between the US and Japan and might also include a variable risk premium. As illustration, take 3-month money market rates in Japan at 0% and in the US at 4.5%. The 4.5% p.a. difference could consist of an expected inflation spread of 2.5% p.a (2% p.a. in US, –0.5% in Japan), an expected real appreciation of the yen vs. the dollar of 1.5% p.a., and a 0.5% p.a. risk-premium in favour of the dollar. Cumulative error in the form of under-estimating inflation differences and a dip in the risk premium might mean that lower-than-expected real exchange rate gains on Tokyo equity values are not fully offset by profits from the yen carry trade. Moreover there is a mismatch problem. A big sudden decline in the Tokyo market would mean that the foreign investor who had fully “hedged” holdings there would find suddenly that the carry trade position was well in excess of matched holdings of Japanese stocks. If the yen were simultaneously strong the investor would realize double loss (equity fall and emerging excess carry trade position swinging into the red). Indeed the closing of excess carry trade positions by foreign investors under these circumstances could give some short-run upward momentum to the yen. The future of the so-called “hedging strategy” in the Tokyo equity market is far from being a trivial question given the amounts involved. Successive huge waves of foreign buying in the Tokyo equity market since the Crash of 1990 have seen the share of foreign ownership rising from 5% in 1990 to 25% in 2005. Domestic holders of Japanese equities have been big cumulative sellers to foreigners. Included amongst these sales have been the run-down of the vast socalled interlocking shareholdings (whereby companies have held shares in each other) and have so contributed to a fall in overall leverage (debt to equity ratios), as the cash proceeds have been used to repay debt. The bolstering of equity values by massive foreign demand should in principle have meant that domestic spending propensities

234 What Drives Global Capital Flows?

(both corporate and household) in the Japanese economy have been sustained at a higher than otherwise level. Equivalently foreign demand for equities would have pushed up the neutral rate of interest in the Japanese economy and the equilibrium level of the yen. Even so, there is no simple relationship between the size of the foreign inflow into Tokyo equities, the neutral level of Japanese rates, and the equilibrium value of the yen. Suppose a given increase in foreign demand brings a big rise in Tokyo equity prices but little actual net flow between domestic and foreign holders (perhaps because of considerable heterogeneity of expectations regarding future returns on the part of Japanese investors). That is more significant – in terms of the neutral yen interest rate and equilibrium yen exchange rate – than the fall-out from a bigger increase in foreign demand which brings a smaller rise in equity prices but a much larger net flow (as might be the case if Japanese corporations are quick off the mark to respond to foreign demand by accelerating their liquidation of interlocking shareholdings or if Japanese investors hold quite homogeneous views regarding returns). And what can we say about the implications (for the equilibrium value of the yen and yen neutral rates) of a long-turn shift to foreign selling in the Tokyo equity market. Suppose that markets shift to expect that over the next decade foreigners would reduce their share of Tokyo equity wealth from say 25% to 15%? Much depends on the trigger to that downward adjustment. If the trigger is a reduced aversion to equity risk or an increase in long-run economic optimism by Japanese investors (relative to the state of mind of foreigners with respect to Japan which remains unchanged) that would mean a stronger yen and higher level of neutral rates even though the basic balance of payments could weaken as equity inflows gave way to equity outflows. The higher level of neutral rates would mean greater strength in non-equity inflows – only a small part of which might show up in the so-called long-term capital account (of the balance of payments). Indeed there was a version of this phenomenon in the late 1980s, when foreign investors did not fully share in the euphoria of domestic investors concerning the Japanese economic outlook and so they (the foreigners) became huge sellers of Tokyo equities. Domestic euphoria, however, went together with eventually rising bond yields and interest rates. And so the yen was generally strong even though the capital account data revealed a large long-term deficit fuelled by net foreign sales of Japanese equities.

Currency Speculation 235

Safe haven currencies We have picked out the yen to illustrate analysis of potential speculative strategies in the currency markets. When it comes to strategies of using currency positions to provide safe havens against various bad states of the world, we use the Swiss franc for illustrative purposes. We describe the Swiss franc as a hedge currency. Through the course of the 20th century, the Swiss franc has demonstrated such hedge properties in a range of bad scenarios. First, there was the jump in value (albeit subject to considerable volatility) of the Swiss franc against the belligerent currencies during the First World War (see Brown, 1987). Then there was the franc’s sharp appreciation against all other currencies during the inflation storms of the 1970s. Finally, the franc has displayed some hedge properties against global equity market crashes and wider financial crises. None of these hedge properties are guaranteed. In the 1930s, the Swiss franc failed as a hedge against social turmoil in France (the arrival in power of the Front National) because the French franc and Swiss franc’s fates were joined as members of the Gold Bloc. As World War Two approached, the flight of capital from Europe was directed to the US not to Switzerland, as the latter’s chances of sustaining neutrality was very much in doubt. The franc did rise against the dollar in the free markets during the late years of World War Two and beyond, but of course many of those European investors who had sought refuge in Switzerland found (or their heirs found) that their assets were subsequently unrecoverable. In the post-war world, the hedge function of the franc has been curtailed in important respects by the exchange rate policies followed by the Swiss National Bank. The year 1978 marked the turn, when the Swiss National Bank (SNB) intervened massively in the foreign exchange markets to pull the franc down in value and made clear that monetary policy was subservient to exchange rate policy. The chance of official action to cut the value of the franc has limited its hedge appeal. In the wake of the equity market crashes of late 2000, forward into the ensuing global recession and darkening geo-political climate (from the September 11 terror attacks through to the build-up of pressure on the Saddam Hussein regime), the franc briefly starred (see Figure 8.2). In the years since then (2003–6), SNB officials have repeated declared that they would combat any new substantial rise of their currency. Some analysts maintain, nonetheless, that the franc does still possess some hedge properties, even if limited.

