The US-China Symbiosis: The Natural Outcome of the US Dollar Standard

This is an interesting depiction of the tightly intertwined political economic dynamics of the US and China from Mark Mark Landler for New York Times and International Herald Tribune.

First the wonderful Charts….

Next, some excerpts from the article (emphasis mine)…

``A new economic dance

``The United States has been here before. In the 1980s, it ran heavy trade deficits with Japan, which recycled some of its trading profits into American government bonds.

``At that time, the deficits were viewed as a grave threat to America's economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world's major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

``The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the Japanese yen for halting Japan's rapid growth. The lesson of the Plaza Accord was not lost on China, which at that time was just emerging as an export power.

``China tied itself even more tightly to the United States than did Japan. In 1995, it devalued its currency and set a firm exchange rate of roughly 8.3 to the dollar, a level that remained fixed for a decade.

``During the Asian financial crisis of 1997-98, China clung firmly to its currency policy, earning praise from the Clinton administration for helping check the spiral of devaluation sweeping Asia. Its low wages attracted hundreds of billions of dollars in foreign investment.

``By the early part of this decade, the United States was importing huge amounts of Chinese-made goods, toys, shoes, flat-screen televisions and auto parts, while selling much less to China in return.

``"For consumers, this was a net benefit because of the availability of cheaper goods," said Lawrence Meyer, a former Fed governor. "There's no question that China put downward pressure on inflation rates."

``But in classical economics, that trade gap could not have persisted for long without bankrupting the American economy. Except that China recycled its trade profits right back into the United States.

``It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save in the state-run banking system most foreign currency, primarily dollars, that they earned from foreign trade and investment.

``As foreign trade surged, this hoard of dollars became enormous. In 2000, the reserves were less than $200 billion; today they are about $2 trillion.

``Chinese leaders chose to park the bulk of that in safe securities backed by the American government, including Treasury bonds and the debt of Fannie Mae and Freddie Mac, which had implicit government backing.

``This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for United States securities, it also helped push interest rates below where they would otherwise be. For years, China's government was eager to buy American debt at yields many in the private sector felt were too low.

``This financial and trade embrace between the United States and China grew so tight that Ferguson, the financial historian, has dubbed the two countries Chimerica.

Finally, my comment:

One very important matter missed out by this insightful article is that these prevailing dynamics operate under the principle of FREE LUNCH or “something out of nothing” concept of the US dollar currency standard.

Basically, the US issues its notes backed by the “full faith and credit” of the US government in exchange for real goods and services from the rest of the world. Thus the natural consequence from the operating platform is to see enormous current account imbalances from the global economy framework-again, where the US exports financial claims (US dollar and US dollar assets) to fund its balance of payment debt driven deficits while it import goods and services elsewhere.

And one major consequence has been the aberrant global “vendor financing scheme” which had been quoted by Mr. Landler at the prologue of the article as…``Usually it's the rich country lending to the poor. This time, it's the poor country lending to the rich."- Niall Ferguson.” (Hey Pope Benedict, don’t you think your campaign against greed should to start with this greed fostering "something for nothing" system?)

And it is also the principal reason behind the serial bubble (inflate-deflate) cycles around the world...

In Japan then…

[M. Landler] ``At that time, the deficits were viewed as a grave threat to America's economic might. Action took the form of a 1985 agreement known as the Plaza Accord. The world's major economies intervened in currency markets to drive down the value of the dollar and drive up the Japanese yen.

``The arrangement did slow the growth of the trade deficit for a time. But economists blamed the sharp revaluation of the Japanese yen for halting Japan's rapid growth…

And in the world today...

[M. Landler] ``This not only allowed the United States to continue to finance its trade deficit, but, by creating greater demand for United States securities, it also helped push interest rates below where they would otherwise be. For years, China's government was eager to buy American debt at yields many in the private sector felt were too low.”

And because of the boom bust character emanating from such framework, trade policies have accordingly been shaped to the operating environment.

[M. Landler] ``But in classical economics, that trade gap could not have persisted for long without bankrupting the American economy. Except that China recycled its trade profits right back into the United States.

``It did so to protect its own interests. China kept its banks under tight state control and its currency on a short leash to ensure financial stability. It required companies and individuals to save in the state-run banking system most foreign currency, primarily dollars, that they earned from foreign trade and investment.

And so the idea being peddled by some experts that trade protectionism needs to be raised via the currency “lever”, aimed at improving the state of global balance of payments, doesn’t square with the realities of the operating framework of the present system which NATURALLY prompts for these anomalies. The fundamental reason is that the present monetary system lacks the self-adjusting mechanism traditionally seen in the gold standard.

Blaming simplistically the US for “overconsumption” or China for “exporting overcapacity” via the currency "manipulation" channel seems like the proverbial “pot calling the kettle black” and deals with cosmetic issues.

