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Nov 24, 2003


Global: Derailing the Global Trade Engine
Global: False Dawn
United States: Review and Preview
Currencies: What an Equity Market Revival Would Mean for G10 Currencies
Europe - All: From Flexibility to Relapse
Hong Kong: Monetary Implications of Renminbi Banking


Global: Derailing the Global Trade Engine

Stephen Roach (New York)


Cross-border trade flows are the glue of globalization.  They are the means by which the world creates ever-virtuous circles of prosperity. The theory is simple: As poor countries enter the global supply chain, their increasingly prosperous workers eventually become consumers. Supply creates new demand, and the world is a net winner.  While it’s hard to argue with this theory, today’s world is having an increasingly difficult time in putting this theory into practice.  The global trade engine is at risk of being derailed.

That would come as a rough jolt to the world economy.  Indeed, there can be no mistaking the increasingly important role global trade has played in driving world economic growth in recent years.  By our estimates global trade in goods and services now amounts to 25% of world GDP, up dramatically from the 19% share just ten years ago and an 11% portion in 1970.  Over the past 17 years, 1987 to 2003, surging global trade has accounted for fully 33% of the cumulative increase in world GDP.  By contrast, over the 1974-86 period, trade accounted for about 17% of the cumulative increase in world GDP.  In other words, since the late 1980s there has been a virtual doubling of the role that trade has played in driving the global GDP growth dynamic.  There can be no greater testament to the power of globalization.

Yet there are worrisome signs that the trade dynamic is now going the other way.  After surging by a record 13% in 2000, global trade has entered one of its worst slumps in modern experience -- average gains of just 2% over the 2001-03 period.  That’s the weakest performance since the early 1980s and only a third of what we estimate to be a 6.5% long-term trend in global trade growth.  Coming in the context of one of the mildest global recessions in recent history, this shortfall is all the more disconcerting.  It suggests that there may be new forces coming into play that transcend the normal pressures of the business cycle.

What worries me most is that the recent shortfall in global trade may be a warning shot of even tougher times ahead.  Two key forces are at work:

The first is a new and powerful global labor arbitrage that has led to accelerating transfer of high-wage jobs from the developed world to lower-wage workforces in the developing world.  Enabled by the Internet and the maturation of vast offshore outsourcing platforms in goods and services alike, labor has become more “fungible” than ever. In a world without pricing leverage, the unrelenting push for cost control gives a sudden urgency to this cross-border arbitrage.  The outcome is a new and potentially lasting bias toward jobless recoveries in the high-wage developed world.  That brings the second major force into play -- a political backlash against the trade liberalization that allows such cross-border job shifts to occur.  It is the politics of this trend that disturb me the most as I peer into the future.

Insecure and scared workers tend take out their fears and frustrations on incumbent politicians.  To the extent that the IT-enabled global labor arbitrage represents a new and lasting threat to job security in the developed world, this political backlash is understandable -- albeit deplorable.  This backlash has now taken on a life of its own -- giving rise to what I believe is a “perfect storm” in global trade policy.  This storm is an outgrowth of five major setbacks on the global trade front -- the first and most worrisome being the breakdown in the WTO ministerial negotiations last September in Cancun, Mexico.  Tensions between poor developing countries and the wealthy industrial world came out in the open on such long-standing issues of agricultural subsidies, competitiveness and investment rules, and financial market transparency.  This failure is on a par with the WTO fiasco in Seattle in 1999 and all but rules out successful completion of the so-called Doha Round of multilateral trade liberalization originally slated for 2004.

The second is the mounting risk of a global trade war over steel. Motivated largely by domestic political considerations, the Bush administration raised tariffs on selected steel imports by up to 30% in March 2002, drawing justification from the WTO's so-called Safeguard Agreement.  The WTO has since found these measures to be illegal and has given the United States until December 15 to rescind them.  The European Union has warned of the imposition of $2.2 billion in retaliatory measures should that not occur.  Others, including most recently, Japan and Norway, have announced that they will follow suit.