236 What Drives Global Capital Flows? 3.5

4.0

3.0

3.5

2.5

CHF/USD CHF/EUR (RHS)

3.0

2.0

2.5

1.5

2.0

1.0

1.5

0.5

1.0 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05

Figure 8.2 Swiss franc exchange rate, 1975–2005

These (hedge) properties stem from two observations. First during periods of global financial storm, there is a tendency for international equity flows to shrink. Investors stop adding to the equity sections of their portfolios. Hence countries which are typically large net buyers of foreign equities (measured relative to their economic size) would experience a sudden curtailment of capital outflow, putting upward pressure on their currency. (There may be some partial offset in the form of an increased demand for foreign bonds, but there is likely to be some matching increase in foreign demand for domestic bonds). This is the case with Switzerland, which has a huge saving surplus (around 13% of GDP in the 2000s), most of which is exported into foreign bonds and equities. Second, carry trade activity (the borrowing of low or zero interest rate currencies to finance assets in higher yielding assets) tends to shrink at such times. Many of the institutions engaged in the carry trade find themselves financially weakened by market crisis, and so they cut back their positions. The Swiss franc, as a prime borrower currency, should gain in value from the cut-back. In addition to offering some residual safe-haven role, the franc also provides some opportunity to speculative investors. Here an essential

Currency Speculation 237

long-run question to weigh is if and when the huge Swiss savings surplus will start to diminish, putting upward pressure on the neutral real interest rate in Switzerland and on the equilibrium value of the franc? Related to that question are the projections of a steady growth in the investment income surplus of Switzerland. There are also some imponderables. Will productivity growth in the protected sector of the economy tend to catch up with that in other advanced economies, meaning downward pressure on the price level and some tendency to real depreciation of the currency (everything else the same) – the reverse Balassa effect already discussed (see Chapter 3, p. 82). Or might any such acceleration of productivity growth go along with a flourishing of investment opportunity in Switzerland putting upward pressure on the neutral real interest rate and equilibrium value of the franc which would outweigh the reverse Balassa effect? On balance, anecdotal evidence suggests that long-run positiontaking by global investors in the franc driven by far distant speculative considerations such as that just discussed has been small. Long-run position-taking appears rather to be dominated by safe haven considerations amongst investors and by profit expectations of carry-traders (who are evidently not scared by the potential scenario where the franc would appreciate substantially). The investors who select the franc as one safe haven must still look for protection in those bad states of the world where the Swiss currency would not perform well. One obvious bad state of the world is energy shortage. If indeed cheap conventional sources of energy become growingly scarce (relative to demand) and a shortfall has to be satisfied (with the stimulus of high prices) via huge new investment, then this would put a brake on global economic progress. The capital invested in the extraction of non-conventional energy supplies, on providing the infrastructure for new forms of energy to be transported or transformed (into required products), and on the development and implementation of new energy-saving technologies, could have been otherwise spent on productivity enhancing projects. Investors looking for a hedge against this particular bad state of the world (in which economic progress would slow overall, albeit not for the energy producing countries!) can of course turn to a range of energy equities – in companies that would profit from the bad scenario described. In addition, so-called petro-currencies would offer some protection. In the contemporary world the prime petro currency is the Canadian dollar. A generation ago it was the British pound (in the late 1970s,

238 What Drives Global Capital Flows?

early 1980s). The correlation between the international value of the Canadian currency and the energy price stems from Canada’s vast nonconventional energy resources which can be exploited profitably only when prices are expected to remain at historically high levels over the long-run (see Chapter 7, pp. 208–9) (see Figure 8.3). Critical in the link between the energy price and the Canadian dollar is the responsiveness of investment in Canada’s energy sector. If energy companies are very conservative in adopting investment projects, budgeting on the basis of long-run prices far below what is presently discounted in the market, then the responsiveness would be that much lower. In principle, markets should force the pace of investment. Energy companies which are conservative, perhaps because they are highly levered rather than mainly equity financed, would find their equity prices languishing compared to their more aggressive rivals. Their management might face dismissal after a bruising take-over battle. In practice, however, analysts raise questions about whether market discipline in the form suggested has worked well in the energy industry dominated by a few large players with oligopoly power. The example of the petro-currency (in this case the Canadian dollar) as a hedge against one particular bad state of the world (from the 1.45

80

1.40

70

1.35

60

1.30

50

1.25

40

1.20

30

1.15

CAD/USD

20

Brent Oil Spot $pb (RHS) 1.10 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Figure 8.3 Canadian dollar vs. oil price, 2003–5

10

Currency Speculation 239

viewpoint of many investors) can be generalized. We suggested above that a prime motivation for holding such a hedge asset (against conventional energy shortage) is concern about a slower rate of economic progress due to a squeeze on productivity growth. But there are other possible motivations which depend on the circumstances of the individual investor. For example, there is the risk of windfall loss on the real value of monetary assets, as would occur if central banks accommodated the initial jump in energy prices and if there were no subsequent reversal (of energy prices and of monetary accommodation). This example is generalized in the next section.

Spectre of negative real rates The association of energy shock with real loss (taking account of interest income) on monetary assets goes back to the traumatic events of the 1970s, when double-digit inflationary conditions swept over most of the advanced economies (with the important exceptions of Germany and Switzerland). Real interest rates on several of the major currencies (US dollars, yen, and Sterling, for example – but not Deutsche marks and Swiss francs) lingered at substantially negative levels for a prolonged period. Investors in fixed-rate bonds reaped large losses. It has been a hotly debated topic amongst economists (see, for example, De Long, 1995) whether the two energy shocks (1973–4 and 1978–9) played a coincidental or catalytic role in the “greatest peacetime inflation”. It is indisputable that the core rate of inflation in the US had already reached (in Spring 1973) double digits before the first energy shock erupted (October 1973). It is also clear from the German example that inflation was not an inevitable consequence of energy shock. A tight monetary policy as pursued by the Bundesbank in 1973 could act as an antidote to any impulse towards inflation from energy prices shooting up towards the sky. In principle, energy shock might bring a short-run fall in the neutral rate of interest, measured in real terms, across all the main currencies (but not in financially feeble developing countries – see Chapter 4, pp. 98–102). That would be the case if savings in the oil importing world fall (under the influence of households seeking to maintain their living standards despite the squeeze on their real disposable incomes from higher energy prices) by less than the rise in savings in the oil exporting world (where governments, corporations, and households might indeed be slow to raise their spending in line wealth gains).

240 What Drives Global Capital Flows?

In the longer term there can be no presumption about a sustained high level of energy prices lowering the neutral level of real interest rates. In principle that might happen if the long-run growth rate of productivity (and productive potential) in the global economy slows – and we apply the logic of simple economic growth models in which the rate of return to capital equals the growth rate. However that is a very distant and unreliable anchor to real interest rate forecasting! Taking a more pragmatic approach, the analyst perceives that a big new source of demand for capital is created – the exploitation of new energy sources, development of new energy distribution networks, and investment in energy-saving technologies. On the other hand, a slower growth of productivity (due to scarcer energy) might mean a higher savings rate (in that households cannot look forward to the same growth of income) and less investment opportunity in the non-energy sectors. The medium-term influence of energy shock on the neutral level of real interest rates is not unambiguously in one direction or another. Indexed government bonds are a hedge against an unexpected transitory (or longer lived) fall in real interest rates in a situation of raised inflation risks, such as might occur in the immediate aftermath of energy shock. In this scenario, though, petro-currencies or energy sector equities are the star hedges. There are other scenarios featuring the same phenomenon – a transitory or longer-lasting fall in real interest rates amidst raised monetary risk – including natural disaster or war, where petro-currency offers no protection. A benign cause of a short-run fall in real interest rates, induced by monetary sources, would be a sudden acceleration of productivity growth under a monetary regime in which the central bank stabilizes inflation at a low level and strenuously avoids any episode of deflation (even if not accompanied by recession or worse). The holding of foreign currency (assets denominated in currencies other than that of the political jurisdiction where the given investor resides) is a hedge against a transitory or long-term dip in real rates that occurs just in one country or regional group of countries. (The assumption is that some combination of exchange risk and expectation of exchange rate change allows real rate spreads across currencies to persist). Where the decline in the neutral level of real rates is global, then currencies are not a hedge vehicle, unless there are considerable monetary divergences (with respect to how actual rates are related to neutral level). In the case of the first and second oil shocks, a dip in market real rates was not general, even though neutral real rates likely fell every-