Yet the policy prescriptions from these experts appear directed at salvaging the statusquo of inflation driven economic growth models of the US dollar standard system. [M. Landler] ``"It is sometimes hard to change successful models," said Robert Zoellick, who negotiated with the Chinese as a deputy secretary of state. "It is prototypically American to say, 'This worked well but now you've got to change it.' "

In short, for as long as the US dollar functions as the backbone of the world's financial architecture, we should expect to see the persistence of the phenomenon of highly skewed global balance of payments and “mercantilist” policies which help shapes them.

Desires to remedy such imbalances without dealing with operating platform of the present global currency standard seems likely a "tooth fairy" approach. This unsustainable system will likely persist until it crumbles under its own weight (like a Ponzi house of cards), possibly fast tracked by the adoption of destructive policies recommended by the "omniscient" liberals, or by a concerted political thrust to overhaul the system.

But since governments are typical reactive agents and where a systemic reconfiguration translates to an admission of a shift in the distribution of geopolitical power, the latter option seems unlikely.

This makes a crisis as the only catalyst for change. Here Secretary Paulson got it right, [M. Landler] ``"One lesson that I have clearly learned," said Paulson, sitting beneath his Chinese watercolor. "You don't get dramatic change, or reform, or action unless there is a crisis."

10 Economic Reasons Why Trade Is Beneficial

Cato’s Dan Ikenson improves on U.S. Chamber of Commerce John Murphy’s list of the top 10 reasons why trade is good trade for America.

Below is John Murphy’s list along with Mr. Ikenson’s enhancements (bold highlights original) [from Cato.org Blog]

1. The United States is the number one manufacturing nation in the world, and that success depends on exports. And since over half of the total value of U.S. imports consists of “intermediate goods” (products that are used as inputs for further value-added activity), manufacturing success also depends on imports.

2. The United States is the world’s number one services exporter and has been since services trade data have been tracked. And one of the reasons that foreigners are able to purchase American services is because they have been able to earn dollars by selling goods to American businesses and consumers.

3. U.S. agricultural exports support nearly a million jobs in the United States. And, agricultural and manufactured imports have made life’s necessities and conveniences more affordable to hundreds of millions of Americans.

4. 95 percent of the world’s consumers lives outside the United States…as do 95 percent of the world’s workers, who produce many of the goods Americans consume as imports less expensively than Americans can, freeing up U.S. resources for investment, innovation, and consumption of the higher value products and services that Americans produce.

5. FTA countries purchased more than 40 percent of U.S. exports in 2009. And imports from those countries have helped extend families’ budgets and reduced the costs of production for U.S. business relying on inputs from those countries.

6. Since the creation of the WTO in 1994, U.S. exports of goods and services have doubled to more than $1.5 trillion. And real U.S. GDP has increased by 50 percent.

7. Imports support millions of U.S. jobs in retail, research, design, sourcing, transportation, warehousing, marketing and sales…and in manufacturing.

8. U.S. exports to China have quadrupled over the past 15 years, and China is now the 3rd largest market for U.S. exports. And U.S. imports from China, too often wrongly portrayed as evidence of U.S. profligacy or decline, have enabled U.S. industries that require access to lower-cost labor for economic viability to be born, to blossom, and to spark the advent of new products and industries.

9. U.S. companies with overseas investments account for 45 percent of all U.S. exports. And foreign companies operating in the United States employ 5.6 million Americans, support a payroll of $408.5 billion, provide compensation that is 33% higher than the U.S. average, account for 18% of U.S. exports, pay U.S. taxes, support local charities, and act as investment magnets in communities across the country.

10. Trade supports 38 million jobs in the United States–more than one in five American jobs. And most Americans enjoy the fruits of international trade and globalization every day: driving to work in vehicles containing at least some foreign content; talking on foreign-made mobile telephones; having extra disposable income because retailers like Wal-Mart, Best Buy, and Home Depot are able to pass on cost savings made possible by their own access to thousands of foreign producers; eating healthier because they now can enjoy fresh imported produce that was once unavailable out-of-season, etc.

Additional comments:

Of course trade IS NOT only good for the US, but FOR THE WORLD. Note that 95% of the world’s consumers and workers reside outside America!

In addition, foreign trade SHOULD NOT be seen or interpreted in isolation.

Instead, what must be understood is that the market represents a process where consumers and producers (and service providers) are vastly interdependent with each other and whose activities are coordinated through the price mechanism.