Third, China bashing has taken an ominous turn for the worse.  The Japanese fired the first rhetorical salvos in this trade battle well over a year ago, accusing China of exporting deflation and hollowing out the Japanese economy.  America has taken the blame game to a new level. The Bush administration has just imposed quotas on imports of selected Chinese textile products, and legislation has been introduced in both houses of the Congress that would impose huge tariffs on all Chinese imports into the US -- 27.5% in the case of the Senate version and most likely even a higher tax in the House version.  The most worrisome aspect of these legislative threats is the broad bipartisan and ideological support they enjoy in the Congress.  Moreover, there is no effective political counterweight to America’s onslaught of China bashing.  The White House has put its protectionist cards on the table by actions on steel and Chinese textiles.  Nor have trade-intensive US multinationals spoken up -- hardly surprising in this post-Enron climate of political vindictiveness.

Fourth, trans-Atlantic trade tensions between the United States and Europe seem to have taken on a life of their own.  It’s not just steel.  It’s also disputes over genetically modified beef and other food products, agricultural subsidies, and a broad array of services.  Particularly contentious is America’s Foreign Sales Corporation tax law (FSC), some $4-5 billion annually of export tax subsidies.  The WTO has also ruled the FSC arrangements illegal, granting the EU up to $4 billion in remedial damages if these measures are not lifted by the start of 2004.  Cross-border US-European trade currently amounts to some US$400 billion annually, hardly a trivial mater.  With Europe and the US both facing intensified structural pressures on the job front, one of the pillars of the world trading system is at risk of crumbling.

Fifth, a darkening outlook for multilateral trade breakthroughs is being compounded by deteriorating prospects for less ambitious bilateral and regional agreements.  The just-concluded negotiations in Miami for the Free Trade Association of the Americas are a case in point.  The meetings adjourned with nothing of great substance accomplished other than an agreement to meet again next year.  The same snail-like progress has been evident with respect to the US-Central America Free Trade Agreement, as well as one with Australia.  In a jobless recovery that is now moving into the full force of the election cycle, the US Congress seems to have little appetite for either the large or the small milestones on the road to trade liberalization.

We all know the dark lessons of protectionism.  The odds of falling into that abyss remain low, in my view.  But support at the other end of the spectrum -- accelerated trade liberalization -- is slipping rapidly.  The lasting impacts of the global labor arbitrage are striking worrisome chords in the body politic of the rich, developed world.  That poses a serious challenge to the trade-led strain of global growth that has been such a powerful force is shaping the global economy since the late 1980s.

Fear lurks in all of history’s darkest corners.  Gibbons put it best in the Decline and Fall of the Roman Empire: “There exists in human nature a strong propensity to depreciate the advantages, and to magnify the evils, of the present times.”  To me, this encapsulates the resistance to globalization.  As these pressures mount, we can only hope -- perhaps demand -- that opportunistic politicians come to their senses. America’s role in sparking the backlash to trade liberalization is particularly disconcerting.  As the world’s unquestioned economic and military superpower, the United States is in real danger of squandering its leadership in the arena of globalization.  Perhaps I’m pushing Gibbons too hard on this point, but to me this dark side of America has some striking similarities with his description of Rome at its pinnacle, “…when the uniform government of the Romans, introduced a slow and secret poison into the vitals of the empire.  The minds of men were gradually reduced to the same level, the fire of genius was extinguished, and even the military spirit evaporated.”


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Global: False Dawn

Rebecca McCaughrin (New York)


Monthly US portfolio flow data rarely attract more than a cursory glance from financial markets, but the latest batch of surpr

Monthly US portfolio flow data rarely attract more than a cursory glance from financial markets, but the latest batch of surprisingly weak data sent ripples through markets this week.  The US Treasury release indicated that net aggregate portfolio inflows plunged to just $4.2bn in September, an even sharper slide than that in the aftermath of the terrorist attack in September 2001 and the lowest level since the LTCM crisis in late 1998.  In our view, September will likely prove an outlier, mostly reflecting a knee-jerk reaction by private investors to the G-7 communiqué.  The massive inflows seen during May-June were also outliers we believe, and as we argue below, the current pace reflects a rebalancing, not an inflection point. 

But first, a few disclaimers on the data:  First, the monthly US Treasury data (TIC) include both official and private portfolio flows, but do not capture investment in short-term securities.  Second, the data tend to overstate foreign investment in US bonds and understate US investment in foreign equities.  Third, the regional data can be misleading because they represent the place of transaction, not the ultimate source, destination, or issuer.  Fourth, the data can be volatile and subject to revisions.  That said, with careful interpretation, in our view, the data still provide valuable indicators of capital flows between the US and the rest of the world.