Currency Speculation 241

where for some time. In particular, the monetary response (to the shock) diverged between Germany and Switzerland on the one hand, and the rest of the world. So in that case the Swiss franc and Deutsche mark were in fact hedges. But that divergence could not be counted on in the future. Indeed in the 2004–5 oil shock there was a divergence in terms of monetary rhetoric. The Federal Reserve was fully ready to tolerate a temporary rise in inflation so long as the core rate remained unchanged and low. In the euro-area the ECB proclaimed that its aim was to hold down overall inflation and that core inflation was a lagging indicator. In Japan the BoJ proclaimed that deflation was coming to an end and this would justify an early end to extraordinary monetary ease, even though some price level measures excluding energy still hinted at mild deflation. Looking beyond the rhetoric, however, the monetary response of the major central banks was largely the same – to accept some short-term acceleration of inflation, so long as core inflation (excluding oil) and inflation expectations remained subdued. The rationale for this response was that an attempt to prevent or reverse any oil-induced transitory acceleration of overall inflation would most probably inflict considerable economic costs. Towards understanding the possible divergences in monetary response (to oil shock) and its consequences for the market real interest rate, consider a strict monetarist regime, in which the central bank targets monetary base and aims for long-run price stability. A sudden jump in energy prices would mean that the demand for money (in nominal terms) would increase relative to supply (monetary base remaining on an unchanged trajectory). A rise in nominal interest rates in the money markets would be essential towards short-run balancing of supply and demand in the market for monetary reserves (base money). The rise in nominal money market rates would be one of the transmission mechanisms forcing non-oil prices down, so that the overall price level rise would be curtailed. There is no guarantee, though, that the price level would fall back to its long run previous stable level – as the demand for money in real terms may have fallen somewhat in view of shrunken real disposable incomes. During a period of transition market interest rates could be somewhat above the neutral level, which may indeed be temporarily depressed. By the same token, once adjustment has occurred (nonenergy prices falling), there may be a period of sub-neutral market rates as the economy bounces back from its situation of some overall slack. It is possible, but far from certain, that the total cumulative real interest income from monetary assets over the whole period of price level

242 What Drives Global Capital Flows?

adjustment to the oil shock will have been depressed compared to what it otherwise would have been. There should be no overall denting of market confidence in long-run conditions approaching price level stability and bond market values should remain well sustained. Compare the path of adjustment that occurs under modern monetary management. A first point is that aiming for an unchanged core rate of inflation is itself not a fully accommodative policy. The socalled core price index includes many items which have high energy content – for example, transportation services (including transportation fares) and chemicals. So consistent with an unchanged core rate of inflation there has to be some bearing down on non-energy prices, but almost certainly less than in the yardstick case of an unchanged path for monetary base growth. It may be that the bearing down can come without nominal money market rates rising at all or at least by considerably less than the full extent of overall inflation (including oil prices). That would be consistent with real interest rates dipping in line with neutral real rates (reflecting the transitory tendency towards excess savings in the global economy, referred to above). Uncertainty as regards the price level in the long run is greater (in the case of core inflation stabilization) than under the previous example (monetary base remains on an unchanged trajectory). There may be no basis for predicting that the present jump in oil prices will subsequently be reversed. Even in the case of reversal, the central bank might not allow a fall in the overall price level or even a serious fall in the inflation rate to take place (to below say, 1% p.a.) and so a permanent increase in the price level or cumulative inflation rate (beyond what would have occurred without the energy price shock) might occur. Long-run inflation expectations might climb. There is the danger in such circumstances of nominal interest rates falling behind the neutral level in real terms (owing to inflation expectations being underestimated by the monetary authorities) triggering thereby a further acceleration of inflation. In any case a period of above neutral interest rates might be required to lower inflation expectations back to their previous level. It is not self-evident that at the end of the monetary process described investors will find that their real income accumulation on money and debt instruments has fallen below normal expectations before the energy shock. Much depends on whether in fact the end result is indeed a higher inflation environment – in which case losses will surely have been realized on fixed-rate assets. There may also have

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been a period in which real income on floating rate assets (these include bank deposits or other money market instruments rolled over repeatedly at maturity) was very low or negative. Also critical is whether the oil price in fact falls back. A period of higher-than-expected inflation brought on by a sudden apparent shortage of resources and resulting in real interest income loss for investors can be seen in most dramatic form in the case of natural disaster or war. Consider first the case of natural disaster (earthquake, hurricane, tsunami, or pandemic, for example). Suppose this is restricted to country A but is on a large enough scale to dislocate a large share of the economy (a historical example is the 1923 earthquake in Tokyo). The savings balance (in country A) would plunge into large deficit, as stricken households now earning little or nothing would try to maintain consumption out of capital, and businesses sought to replace destroyed capital (whether inventory, machinery, or plant). The government deficit would explode. Some particular items in short supply (for example materials required for reconstructions) would jump in price. It is very likely that the neutral interest rate in real terms for country A would rise far – at least over the short and medium-term. If the central bank in such circumstances were to run a strict “monetarist” policy – maintaining the high-powered money stock on its preordained growth path – then almost certainly there would be a huge jump in short-term interest rates, and this would add to overall distress. More plausibly, the central bank would take the view that the jump in prices would subsequently be reversed, and that some considerable immediate rise in the price level should be tolerated. Indeed the subsequent fall-back in the price level once the resource shortage was relieved would mean that a low level of nominal interest rates for medium or long maturities (with respect to money and bond market instruments as viewed during the period of shortage) would in fact translate into a high real interest rate. The test for the central bank would be to stand firm during the subsequent “deflationary” period, when the price level fell, and not engage then in stimulatory policies which resulted in prices remaining far above their pre-natural disaster level. The fall in the price level might mean that real interest rates rise considerably at this stage, to well above the hypothetical neutral level, and induce economic slump. The monetary pilots at the central bank, in attempting to avoid the hazard of depression, might in error steer the economy into an inflationary episode.