The great Professor Ludwig von Mises calls this connexity. He wrote, (all bold highlights mine)

What links together in our actual world the various fields of want-satisfaction is the existence of a great many nonspecific factors, suitable to be employed for the attainment of various ends and to be substituted in some degree for one another. The fact that one factor, labor, is on the one hand required for every kind of production and on the other hand is, within the limits defined, nonspecific, brings about the general connexity of all human activities. It integrates the pricing process into a whole in which all gears work on one another. It makes the market a concatenation of mutually interdependent phenomena.

It would be absurd to look upon a definite price as if it were an isolated object in itself. A price is expressive of the position which acting men attach to a thing under the present state of their efforts to remove uneasiness. It does not indicate a relationship to something unchanging, but merely the instantaneous position in a kaleidoscopically changing assemblage. In this collection of things considered valuable by the value judgments of acting men each particle's place is interrelated with those of all other particles. What is called a price is always a relationship within an integrated system which is the composite effect of human valuations.

This means that foreign trade is highly interrelated with domestic trading activities.

Thus, trade data shouldn’t be seen only in the light of either foreign or local but should account for both.

Looking at trade in different prisms would only stimulate the misimpression that trade operates on a closed framework, a false fodder for anti-trade exponents or the protectionists.

'Crisis looms due to weak dollar' by Dr. Jiang Ruiping published by the China Daily

Crisis looms due to weak dollar
Jiang Ruiping

Updated: 2004-09-28 08:42

Many international institutions and renowned scholars have recently warned that the possibility of a US dollar slump is increasing and may even lead to a new round of "US dollar crisis."

Since China holds huge amounts of US-dollar-denominated foreign exchange reserves, the authorities should consider taking prompt measures to ward off possible risks.

It is still too early to conclude if the US dollar is heading towards a crisis. But it is an indisputable fact that it has gone down continually. Its rate against the euro, for example, has dropped by 40 per cent since its peak period and it lost 20 per cent of its value against the euro last year alone.

It is becoming more and more evident that the possibility of a further slump of the US dollar is increasing.

From a domestic perspective, the worsening fiscal deficit will put great pressure on the stability of the US dollar.

In 2001 when the Bush administration was sworn in, the United States enjoyed a US$127.3 billion surplus. The large-scale tax cuts, economic cool-down, invasion of Iraq and anti-terrorism endeavours have abruptly turned the surplus into a US$459 billion deficit, which accounts for 3.8 per cent of the US gross domestic product (GDP).

By the 2004 fiscal year, the US Government's outstanding debt stood at US$7.586 trillion, accounting for 67.3 per cent of its GDP, which exceeds the internationally accepted warning limit.

The deteriorating current account deficit of the United States is another factor menacing the future fate of the dollar.

In recent years, the US policy that restricts exports of high-tech products, coupled with overly active domestic consumption and the oil trade deficit caused by rising oil prices, has deteriorated the US current account balance. This poses a great threat to a stable US dollar.

During the 1992-2001 period, the average US current account deficit was US$189.9 billion. In 2002 and 2003, however, the figure soared to US$473.9 billion and US$530.7 billion respectively. Experts predict that following its increasing imports in the wake of its economic recovery and continuing high oil prices, the United States will hardly see its current account balance improve.

Given the huge US current account deficit, the US dollar, if it is to remain relatively stable, must be backed up by an influx of foreign direct investment (FDI).

In 1998, 1999 and 2000, FDI that flowed into the United States was US$174.4 billion, US$283.4 billion and US$314 billion respectively. Starting from 2001, however, global direct investment began to shrink and US-oriented direct investment also decreased. In 2003, FDI into the United States was 44.9 per cent less than that in the previous year.

The decrease in FDI will put more pressure on the US dollar, which has been endangered by the huge US current account deficit.

Internationally, the Japanese Government's intervention in the foreign exchange market may become less frequent following the gradual recovery of the Japanese economy.

To deter the Japanese yen's appreciation and promote exports, the Japanese Government used to intervene in the foreign exchange market to keep the yen at a relatively low level. In 2003 alone, it put in 32.9 trillion yen (US$298.76 billion) to purchase the US dollar. The intervention constituted a major deterrent to US dollar devaluation.

As the Japanese economy fares better, the Japanese Government tends to back away from the market. Since April, it has not taken any steps to swing its foreign exchange market.

Another factor behind the risks of a US dollar slump is the weakened role of the so-called "oil dollar."

Given the deteriorating relations between the United States and the Arab world, quite a few Middle Eastern oil-exporting countries have begun to increase the proportion of the euro used in international settlement. Reportedly Russia is also going to follow suit.

If an "oil euro" is to play an ever increasing role in international trade, the US dollar will suffer.

In China's case, its rapidly increasing foreign exchange reserve will incur substantial losses if the US dollar continues to weaken.

At the end of 2000, China's foreign exchange reserve was US$165.6 billion. By the end of 2002, it rocketed to US$286.4 billion before it soared to US$403.3 billion by the end of 2003. By the end of June this year, the reserve was registered at a staggering US$470.6 billion.