The plunge in portfolio investment in September took place across most assets (excluding corporate bonds), and was triggered by a retrenchment by European, Asia ex-Japan, and “other” (mostly offshore) investors.  Thanks in part to Japan’s MoF intervention in September, funds from Japan were the only significant inflows recorded for the month.  While Asian central banks have helped to prop up foreign demand for US securities this year, the transatlantic axis still matters.  After averaging $28bn in net purchases of US securities during the first eight months of this year, Europeans suddenly switched gears in September, selling off $403mn.  The impact is a reminder of how critical Europe is to the pace of capital inflows.

Generally, such a dramatic month-to-month swing is accompanied by an external shock (i.e., September 11 attack, LTCM/Russian debt crises, corporate scandals, Iraq crisis, etc.).  The only key event this time was the issuance of the G-7 communiqué, which was initially hailed as a mini-Plaza Accord.  US officials have since muted their rhetoric and the initial panic has subsided.  Official institutions appear not to have heeded the message in any case, hardly flinching and continuing to steadily increase their holdings of US securities. 

A closer look at the TIC data indicates that foreign official institutions actually stepped up their investment significantly during September.  More recent weekly custody holdings data (which capture both long-term and short-term securities) through November 19 point to a sustained accumulation of US government securities.  Private investors, however, were clearly spooked by the communiqué’s message -- gross private inflows slid to just $4.3bn for the month, down from $62.4bn the prior month and $40.4bn a year ago.  Private investors tend to be more fickle than official institutions.  They are also more important as a source of financing, and thus can spark sharp reversals.  Although central banks have played an important role in financing the deficit over the last year and a half, they are not the linchpin that they are often perceived to be, in our view (see McCaughrin, “What are the Options?” September 19, 2003). 

In addition to the initial exaggerated reaction to the communiqué, the fall-off in investment in September also reflects the rebalancing that took place following the post-Iraq relief rally.  The last three quarters were punctuated by very different developments: During Q1, geopolitical concerns weighed heavily on demand for US assets, as gross inflows slowed to $139bn.  Then in Q2, the relief rally following the Iraq invasion helped to unleash pent-up demand for US assets, resulting in a record $247bn in foreign inflows for the quarter.  Then, as perceptions normalized and the relief rally lost some momentum, inflows moderated to a still healthy $153bn in Q3.  September may have been an outlier, but so were the massive Q2 inflows.  All in all, factoring in growing outflows and September’s plunge, the US has still managed to attract $688bn in net aggregate portfolio inflows on an annualized basis this year, more than sufficient to cover the projected current account deficit of $600bn. 

While we doubt September’s pace will persist, there are three risks which could become more serious if foreigners were to continue to aggressively retrench from US assets.  First, US investment in overseas securities is rising, which is contributing to downward pressure on our net aggregate intake of capital.  After five years of subdued outflows, US investors are rediscovering overseas markets, primarily equities in Japan, Europe, and emerging Asia.

Second, more sluggish net aggregate portfolio inflows are of concern in light of the disproportionate composition of US financing. Foreign direct investment (FDI), the other key component of US capital inflows, offers little offset.  Ever since the M&A bubble burst, the external financing needs of the US have remained disproportionately dependent on portfolio flows.  Indeed, FDI has been a net drag on financing for the last eight quarters.  Higher frequency M&A data ― a rough proxy for FDI flows ― suggest that this trend is unlikely to change before year-end.

Third, while global investors demonstrate a greater preference for US assets relative to other foreign assets, this year their allocation has been especially disproportionate.  Looking strictly at portfolio flows into the US, Japan, and Euroland, US assets have attracted 71% of total foreign investment in these economies through the first seven months of this year, compared to 57% during 1998-2002.  Meanwhile, the allocation into Japanese assets has held steady at 5% of total investment.  Euroland assets have borne the brunt of the pullback, attracting 24% of the cumulative investment in these three economies so far this year, compared to 37% during 1998-2002.  A key concern is that foreign investors may respond to being “underweight” Euroland assets.

The sharp drop in portfolio inflows in September was partially a knee-jerk reaction to the G-7 communiqué and partially an extension of the rebalancing seen in Q3.  A single data point does not signal a full-scale decamping from US assets, but it does remind us of the vulnerability of our external financing needs to private investors and the importance of the transatlantic axis.