244 What Drives Global Capital Flows?

We can visualize a particular variant of the deflationary danger stage in the hypothetical case of country A operating under a gold standard regime under which international capital flows are highly elastic. Capital would flow in during the period of resource shortage and the price level would rise, whilst nominal rates remained at the international level. Subsequently, as resources again became available, the price level would fall back and capital would flow out. Whether the price level ended up lower or higher than at the start would depend on whether the natural disaster had permanently affected country A’s international competitiveness or international balance sheet (and the related investment income account in the current account of the balance of payments) in some major respect. Under the gold standard – or absolutely fixed exchange rate system – there is no option of slowing down the process of price decline once the resource shortage is overcome. And so the danger of depression (induced by market real rates far above neutral) might become acute. There is the option under such circumstances of a temporary break from the gold standard, during which the central bank pushes rates down towards zero. Suspension, however exceptional the circumstances, carries a credibility problem for the future. In the case of a floating exchange rate regime with independent paper currencies, the central bank could ease the process of price deflation by engaging in stimulatory monetary policy. This may be constrained, however, by the zero rate boundary to nominal rates, meaning that only non-conventional monetary policy could be effective. Tools would include explicit devaluation of the currency, aggressive monetary base expansion, and negative interest rates (see Chapter 4, pp. 114–5). These tools are all cumbersome and their application may lead to a price level (or cumulative inflation) higher than what would have been the case if natural disaster had not struck. A permanent loss of real interest income (cumulatively) and losses on fixed-rate bonds might be suffered by investors. Foreign currency assets (bought before disaster strikes) offer investors protection against this eventuality, so long as it is confined geographically. In the case of worldwide natural disaster, there is no such protection possible from foreign currency assets. It is not clear that any other asset could offer protection. Even indexed government bonds might be tampered with – as emergency decrees could restrict the extent of their compensation for price rises due to natural disaster. Equities or real estate do not offer infallible protection against worldwide natural disaster Profits earned by corporations or rental income

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received from physical properties in the wake of these disasters are likely to fall far short of expectations held by investors prior to their occurrence. It is a matter of conjecture whether the cumulative loss on the real assets is more or less than on the monetary assets. Much depends on just how far the monetary authorities fail to reverse the initial jump in prices and what longer-term inflationary problem might thereby set in. Monetary diversification (across currencies) should still pay off. Some monetary authorities will be more successful – or better placed (in terms of the socio-political context) – than others to steer a course that does not substantially erode monetary values. An extreme example of a bad state of the world characterized by resource shortage and induced inflation is war. Resources are diverted from the production of butter to guns. The output of consumer goods and services falls. Yet real incomes and wealth fall only partly in step. (There is rapid growth in incomes from production of guns offset only in part by increased tax deductions, on the assumption of a big widening of the government budget deficit). Prices of goods and service in short-supply (in the absence of price-rationing, discussed further below) come under upward pressure. In the illustrative case of the central bank pursuing an unchanged rate of expansion for money supply, it is likely that there would be some upward pressure on money market rates. That would reflect demand for money (swollen by the higher prices) exceeding supply (of money). Money rates at above the neutral level (which in real terms would surely have risen, reflecting a shift of the savings balance into deep deficit – see below) would bear down on prices. In the new equilibrium, prices would settle at a higher level than during the preceding peace, but lower than in the first stage when prices shot up under the influence of scarcity, in line with the fall in demand for real money balances (in line with the decline in aggregate real incomes). Long-maturity rates, even in nominal terms, might remain low, reflecting anticipations of an eventual decline in the price level once peace is restored. (Expectations of an eventual price decline means that low nominal long-maturity rates could indeed be abnormally high in real terms). Massive budget deficits would be an important factor in the swing of the overall savings-investment balance into large deficit. High real rates would rein back private spending (whether by households or businesses outside the military sector) making way for the transfer of resources to military use. In a global context, the high real rates would also induce capital inflows, most likely from neutral countries.

246 What Drives Global Capital Flows?

When peace returned, a reverse set of dynamics to the above would come into effect. The neutral level of real interest rates would fall, and so would the general price level (fall) as resources were transferred back to production of butter. If the price decline were violent (as might happen if rampant wartime commodity speculation came to an abrupt end and moved into reverse) then in principle interest rates might have to fall well below neutral level to prevent an economic depression and limit the overshoot (in the downward direction) of the overall price level. Indeed, in the context of overall deflation, the zero rate boundary might become effective, meaning that equilibrium cannot be reached under conventional monetary policy. As in our illustration above, a period of unconventional policy would be optimal. In practice, the examples of the US in the First and Second World Wars shed some light on the theoretical discussion. In both cases there was substantial price rationing (more in the second than in the first). Price controls (meaning that spending is limited by rationing) mean that interest rates during wartime can stay at a much lower level than otherwise without recorded inflation soaring. (Long-maturity rates, however, might reflect expectations of very high real interest rates in the post-war situation once rationing is abandoned). At the end of the war the private sector has large pent-up demand (held in the form of above-normal holdings of money and government bonds relative to income). Interest rates then would have to rise sharply – and stay high over a sustained period – so as to bring savings and investment into equilibrium. It may prove politically unacceptable to rein back in this way reconstruction spending to allow space for households to spend revenues saved during wartime. Calls would grow for some windfall taxation of the wealth overhang – some of which had accumulated in the black economy. A bout of inflation, during which the central bank deliberately pegs interest rates at a very negative level in real terms, could satisfy the calls. In the example of the First World War, the US price level rose by 13% in 1916, 24% in 1917, and 15% in 1918. In the first year of peace, 1919, the price level stabilized, then jumped by 14% in 1920, before falling back by 15% in 1921 and 5% in 1922. Elements of the story above can be intertwined with this data. Evidently the Federal Reserve did not aim to hold down inflation induced by resource shortage during the war, and in fact gave it a helping hand by holding rates below the neutral real level. The fall-back of inflation to virtually zero in 1919 reflected the resumption of peacetime production and relief of scarcities. The Federal Reserve did not realize the temporary nature of