About two thirds of the reserve is dominated by the US dollar. As the dollar goes down, China will suffer great financial losses.

Experts estimate that the recent US dollar devaluation has caused more than US$10 billion to be wiped from the foreign exchange reserve.

If the so-called US dollar crisis happens, China will suffer further loss.

The high concentration of China's foreign exchange reserve in US dollars may also incur losses and bring risks.

The low earning rate of US treasury bonds, which is only 2 per cent, much lower than investment in domestic projects, could cost China's capital dearly.
Due to high expectations of US treasury bonds, international investors used to eagerly purchase the bonds, which leads to bubbles in US treasury bond transactions. If the bubble bursts, China will suffer serious losses.

Moreover, since the Chinese trading regime requires its foreign trade enterprises to convert their foreign currencies into yuan, the more foreign exchange reserves China accumulates, the more yuan the Chinese authorities will need to put in the market. This will exert more pressure on the already serious inflation situation, making it harder for the central authorities to conduct macro-economic regulation.

Besides, investing most of its foreign exchange reserves in US treasury bonds also holds great political risks.

To ward off foreign exchange risks, China needs to readjust the current structure, increasing the proportion of the euro in its foreign exchange reserves.

Considering the improving Sino-Japanese trade relations, more Japanese yen may also become an option. During the January-June period this year, the proportion of China's trade volume with the United States, Japan and Europe to its total trade volume was 36.5 per cent, 28.6 per cent and 37.4 per cent respectively. Obviously, seen from the perspective of foreign trade relations, the US dollar makes up too large a proportion of China's foreign exchange reserves.

China could also encourage its enterprises to "go global" to weaken its dependence on US treasury bonds.

And using US assets to increase the strategic resource reserves, such as oil reserves, could be another alternative.

The author us director of the Department of International Economic under China Foreign Affairs University.

(China Daily)

WTO's Pascal Lamy Challenges Protectionists

In a speech before the Paris School of Economics, WTO director Pascal Lamy dispels mercantilist myths and calls protectionists to an open debate.

Here is the Mr. Lamy's speech: [all black and blue bold highlights including italics-mine]

It is a great pleasure for me to be here today. I can think of no better place than the Paris School of Economics for what I wish to discuss today — facts and fictions about international trade economics.

Economists have long analysed and helped us understand trade, why nations needed it to prosper, and what governments had to do to reap the gains while managing the costs. The many theories you and your predecessors have developed leave no doubt about the importance of trade to growth and economic development.

But if the economics of trade policy are clear, the politics of trade are highly complex. Trade policy, like so many other areas of policy, has ramifications on how resources are distributed, and this inevitably creates competing interest groups within society. Pressures exerted by such groups mean governments must balance these interests in ways that do not necessarily conform to what economic analysis might prescribe.

The public debate that inevitably accompanies contested policy formulation challenges the notion that open trade brings overall societal benefits. At the same time, contested policy provides a fertile field for the growth of urban legends and falsely premised ideas with popular appeal.

In my comments today, I wish to identify and address some of these fallacies. We need to bring sound economic analysis to centre-stage in this debate. Secondly, I want to locate trade policy in a wider policy setting because it is at our own peril that we take trade policy and all its political complexities out of their proper context.

Fallacy #1: Comparative advantage does not work anymore

At the outset, let me recognize Paul Krugman’s intellectual contribution to international trade theory — the so-called “new trade theory” — in which he shows that, even in the absence of productivity differences between two countries, trade benefits them both. He focuses on the presence of increasing returns to scale, in which a firm’s average cost per unit declines as production increases and underscores that consumers value variety in consumption. While the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by the classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.

We often hear the claim that the principle of comparative advantage and mutually beneficial exchange may have been true in the past, but it no longer applies in the 21st century — where, among other changes we see the seemingly inexorable rise of countries like China and India.

There are those who now call into question Ricardo's theory that differences in relative productivity between countries lead to their specialization in production and to trade. Doubt has arisen that this specialization based on comparative advantage results in higher total output, with all countries benefiting from the increased production.

There is a much-cited paper by Paul Samuelson in the Summer 2004 issue of the Journal of Economic Perspectives which showed theoretically how technical progress in a developing country like China had the potential to reduce the gains from trade to a developed country like the United States. This paper appeared to be a dramatic about-face against the idea that open trade based on comparative advantage is mutually beneficial.