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United States: Review and Preview

Ted Wieseman/David Greenlaw (New York)


The Treasury market saw modest 10-year led gains over the past week, taking yields at the longer end of the curve to their lowest levels since before the surprisingly strong September employment was released October 3.  The gains came despite good results from various data releases and surveys that pointed to upside in the key employment, ISM, and motor vehicle sales reports due out the week after Thanksgiving.  Investors were also able to brush off indications that disinflationary pressures -- and Fed concerns about disinflation -- are easing.  Instead, the market benefited from a flight to safety following the terrorist attacks in Turkey, trade frictions that hit the dollar, and a drop in the stock market.  The more negative geopolitical backdrop along with the ongoing pause in demand in the economy -- even as higher frequency data point to a reacceleration in consumer spending and the production recovery remains on track -- appears also to have increased anxiety among investors about the sustainability of the economic recovery.  It was also a heavy week for spread product issuance, which dominated intraday market attention for much of the week, as issuers looked to get financing done ahead of what's likely to be very thin conditions in the coming holiday week.

Benchmark Treasury yields fell 2 to 8 bp over the past week, extending the 20 to 25 bp rally seen the prior week.  The 10-year led the way higher, with 2's-10’s flattening 6 bp and 10’s-30’s steepening 2 bp on an 8 bp drop in the 10-year yield to 4.15%, a 2 bp dip in the 2-year yield to 1.80%, and a 6 bp fall in the long bond yield to 5.00%.  The 5-year continued to perform relatively strongly on the curve, as its yield fell 7 bp to 3.13%, while the 3-year lagged, with its yield down 3 bp to 2.33%.  Despite the generally strong economic data and more mixed comments from the large number of Fed speakers, the market continued to scale back the amount of Fed tightening priced into the futures market, as the April fed funds contract rallied 1 bp to 1.095% and the July contract 2.5 bp to 1.365%.

Data releases and surveys out the past week pointed to solid results for key economic data due after Thanksgiving.  Jobless claims posted a surprising 15,000 decline to 355,000 in the latest week (which coincided with the survey week for the November employment report), taking the 4-week average to nearly a 3-year low of 367,250.  This compares with 4-week averages of 393,500 in the October survey period and 411,250 in September.  We expect November nonfarm payrolls to rise 175,000, excluding any temporary strike impact, which would be the strongest gain in three years.  The California grocery strikes could reduce the actual gain by 50,000 or so, but we will wait until the release of the BLS's monthly strike activity report to incorporate this into our estimate.  Regional manufacturing surveys were mixed but generally indicated that the production rebound remains on track.  Looking at rebased and weighted composites of the activity indicators, an ISM comparable version of the Empire State manufacturing survey would have risen to 61.6 from 59.1, while the Philadelphia Fed survey would have fallen to 56.2 from 58.5.  We look for the November ISM to tick up a half point to a four-year high of 57.5.  Finally, Morgan Stanley auto analyst Steve Girsky expects November motor vehicle sales to rebound to a 16.3 million unit annual rate from a 15.6 million unit annual rate in October.  Combined with recent positive indications from weekly chain-store reports, this would point to a reacceleration in consumer demand heading into the key holiday shopping season from the September/October pause that followed the surge in spending over the April to August period.

Meanwhile, the CPI report indicated that disinflationary pressures may be ebbing as demand has surged over the past six months.  Core CPI inflation collapsed in the first part of this year as demand again relapsed ahead of the war, rising only 0.6% annualized in the four months through April -- down sharply from the +1.9% rise in 2002.  Over the past six months, however, core inflation seems to have stabilized near +1 1/4% to +1 1/2%.  While this is still below the 2% or so that appears to be the consensus preferred rate at the Fed, comments from several Fed officials during the past week indicated lessening fears of a further "unwelcome fall in inflation."  We do not believe the FOMC will alter its official stance at the upcoming meeting, but Fed officials appear to be moving closer to adopting a more neutral risk assessment and policy statement in the months ahead.

Key data releases this past week included business inventories, CPI, and housing starts:

* Business inventories posted a surprising 0.3% increase in September, with the retail component up 1.0%, wholesale up 0.4%, and manufacturing down 0.4%.  Within retail, autos rose 1.5%, in line with industry data, while the ex auto component jumped 0.8%, the largest gain in three years.  With business sales up 0.6%, the inventory/sales ratio held at a record low 1.36 for a third straight month.  Upside in September wholesale and retail inventories indicates that restocking in response to the Q2 and Q3 surge in demand started somewhat earlier than previously believed, pointing to a smaller inventory decline in Q3 and upward revision to GDP.  We expect this process to continue in the months ahead and significantly boost Q4 growth.