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the calm climate on prices and failed to push rates up into line with the then neutral real rate level reflecting peacetime prosperity amidst a high propensity to spend in the post-war environment. (It is possible, nonetheless that the new neutral level was lower than during the war itself, but of course market rates had been far behind). Contemporary critics realized the inadequacy of Federal Reserve policy at this time (1919), as evident from Joint Congressional Commission of Inquiry (see Friedman and Schwartz, 1963, p. 229). Critics cite the boom which got underway in 1920, largely speculative in nature. This then gave way to the bust of 1921. The Federal Reserve (created in 1913 and with little peacetime experience) reacted severely to the boom and associated speculative price rises. But it then failed to prevent a short episode of severe deflation. Friedman criticizes sharply the Federal Reserve for overkill in early 1920 (when large rate hikes occurred). In one sense, however, that line of attack (by Friedman) misses a wider issue – as to whether the Federal Reserve should have been seeking to induce, albeit belatedly, some rollback of the price level rises related to resource scarcity during World War One. It stood in the way of that roll-back during 1919–20 by at first following an over-easy monetary policy. It then sought to correct its error – but in a way that had abrupt and painful economic consequences. If the aim had been to foster a smooth roll-back of the wartime price level, then policy should have been tight throughout 1919–20. Strategy rather than fine-tuning is the issue to debate. Following the Second World War, the Federal Reserve took no chances on abetting a process of price level decline, at least part way back to pre-war levels, once resource shortages eased. Nominal money market rates and Treasury bond yields were maintained at around the same low level (1% for bills, 2.5% for long-maturity bonds) that had prevailed during wartime, when aggregate demand had been restrained by a much more powerful system of physical rationing than had been in force during the First World War. The lesson learnt from the previous post-war recession (1920–1) was that deflation and recession should be enemy number one. The price level had risen by 8% in 1941, 13% in 1942, 13% in 1943, 7% in 1944 (restrained in that year by greater rationing), and 4% in 1945 (lowered by a relief of resource shortages following the end of war). In 1946 and 1947 the price level bounded ahead by 18% and 10%. There were then two years’ calm – in 1948–9 – during which the price level was stationary (up 1% in 48 and down 2% in 49). In 1950–1 there was a new inflation surge associated with resource shortages

248 What Drives Global Capital Flows?

during the Korean War – prices rising by 8% and 5% in each year respectively. In the peace that followed the Federal Reserve did not allow the overall price level to fall back. It was only in March 1951 that the Federal Reserve and Treasury entered into an accord which effectively brought a formal end to the former’s price-fixing operations in the government bond market and so made possible again an independent monetary policy (see Hess, 1969). The Federal and Reserve and US Treasury had been working partners in an almost 50% increase in the price level (1945–52) under conditions certain to impose huge real loss on all holders of dollar assets (whose principal was fixed in nominal terms). By contrast in the seven years following the end of World War One, the price level had fallen by a cumulative 5%. Where could investors in 1945 have found refuge from the coming direct attack on monetary wealth organized jointly by the government and Federal Reserve? Foreign currencies provided no hedge at all, in that the dollar was generally strong and the rest of the world struggled with dollar shortage (huge payments deficits in the midst of post-war reconstruction). Back in 1934 the Roosevelt Administration had raised the official price of gold in terms of dollars by around 70%. And so the yellow metal now offered no hedge protection to investors who could obtain stocks (either on a legal or illegal basis according to the political jurisdiction in which they lived). (Arguably gold did provide protection to those few farseeing investors back in 1930–2 who saw the possibility that depression could be followed by a long bout of inflation. The insurance pay-out occurred upfront). In fact this was a period (1945–52) when real estate and equities first gained their reputation as hedges against inflation. But that was an illdefined concept. More precisely they were hedges against a deliberate but controlled exercise in the partial destruction of real monetary wealth by government via the holding of all interest rates at substantially sub-zero real levels, far below the neutral level. Moreover it was essential (to the hedge-asset performing well) that this was a time of growing economic prosperity. The example of post-war destruction of real monetary wealth has a very tame parallel in the situation of peacetime productivity or positive terms of trade surprise where the monetary authority is seeking to prevent a fall in the actual price level (or to maintain inflation at a low positive level rather than allowing it to dip to zero or even into negative territory). Take as yardstick again the case of the central bank aiming to maintain money supply growth on a target path or at a target level. An acceleration of productivity growth (or a new trend

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improvement in the terms of trade) as might occur in advanced economies as the pace of globalization accelerates would, under this monetary regime, put downward pressure on the steady-state inflation rate or on the overall price level – both towards a new lower long-run equilibrium level as the case may be (dependent on the exact monetary rule followed). That adjustment downwards might carry economic costs. As money demand accelerates (under influence of faster economic growth) relative to money supply, money rates would rise above the neutral rate in real terms (and that latter variable might well have risen). Some prices could be rigid downwards. And so the economy could be in a recessionary disequilibrium for some time. A fall in the inflation rate to near zero might mean that anti-recessionary monetary policy could not in future be accomplished with the use of conventional tools. Rather than accept these costs, the monetary authority may bolster the pace of monetary growth in pursuing its aim for stable prices (rather than falling) or an unchanged moderate rate of inflation (rather than a lower one). In that situation the nominal money market rate might dip below the neutral rate during a transitory period (in which the central bank presses on the monetary accelerator until the new higher rate of money supply growth is achieved. Real market rates of interest might well fall during this interim period to below previous levels. A corollary of the fall in the real rate would be a transitory decline in the real exchange rate of the currency (issued by the economy whose productivity growth has increased). Hence foreign currency assets would offer some protection against the real income loss during the process of monetary acceleration. Where productivity growth gains and matching transitory monetary acceleration are a global phenomenon the real estate or equities may be the only protection against real income loss (on monetary assets), but they are subject to considerable risk on their own account. Moreover the phenomenon of monetary acceleration linked to stabilizing the price level or inflation may very well go together with a bout of asset price inflation (in real estate or equity markets or both) culminating in a bubble and bust. Indeed, the Austrian school’s diagnosis of the US asset price inflation (real estate and equities) in the 1920s is based on just such a sequence (see Oppers, 2002 and Hayek, 1931). The rapid productivity growth of that period coupled with low or stationary money supply growth would have meant a significant trend decline in the price level. Instead, the Federal Reserve (according to the Austrians) held the market rate of money rates below the neutral rate in order to shore up