I emphasize the word “appeared” because subsequent analysis by Jagdish Bhagwati, Arvind Panagariya, and T. N. Srinivasan contradicted this view. In that paper, starting from autarky, China and the United States open up to trade and experience the usual gains based on comparative advantage. In the following part of the paper, Samuelson considers how technological improvements in China will affect the United States. In the case where China experiences a productivity gain in its export sector, both countries benefit. China gains from the higher standard of living brought about by the increase in productivity while the United States gains from an improvement in its terms of trade. In the case where China experiences a productivity gain in its import sector, there is a narrowing of the productivity differences between the countries which reduces trade; and as trade declines, so too do the gains from trade.

So what Samuelson has showed is not that trade along lines of comparative advantage no longer produces gains for countries. Instead, what he has shown is that sometimes, a productivity gain abroad can benefit both trading countries; but at other times, a productivity gain in one country only benefits that country, while permanently reducing the gains from trade that are possible between the two countries. The reduction in benefit does not come from too much trade, but from diminishing trade. Furthermore, even in this case, Samuelson himself does not prescribe protectionism as a policy response since, as he put it ,“what a democracy tries to do in self defense may often amount to gratuitously shooting itself in the foot”.

In my view, the analysis by Bhagwati, Panagariya and Srinivasan should convince us that the principle of comparative advantage, and more generally, the principle that trade is mutually beneficial, remains valid in the 21st century.

Fallacy #2: It is unhealthy for trade to grow faster and faster compared to output

After the Second World War we have seen a marked expansion of international trade, with trade growing much faster than world production. The ratio of international trade to the value of world GDP has risen from 5.5 per cent in 1950 to over 20 per cent today. There are those who argue that this trade expansion poses a danger to the health of the global economy.

I would argue this is a reflection of the international fragmentation of production and the rise of trade in intermediate products. Reductions in transport costs, the information technology revolution, and more open economic policies have made it easier to “unbundle” production across a range of countries. The parts and components that make up a final product are manufactured in different countries around the globe, many of which are developing countries. These intermediate goods may cross national borders several times before they are assembled as a final product. Some of what passes for international trade is in reality intra-firm trade, exchanges of intermediate inputs and goods for processing between establishments belonging to the same company. By allowing each country that is a member of the supply chain to specialize in the part or component in which it has a comparative advantage, the internationalization of supply chains creates enormous economic benefits.

This growth in the trade of parts and components means that import statistics will overstate the degree of competition that comes from one’s trade partners. In international trade theory, trade in goods is seen as a substitute for the movement of factors of production. Thus, a country's imports of goods from its trade partner are seen as additional supplies of the partner country's labour and capital, which competes with the importing country's own workers and entrepreneurs. But the share of value added by factors of production of the origin country in traded products is considerably lower than in the past.

Take the example of an iPod assembled in China by Apple. According to a recent study, it has an export value of $150 per unit in Chinese trade statistics but the value added attributable to processing in China is only $4, with the remaining value added assembled in China coming from the United States, Japan, and other Asian countries. Now I know we tend to use statisticians like lamp posts — both for support and for illumination — but I find these statistics very enlightening. The degree to which a given volume of imports implies competition between the factors of production in the country of origin and the importing country's factors of production will be overstated. Focusing on gross values of trade or imports coming from a particular country also understates the degree to which the importing country’s own firms benefit from trade because part of their output is incorporated in the imported good.

So bilateral trade statistics may not correctly reflect the origins of traded products. To go back to the example of the $150 dollar iPod imported from China, it turns out that less than 3% ($4 out of $150) of the value of the product reflects China’s contribution, with the bulk of the product’s value being made by workers and enterprises in the United States, Japan and other countries. And yet current trade statistics would attribute $150 to Chinese exports.

Relying on conventional trade statistics also gives us a distorted picture of trade imbalances between countries. What counts is not the imbalances as measured by gross values of exports and imports, but how much value added is embedded in these flows. Let us take the bilateral trade between China and the United States as an example. Based on data from the Institute of Developing Economies (IDE-Jetro) and WTO estimates, in 2008 the domestic content comprised 80% of the value of the goods exported by the US. The comparable figure was 77% in the case of Japan, 56% for Korea and 42% for Malaysia and Chinese Taipei, meaning that about half the exported value originated from other countries. Using conventional trade statistics would overestimate the US bilateral deficit vis-à-vis China by around 30% as compared to measuring in value added content. The figures would reach more than 50% when the activity of export processing zones are fully taken into account. Does it make sense for us to start measuring trade in value added rather than on gross value as is the case today!

Fallacy #3: Current account imbalances are a trade problem and ought to be addressed by trade policies.

Imbalances are a natural and widespread economic phenomenon, if we only care to observe it. If we examine the flows of spending and income between Aix en Provence and the city of Paris, or between the 16ème and 5ème arrondissements of Paris for that matter, the flows are not balanced. But we do not think this is a problem and make no big deal of it. Yet we worry about imbalances between countries.