* The consumer price index was unchanged in October, as an even bigger than expected plunge in energy prices (-3.9%) offset a larger than expected 0.2% gain in the core.  The core was boosted by a 0.4% rise in the key shelter category, half of which was accounted for by a 2.3% jump in hotel rates that contributed 0.1 percentage point to the overall core CPI increase.  This upside will likely be largely reversed in coming months.  Otherwise, trends in key core components were little changed, with some upside in services offset by continued goods price deflation.  Excluding the hotel distortion, the core CPI was up 0.1%, in line with the trend seen the past six months, as underlying inflation has stabilized near 1 1/4% to 1 1/2% after plummeting in the early part of the year.

* Housing starts posted a surprising 2.9% gain in October to 1.96 million units, a nearly 18-year high.  The key single-family component jumped 5.7% to a record high 1.617 million, while the multi-family component fell 8.5% to 343,000.  Surprisingly, the strongest region was the West (+17.7%), where we expected the fires in Southern California to depress activity.  Going forward, rising apartment vacancy rates may continue to weigh on multi-family starts, but high homebuilder sentiment, still low rates from a longer-term perspective, improving consumer income, low inventories of unsold homes, and a sharp rise in backlogs of permitted but unstarted houses (+21% year/year) point to solid underlying support for single family activity.

A bunch of economic data releases and a 2-year auction will be squeezed into the shortened upcoming week ahead of an early Wednesday close, the Thanksgiving holiday Thursday, and another early close Friday.  Due out on Tuesday are revised GDP, Conference Board consumer confidence, and existing home sales.  Wednesday looks like it could be messy, with durable goods, jobless claims, personal income and spending, Michigan consumer confidence, new home sales, Chicago PMI, and an early 2-year auction (which we expect to be unchanged in size at $26 billion) all crammed in before the 2:00 PM close:

* Figures for construction spending and inventories came in above the BEA's assumptions.  So we look for an upward revision to Q3 GDP to +8.0% from the initial print of +7.2%.  The reading for final sales is also likely to be boosted to +8.0% (versus the prior +7.8%).

* We forecast October existing home sales of 6.40 million units.  Resales soared to another new all-time high in September.  The fundamental picture for real estate markets remains quite healthy, but with mortgage application volume edging a bit lower in recent weeks, it looks like we may be past the absolute peak.  So we look for sales to slip by about 4% to a pace that is still 7% above the 12-month average.

* We look for the Conference Board's measure of consumer confidence to rise to 86.0 in November.  The University of Michigan sentiment gauge posted a 4-point gain in early November. Since the Conference Board measure places more emphasis on labor market conditions, we expect to see a somewhat larger advance (the index was 81.1 in October).

* We expect October durable goods orders to tick up 0.1%.  Although surveys point to a pick-up in the underlying pace of order volume, a partial retracement of the surge in motor vehicle bookings seen in September should help restrain the headline figure this month.  Meanwhile, the key core category -- nondefense capital goods excluding aircraft -- is expected to post a solid gain (+0.7%), which would mark the fifth rise in the past six months.

* We forecast a 0.4% rise in October personal income and a 0.1% increase in spending.  The October labor market report points to a modest acceleration in income growth relative to the recent pace.  Meanwhile, a fall-off in unit sales of motor vehicles and sluggish non-auto retail sales imply only a fractional rise in overall consumer spending for October.  Consumption appears to have downshifted to a +1.5% growth rate in Q4.  Of course, this comes on the heels of a better than 6% rise in Q3.  In general, it appears that consumer spending has been running at an underlying pace of 4% over the past few quarters. We expect this trend to continue into 2004.

* We forecast October new home sales of 1.15 million units.  In recent months, sales of newly constructed residences have edged down only slightly from the all-time record peak of 1.20 million units set back in June.  The latest homebuilder survey -- though down a bit from the peak -- points to a continued high level of optimism.  So we look for sales to edge up by about 0.5% in October.  Note that the expected result would be more than 8% above the average recorded over the prior year.

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Currencies: What an Equity Market Revival Would Mean for G10 Currencies

Karin Kimbrough (New York)