250 What Drives Global Capital Flows?

the price level. The below neutral level of real rates played a crucial role in generating the asset price bubbles, which subsequently burst as rates in the late 1920s (1928–9) rose to neutral level and eventually well above. It is too early to tell whether history has been repeating itself in the early 2000s (2002–6) with the Federal Reserve offsetting the downward influence of rapid productivity growth and terms of trade improvement (fuelled in part by a heightened pace of globalization) on the US price level by holding money rates at below neutral level. During the same period (2002–4) the US dollar fell sharply. Many commentators suggest that the residential real estate market in consequence entered a bubble. Then in 2005 the Federal Reserve sought to drive short-term market rates back up to neutral level, now convinced that inflation expectations and underlying monetary growth had risen to levels consistent with the optimum path of low and stable inflation (rather than actual deflation, which had surfaced as a risk in early 2003). The energy price shock of 2004–5 undoubtedly played a role in overcoming the perceived danger of inflation falling too low (or of actual deflation emerging). Perhaps the red-hot residential real estate market which characterized the growth-cycle upturn in the US economy during 2004–5 will prove to be the latest example of the bubble-and-burst phenomenon. As rates move to neutral and above a process of asset deflation could set in. From the viewpoint of a US investor at end-2005, foreign currency assets were widely touted as the best hedge against the scenario of real estate market crash. The problem was that the dollar had already fallen steeply (in 2003–4) (with only a modest overall recovery – measured in real effective exchange rate terms – during 2005), and the main alternative international currency, the euro, could also be influenced by the bursting of hot real estate markets in Spain, France, Italy and the Netherlands. Moreover many global investors had concerns that the failure of progress towards monetary union in Europe would eventually doom the euro. Gold was sparkling again but was widely seen as in speculative frenzy. The Swiss franc seemed to be totally drained of any protective strength. The search of the rational investor for safe haven was not leading in a clear direction.

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Index aggregate global gap, 18, 19, 20, 23 its clue to grey and black capital flows, 49–55 Alberta tar sands, their influence on Canadian dollar exchange rate and interest rates, 207–9 arithmetic of external debt growth, 123 Asian dollar bloc electoral considerations in why Bush Administration launched attack on, 172 Washington assault on, 171 why ECB’s Trichet joined in unholy alliance with Washington against, 176–8 why Greenspan and Bernanke supported the attack on, 173 Asian savings surpluses their influence on neutral rate spread between dollars and euros, 71 their recycling to the US via the euro-area in part, 15 Australia, its large savings deficit, 21 Austrian school of economics, its diagnosis of asset price inflation and causes, 249 bad states of the world, for example natural disaster, war, and how to hedge against, 243–5 balance of payments accounting errors in, 3 identities, 3 see also command-type model of balance of payments adjustment; world balance of payments Balassa effect reverse Balassa, 80 speculation on, 79–81 Swiss franc and Japanese yen as examples of reverse Balassa, 80

Bank for International Settlements, Canadian influence in, 152 Banking system rarely an important conduit (as distinct from intermediary) for capital flows, 131 bank secrecy, defenders and opponents of, 39–41 banknote exports, as form of hidden capital flow, 47, 58–64 banknote markets, 58–60 scandal in, 62 banknotes, 1:1 convertibility suspended under negative interest rate regime, 115 Bernanke monetary shock, 2003, 109 impact on currency markets, 170 big neighbour next door examples of Japan vs. China and Germany vs. Eastern Europe, 85–6 influence on trade and capital flows, 86–7 black money defined, 38–9 methods of detecting flows, 42–4 role in financing US deficits, 55–6 bond markets, their failure to predict deflation, 102, 108 Brazil, a growing savings surplus in the long-run?, 128 Bretton Woods its breakdown, 150, 153 revived in Asia, 77–8 bubble aftermath, the fall of neutral interest rates to negative level, 110 bubble economy, in Japan, 103 bubble markets, in yen, 107 in US residential real estate market, 250 Burns, Arthur, responsible for the greatest US peacetime inflation, 163

256

Index 257 Canada exchange rates, 207–10 its “French” position in international currency diplomacy, 152 the energy bonanza in Alberta and its influence on relative prices and Canadian dollar, as prime petro-currency, 238 capital account data problem with traditional concepts, 16 see also currency flow of funds analysis capital export restrictions in China, 142 capital flight and its use of turntables, 11 banknotes as vehicle of, 58 historical examples, 78 its relevance to neutral rate spreads, 73–5, 78 within monetary union, 195 capital outflows, weakened by deflation in Japan, 104 carry trade contraction during global financial crisis, 236 in yen, 28, 233 Cayman Islands, 47 China as example of round-tripping in global flow of capital, 13 as example of turntable in global flow of capital, 14 its currency diplomats skilled, 152 its emerging savings surplus, 90–1 China-US-France currency diplomacy, 174–8 Chinese diaspora, as source of capital, 14 Chinese savings surplus, set to grow much larger?, 128, 142 Chinese yuan, external flow of funds in, 32 command-type model of balance of payments adjustment, use of by euro-negotiators in currency diplomacy, 2003–5, 177

concentration risk, as factor in sustainability of US current account deficit, 129 corporate sector savings, how to integrate with household savings analysis, 228 crash of Japan bubble economy, 103 of Tokyo equity market, 105 currency diplomacy China becomes active in, 152 definition of three main types of, 146 France’s role in, 150, 153–8 its focus on China, 142 role of UN security council seat in, 151 use of US trade threats in, 147: trade-offs with other forms of diplomacy, 149, 175 see also China-US-France currency diplomacy; outlook for currency diplomacy; Tokyo-Washington dialogues on currency policy; US currency diplomacy currency flow of funds analysis advantages of compared to capital account analysis, 26–7 problems of, 37 currency flows, how to measure, 16–17, 26–37 currency preference its influence on interest rate differences between countries, 71–2 possible influence on neutral rate spread between dollars and euros, 71 currency risk, as determinant of savings balance, 7 De Gaulle, Charles his promoting of France’s voice in currency diplomacy, 153 his rejection of a trade-off between US nuclear help and renouncing gold, 153

258 Index deflation as obstacle to international equilibrium, 103 in Japan, 103 Delors, Jacques, his view about feasibility of Socialism in France or Europe, 196 demographics, its influence on global capital flows and relative price change, 204–7 descent into deflationary disequilibrium, 103 direct investment flows how related to neutral rate spreads, 84–7 into China, 92–3 disequilibrium affecting the savings-investment balance and its relation to balance of payments, 4, 6 caused by export surplus outstripping savings surplus, 88 Chinese balance of payments in, 89 disequilibrium scenarios and divergences between market and neutral interest rates, 87–8 why observed savings balances may be out of line with equilibrium, 20 diversification away from the US dollar, by Asian investors, 15 divorce of monetary union, principles of how this would occur illustrated for European Monetary Union, 210–14 Dubai G-7 summit, 112, 148, 174–6 see also G-7 diplomacy earnings yields, how to use in equity market valuation, 219 East Asian countries, move into savings deficit from surplus following debt crisis, 23 East European economies, their aggregate savings deficit, 20 elasticity pessimism as expressed by Laurence Summers, 137 with respect to trade, 135