I think one legitimate reason why one may be more concerned about imbalances between countries is that they may be governed by a different set of economic institutions and regulations. Fiscal and monetary policies are likely to be different. Regulations, particularly in the financial sector, could also differ even among neighbours. Exchange rate systems may vary significantly as well. These differences may introduce “distortions” and thus provide a legitimate reason to pay greater attention to imbalances among countries. Another reason for paying attention to imbalances is when the amounts are large, in absolute and relative terms, and there is fear that they could have significant spillover effects on other countries.

Current account imbalances between countries are primarily a macroeconomic phenomenon, a sign of international differences in aggregate savings and investment behaviour and have little to do with trade policy. A current account deficit of a country reflects dissaving by domestic residents — an excess of total expenditures, both private and public, over national income. A current account surplus, on the other hand, represents savings by domestic residents with national income exceeding total expenditures.

Put in another way, a current account surplus is created if domestic savings exceeds domestic investment, which means that the country is a creditor to the rest of the world. A current account deficit ensues if domestic savings is less than domestic investment, in which case, the country is drawing on savings provided by foreigners.

The growth of global imbalances in the last decade reflects in part the greater integration of financial and capital markets. This has made it easier to accommodate big differences in savings propensities and investment opportunities across countries. Domestic residents can afford to save less because citizens of other countries are saving more, and with few restrictions on capital flows, those foreign savings can be made available at lower cost to domestic residents.

In the absence of policy distortions, imbalances provide a means to better allocate capital internationally. Imbalances are a sign that savings in one country are being deployed or used in another country. If investment prospects are plentiful in a country, but its residents are unable to generate a sufficient amount of saving to exploit them, foreign savings can fill the gap. The domestic economy benefits from being able to undertake the profitable investment project while foreign investors get a higher return than what they can obtain in their own country.

Given that current account deficits and surpluses originate in differences in savings propensities and investment opportunities across countries, trade restrictions will not permanently reduce deficits since they do not alter the underlying conditions driving the imbalances. In fact restrictions could make matters worse. First, they can trigger retaliatory action by those affected by the import restrictions. Second, import restrictions create economic inefficiency, not least in the country applying the restrictions. As Abba Lerner taught us a long time ago, policymakers often fail to recognize that one undesirable, but irrefutable consequence of applying import restrictions is that such restrictions also discourage exports.

Given that differences in savings behaviour between countries lie at the root of current account surpluses or deficits variations in exchange rates will not correct chronic imbalances.

Exporters, moreover, often do not fully pass through the effect of an exchange rate appreciation or depreciation to the selling price in export markets. There is an extensive economic literature that documents this “less than full pass through” to prices of exchange rate changes in a wide variety of industries from automobiles to photographic film to beer. This may explain why empirical studies about the impact of exchange rate changes on imbalances tend to show only limited or ambiguous effects and why adjustment in exchange rates may have little effect on imbalances.

My arguments assume that exchange rates are allowed to adjust freely to their equilibrium levels as determined, for example, by long-term inflation differentials as in the so-called purchasing power parity theory, or by interest rate differentials as in the classic Mundell-Fleming explanation. I know that the lack of exchange rate flexibility in some countries has been raised as a problem in the context of global imbalances. The only thing I can say about this issue is that it is difficult to talk about the optimal exchange rate system for a country — whether completely flexible or fixed — without addressing the much broader question of what the appropriate international monetary system must be.

Fallacy #4: Trade destroys jobs

The problem with the argument that trade destroys jobs is that it sees only the threat posed by imports to jobs but does not take into consideration how jobs may be created in the export sector as a consequence of trade opening. It also fails to take into account that trade opening can increase the rate of economic growth, and therefore improve the ability of the economy to create new jobs.

I recognize that traditional trade models assume full employment so that more trade in those models does not result in the creation of new employment. Jobs are merely reallocated from shrinking to expanding sectors. Nevertheless, even if trade opening does not necessarily create new jobs, the re-allocation of labour is valuable. It means workers are moving from sectors where their marginal product is lower to those where it is higher, resulting in productivity gains to the economy and increased output.

More open trade can increase the rate of economic growth by increasing the rate of capital accumulation, speeding up technological progress through innovation or knowledge creation, and improving the quality of institutions. A country that opens up trade may become more attractive to foreign investors with more foreign capital flowing to its shores. Since technology is often embodied in goods, trade can be a very effective means of diffusing technological know-how.

Another way in which trade can increase productivity is “learning-by-exporting”, whereby participation in world markets enables producers to lower costs or move up the value-added chain over time. This diffusion of technology through trade is important because of the skewed distribution of research and development expenditures around the world, which is even more skewed than the distribution of world income. For example, the G-7 countries accounted for 84 per cent of global R & D expenditures in 1995 but only 64 per cent of global GDP. Finally, international trade can have a positive impact on the quality of a country's institutions, such as the legal system, which in turn improves economic performance. A faster growing economy will be able to absorb more workers than a slow-growing or stagnant economy, a point that may be particularly important for poor countries with large or rapidly expanding populations.

Trade opening can today contribute to economic growth and through that to creating much needed jobs. The stimulus package of the Doha Round is there to be taken.

Fallacy #5: Trade leads to a race to the bottom in social standards.

Some have argued that more trade will drive governments in rich countries to lower their social or labour standards. More trade would hurt workers in rich countries. The problem with this argument is that there is very little empirical basis for it. It is difficult to find examples where countries have lowered social or labour standards in response to trade competition.

One variant of this argument has been used by Emmanuel Todd who claims that open trade between developing countries such as China and industrial countries is the reason for the economic crisis. In his view, the competition coming from low-wage countries has put pressure on wages in industrial countries and caused a deficiency in aggregate demand.

I would argue that differences in wages largely reflect differences in labour productivity. There is a fairly close correlation between wages and productivity across countries with some estimates going so far as to suggest that 90 percent of wage differences between countries can be explained by productivity differences. While wages in many developing countries may be low, labour productivity in these countries is also a fraction of western levels.

A more fundamental problem with Todd’s analysis of the causes of the economic crisis is his presumption that trade is a zero sum game, that what one nation gains, another country loses. But we know from economic theory that trade is mutually beneficial and that there are overall gains to countries who are involved in trade. Hence, trade should increase incomes of trading countries and, consequently, increase demand rather than lead to a deficiency in demand.

The rise of China and India meant the integration of tens, if not hundreds, of millions of Chinese and Indian workers into the global economy. What is astonishing is that this integration occurred at the same time unemployment rates in OECD and Euro zone countries were declining. Between 1998 and 2008 for example, the average unemployment rate in the Euro area fell from 9.9% to 7.4% while the corresponding reduction in the OECD countries was from 6.6% to 5.9%. Surely, if the zero sum argument is correct, the rise of China and India would have thrown millions of workers in developed countries out of work.

Finally, some also argue that trade has been responsible for the observed widening of the gap in the wages of skilled and unskilled workers in industrial countries. However, much of this gap can be explained by skill-biased technological change rather than by trade. Skill-biased technological change refers to improvements in technology, such as the information technology revolution, which increased demand for skilled workers relative to unskilled workers. In the United States, this technological change combined with the slowdown in the relative supply of college-equivalent workers led to the expansion of wage differentials between skilled and unskilled workers. While industrial countries have experienced greater trade openness during the same period, trade has not played a big role in rising wage inequality. Empirical studies that have attempted to measure the contribution that trade has made to inequality give estimates of only between 4% and 11% to 15%.

Fallacy #6: Opening up trade equals deregulation

There is a tendency to confuse trade opening with deregulation of the economy. One way to distinguish between the two is that trade opening refers to a reduction in trade barriers or a reduction of those measures that discriminate against foreign goods and services. A country that opens up to trade does not compromise its ability to regulate, provided of course those regulations do not discriminate in an unjustifiable manner against foreign goods and services, thus contradicting opening commitments.

There are many good reasons why governments intervene in the economy and why such intervention needs to continue even while trade is being opened. The production or consumption of a good may generate pollution (an environmental externality) as a by-product. The market for a good or service may be characterized by information asymmetry, with sellers being more informed about the quality or safety of their product than buyers. Firms may be restricting competition by colluding or abusing their dominant position. There may be moral hazard, i.e. excessive risk taking, in the banking system because of the existence of deposit insurance. In all these cases, regulations may form part of the public policy response to the underlying market failures. Moreover, there are very legitimate distributional reasons for governments to intervene in markets with a view, for example, to improving poor people's access to public services or to ensure equitable access to such services across all regions of a country. WTO rules do not constrain governments' ability to pursue such regulatory objectives.

To see the difference between trade opening and deregulation, I would like to take financial services in the North American market as an example. The North American Free Trade Agreement (NAFTA) opened up cross-border trade in financial services between Canada and the United States, but otherwise allowed each country to retain its system of financial governance. I believe this is one reason why despite freer trade in financial services, the financial systems of Canada and the United States had radically different experiences during the financial crisis. Lax regulations in the U.S. mortgage market contributed to the resulting sub-prime crisis. Meanwhile, on the other side of the border, for Canadian banks, which were more tightly regulated, sub-prime loans in 2006 accounted for less than 5% of new mortgages in Canada, compared to 22% in the United States. They were hardly touched by the crisis. In the midst of the global crisis in late 2008, they remained liquid and had an average tier 1 capital ratio that was significantly above the regulatory minimum.