energy bonanza illustrated for Canada, 207–9 its influence on capital flows inside and outside monetary union, 207–10 equilibrium path for exchange rate, 69, 122 equity capital flows analysis of in yen analysis, 230 as force behind and relation to neutral rate spreads, 84–7 errors and omissions in balance of payments, 44–9 EU, exchange of information by tax authorities, 40–1 EU Commission, its false diagnosis of US current account deficits and the role of EU in global adjustment, 142 Euro banknotes popular in grey areas of world economy, 59–60 external flow of funds in, 33–4 euro-area as turntable in flow of funds from Asia to the US, 14–15 enters arena of currency diplomacy at Dubai, 171–2 problems of measurement, 24 savings surpluses and deficits diverge largely between member countries, 20 Euro-Group, its participation in currency diplomacy, 171 Euro-nationalists, 176 see also Trichet, Claude European Central Bank its contribution to international disequilibrium, 2001–4, 157 its refusal to focus on German price level only despite large relative price level adjustment within EMU, 189–91 European Monetary Union, see divorce of monetary union; German problem in EMU; German savings surplus; national socio-economic choice within monetary union; real interest

Index 259 rate spreads within a monetary union; relative price level adjustment within monetary union; Rhenish capitalist model exchange rate trends in real terms, 79 relevance to neutral rate spreads and savings surpluses and deficits, 79–80 speculation on, 79–83 see also equilibrium path for exchange rate exchange restrictions, their influence in China, 89–90 Federal Reserve, its failures in monetary policy during 2000–1, 108 Federal Reserve Bank of New York, its ECI program for foreign dollar banknote holdings, 61–2 Financial Action Task Force (FATF), 39–40 five wars of globalization, 39 floating vs. fixed exchange rates, benefits and costs in reparations problem, 98 foreign appetite for US dollar assets, satiation of, 126–35 foreign exchange intervention by Japan 2003–4, 111, 170 justified by zero rate boundary, 111 foreign exchange reserve accumulation, see sterilized foreign exchange intervention freely floating exchange rates, why not possible under deflation conditions, 115–18 France a potential alliance with Japan in 1971 to maintain international monetary blossoming of French currency diplomacy under Trichet’s presidency of ECB, 156, 174–6 its attitude and importance in currency diplomacy vis-à-vis China, 152 its vision of a multi-polar world, 153

opposition to German monetary nationalism, 155 response to Nixon shock, 148 why so active in currency diplomacy, 150, 152–7 Friedman, Milton, his criticism of Federal Reserve policy after First world war, 247 G-7 diplomacy, as front for US-Japanese bilateral deals?, 148 general equilibrium and interest rate neutrality, 68–70 related to savings balance and balance of payments, 3 German economic miracle, 1925–8, capital flows during, 78–9 German problem in EMU, 187–93 German reparations problem revisited, 94–6 as example of transfer problem, 95 currency losses made in connection with, 220 false analysis of by Keynes, 95 key issue was inability of private capital markets to function, 97–8 German savings surplus, its bulge in 2003–5 and issues raised for European Monetary Union, 187 Germany impact of its unification boom, 23 its huge savings surplus, 2005–6, 21 role in currency speculation, 2004–5, 224 Global financial storms, what are the safe-havens against these?, 236 see also carry trade Gold its failures as a safe-haven investment, 248 the raising of the official price in 1934, 153 Gold standard system, the transfer or reparations problem under, 98 Greenspan, Alan his brief participation in Clinton Administration’s currency diplomacy vis-à-vis Japan, 164, 169

260 Index Greenspan, Alan – continued his involvement in Bush Administration’s currency diplomacy with respect to China, 163, 173 his general distaste for currency diplomacy, 163–4 his one-day visit to Beijing in 2005, 164 his opposition to and undermining of Louvre Accord on eve of Wall Street Crash, 163 his view on sustainability of US current account deficit, 126 why he favored break-up of Asian dollar bloc, 173 see also Wanniski, Jude grey and black areas of the world, on dollar standard?, 131 grey capital, black and grey distinguished, 38–9 hidden capital exports, 45–7 hidden capital inflows, 46–7 into residential real estate markets, 47 Houthakker-Magee effect and pessimism on US trade, 137 immigration, its influence on capital flows, 206 indexed government bonds, as safe-haven against spectre of negative real rates, 240 India a growing savings surplus in the future?, 128: a big appetite for dollar assets?, 131 inflation driven by real scarcity, 240 how to hedge against, 240–5 the special case of war-time inflation, 246–8 interest rate neutrality 2-dimensional definition of, 66–7 how capital flight affects, 74–6 how long-term rates can diverge from, 68 partial concept in one country only, 70

pursuit of by Greenspan Fed, 67 why most of time neutrality does not hold, 67–70 investment income, missing amounts received into tax havens and offshore centres, 18, 31, 50, 54 investment opportunity, changes in and influence on capital flows, 84–5 Japan as big round-trip in global flow of funds, 25 as small turntable in global flow of funds, 25 Japan savings surplus below equilibrium level in 2005, 22 forecasts of as integral part of currency analysis, 229 Japanese yen assessment of exchange rate trends in, 81–3 flow of funds in, 27–9 use of savings-investment analysis in predicting exchange rate trends, 231 Keynes, John Maynard his view that Germans should cut back beer consumption, 137: his losses as currency speculator, 220 see also transfer problem Koizumi government, its excellent relations with Bush Administration, 111 limits to size of US current account deficit, 122, 132 lost Decade, of Japanese economy, 103 Louvre Accord, 1987, 156 initially supported by Treasury Secretary Baker and then undermined by same, 162 Luxembourg cooperation with EU on tax, 41 its defence of bank secrecy, 40 Middle East oil exporters, their savings surplus, 22

Index 261 Mieno, Yasushi faulty concept of role of Japan’s savings surplus in currency market equilibrium, 168 his contribution to Japan’s deflation, 105 miracle economy, savings deficit not characteristic of, 128 monetary base policy, why better suited than rate-targeting to international equilibrium, 112–15 monetary authorities, as source of disequilibrium in global economy, 140 multi-polar world, France’s and euro diplomats’ ambition for, 181 narcotics trade, its influence on currency flows, 45, 56 national socio-economic choice within monetary union, 193–7 natural interest rate, definition of, 66 negative interest rate regime, its possible introduction in Japan or elsewhere, 114–15 negative interest rates, neutral level negative in Japan, 110 Netherlands, its experience of adjustment to rising energy revenues, 210 neutrality, see interest rate neutrality Nixon shock, 147–8, 164 non-sustainability of current account deficits economic concept of, 125–6 failures of Japanese monetary policy and currency diplomacy in response to, 165–6 North Korea, nuclear crisis there plays a role in currency diplomacy between Japan, US and China, 149 Norway, public sector foreign asset accumulation in, 74 OECD role in promoting exchange of information in tax matters, 40–1: its pessimism on US trade deficit, 139

oil shock analogy with reparations, 100 and the transfer problem, 98–103 its effect on global capital flows, 22 OPEC cartel, and the transfer problem, 94–5, 99–102 outlook for currency diplomacy, 178–81 passive investment strategy, 215 defined, 217 petro-currencies, speculative calculation in, 237–8 Plaza Accord, 146 the most over-sold accomplishment in the history of currency diplomacy, 161 population ageing its influence on interest rates and price levels inside and outside monetary union, 204–7 see also demographics pre-retirement generation, their role in bolstering savings rate, 128 private bankers, in Switzerland and Luxembourg, 31 productivity growth as source of deflation, 250 influence on exchange rate trends, 80–2 see also Austrian school of economics; Balassa effect radio-frequency tags, for detecting black capital flows, 64 real estate market speculation in China, 92 its influence on capital flows, 92 its influence on capital flows within monetary union, 197–204 real estate, when is it a hedge against inflation?, 249 real interest rate spreads within a monetary union, 183 perverse movements possible, 184 regime change as an aim of currency diplomacy, 146

262 Index relative price level adjustment within monetary union, 184 potential barriers to and possible overall size, 184–7 small and large countries distinguished, 186 residential real estate market price formation, an analysis of, 197–202 Rhenish capitalist model, how the costs are divided in a monetary union, 188, 193–5 risk premiums, estimation of for different asset classes, 218 round-trips in the global flow of capital, 11–15 examples of, 12–13, 25 Rueff, Jacques, his role in French currency diplomacy under de Gaulle, 153 Russia, its huge savings surplus in 2005, 20 safe-haven currencies definition of, 235 role of in portfolios, 235–9 see also Swiss franc Sakakibara, Eisuke, role in US-Japan currency diplomacy, 169 savings deficit countries, characteristics of, 7 savings surplus countries characteristics of, 7 small countries with huge surpluses in East Asia and Western Europe, 20–1 savings surpluses and deficits currency risk as determinant of, 7 equilibrium path for, 6 how estimation of is a key component of speculative currency analysis, 224–6 their relationship to balance of payments, 3, 9 shipping companies, their unreported trade and capital transactions, 51 short circuits how monetary base policy might prevent, 112 how they interfere with freely floating currencies, 118–21

in case of yen, 210 in case of dollar, 208–10 in global capital flows, 2000–4, 106–12 Singapore political risk in its financial centre, 41 public sector foreign asset accumulation in, 74 small advanced Asian economies, their external flow of funds, 30 smuggling, impact on reported balance of payments, 45–6, 54 see also narcotics trade socialism, is it possible within monetary union?, 196 speculation, defined, 215 speculative talent, how to assess, 219 speculators against the dollar a basis for calculation, 221–6 how they miscalculated in 2004, 221 sources of power behind capital flows, 66 Spain, as real estate bubble economy in monetary union, 183 spectre of negative real interest rates, 239–50 where investors can look for safe-havens against, 239–48 sterilized foreign exchange intervention, 74 disadvantages of, 79 fictional use of in Europe of 1960s, 75 rare successes of, 74–5 use of in East Asia, 76–8 Sterling, external flow of funds, 33 Strategic Impediment Talks between Japan and US, 167 Summers Laurence, his pessimism about US current account deficits, 137 sustainability, of huge current account deficits or surpluses Greenspan’s view of, 124 problem defined and arithmetic of, 123 see also non-sustainability of current account deficits

Index 263 Swiss Federal Banking Commission, action against UBS, 63 Swiss franc and reverse Balassa effect, 237 as safe-haven currency, 235–7 assessment of exchange rate trends, 80–3 Switzerland as centre of banknote market, 59–60 cooperation with EU on tax, 39–41 its defence of bank secrecy, 40 its huge savings surplus, 236 tax havens and offshore financial centres, 31 two forms of black capital flow to, 55–6 Tokyo equity market build-up of foreign holdings in since Crash, 1990, 233 illusory currency hedging of, 233 Tokyo-Washington dialogues on currency policy, 164–71 trade invoice tampering as means of exporting hidden capital, 48, 52 two types distinguished according to their impact on recorded trade balances, 47, 51–4 transfer problem as defined by Machlup, 95 false analysis of by Keynes, 95 general definition of, 95–6 how US deficits fit in to analysis of, 96–7 in context of oil shock, 100–3 see also zero rate boundary Trichet, Claude an old-hand French currency diplomat, 152 his blindness to the global dimension of interest rate neutrality and his embracing of euro nationalism, 157 his position on Chinese currency issue at G-7 summits, 153, 174–5 turntables in the global flow of capital, 8–11 defined, 8

example of, 2003–4, with respect to Europe between Asia and US, 9 how to measure and identify, 24–6 illustrated in Latin American capital flight, 11 UK as a centre of round-tripping in global flow of capital, 25 UK savings deficit, 20 UN Security Council currency diplomacy, 151, 175 its action against Iran and related diplomatic trade-offs between Beijing and Washington, 149 lack of a seat there for Germany or Japan has influence on their role in Union Bank of Switzerland, forced to withdraw from US dollar banknote program, 62 US currency diplomacy in the 1960s, 159 in the 1970s and 80s, 160–1 see also Nixon shock; Plaza Accord US dollar final reconciliation of global flow with black capital analysis, 55–7 foreign holdings of banknotes in, 60–3 global flow of funds in, 35–7 US Internal Revenue Service, pursuit of offshore credit card transactions, 52 US mega current account deficit benchmarks of sustainability, 22 its origins, 72–3 its financing related to transfer problem?, 95 its sustainability, 18 growth arithmetic of, 122–5 see also limits to size of US current account deficit; sustainability US trade law, its use in currency diplomacy, 147 Volcker, Paul his active role in US currency diplomacy, 161–2 reasons for supporting Louvre Accord, 162

264 Index Wanniski, Jude, his criticism of Greenspan’s conduct on eve of Wall Street Crash and in particular his undermining of the Louvre Accord, 163 war, its influence on global capital flows and asset prices, 245–6 Washington its periodic efforts to devalue the dollar, 146 its traditional positions and use of trade weapons in currency diplomacy, 157–64 withholding tax, in Switzerland, Luxembourg and Austria as part of EU agreement, 40

world balance of payments concept described, 19 history of, 19 zero rate boundary as barrier to Japan’s international equilibrium, 104 as obstacle to solving transfer problem, 100–3 as potential barrier to US equilibrium, 106–7 Zurich airport, as one-time hub for global currency trade, 63