The issues I have touched upon today are crucial to get the economics of trade right. But they can also contribute to a more informed political debate on trade. We need debate, and informed choices, because trade has an impact on our lives, whether as workers or as consumers.

But I also wish to avoid getting stuck in the old policy rut that simply promotes greater trade openness as a matter of virtue or as the secret of a nation's economic success. Debunking fallacies about trade is not enough. We should always remind ourselves that trade is but one element of the story, an element from which it is possible to expect too much as well as too little.

The benefits from open trade will only be realized if the overall policy context is right. This is why I believe that what I have referred to as the “Geneva Consensus” is so important. The essence of this consensus is that trade openness can — and I stress CAN — contribute to economic well-being and political harmony in important ways, but only if other conditions are met. What are these conditions?

Firstly, we need sound macroeconomic policy, and not a doctrine that sees trade policy as a quick fix for over-arching economic fundamentals.

Second, trading opportunities created by openness are worth little, and perhaps even unwelcome, if price signals do not reach their destination because this is made impossible by a lack of physical infrastructure and functioning markets. These elements are part of a basic development agenda, one in which the international community certainly has a role. This is why I have placed so much emphasis on the Aid-for-Trade initiative. This programme is firmly grounded in the belief that facilitating trade in the broadest sense is part of a grand international bargain. I should emphasize that arguing for pre-conditions to make trade openness work is not to make the case for eschewing trade openness. On the contrary, it is the case for creating conditions to embrace openness.

Finally, governments have a responsibility to address the distribution of the benefits from trade. If trade opening is perceived as benefiting a small privileged group, quite possibly at the expense of others in society, then it loses its political legitimacy. Spreading the benefits from trade is no easy matter, especially for poor countries. Challenges arise both in terms of adjustment costs associated with changes in relative prices, as well as in a more fundamental sense which has to do with creating social infrastructure and personal opportunity.

These are just a few facts that I wanted to share with you and I would like to thank you very much for your attention.

Let the public debate commence now.

The US Dollar Renminbi Standard Myth

Another bizarre mercantilist claim today is that the world monetary system operates on a supposed “USD-Renminbi” standard.

(From Tradingeconomics.com)

Such claim has been anchored on supposed “trade imbalances”, particularly US trade deficits, from where the world evolves only around only two nations, the United States and China. From such premise it is easy to dismiss this as false choice.

A further assumption is that central bankers of both nations have only been fixated on each other’s economy while ignoring the rest of world.

Nevertheless here a few charts to dispel such myths

Based on merchandise trade, it would be a mistake to assume that both these countries equally been trade oriented.

The fact is that the US despite the deficits, external trade in goods account for only a little over 20% of the economy. This makes the US essentially relatively a closed economy.

Meanwhile China’s merchandise trade is about half their economy. In contrast Germany’s external trade accounts for more than 70%. 

Germany largest share among the three squares with the EU’s position as the largest trading bloc. (Wikipedia)

To further add, China accounts as the second largest trading partner to the United States. (US Bureau of Commerce)

Also in terms of trade deficit with the US, while it is true that China has the largest surplus, there are many other countries that maintains where the US has a deficit. (US Bureau of Commerce) Add all to the 9 largest trading partners with surpluses these will easily overshadow China. A further implication is that should protectionist measures be imposed on China, US deficits will only shift to these countries.

Yet for those blinded by deficits, they fail to also account that China’s exports have been (51%) owned by foreign owned companies based on China.

In reality, the obsession towards trade deficits are misleading for the simple reason that trade deficits are balanced out by capital account (Mark Perry)

To quote Professor Mark Perry (bold original)

As a direct consequence of our current account deficits, the U.S. economy has been the beneficiary of more than $8 trillion worth of capital inflows from foreigners since 1980. Because the Balance of Payment accounts are based on double-entry bookkeeping, the annual current account and capital account have to net to zero, so that any current account (trade) deficit (surplus) is offset one-to-one by a capital account surplus (deficit) and the balance of payments therefore always nets out to (equals) zero. And that's why it's called the "balance" of payments, because once we account for trade flows and capital flows, everything balances, and there are no deficits or surpluses on a net basis.

The other side of the coin is that China’s ownership of US debts has been overstated.

In reality, foreign ownership as a total of US treasuries account for only 25% (Wikipedia)…

…where China owns about 8% share of total foreign ownership as shown by the breakdown above. 

In terms of international currency reserves…

The Euro-USD constitutes 90% of global foreign exchange reserves. Add the pound sterling, yen and the swiss franc such would account for 95% of foreign reserves. (Wikipedia) In other words, global trade and banking reserves have hardly been about the Chinese yuan yet. Although China has been making inroads with other emerging markets (e.g. ASEAN, Brazil India Russia, Chile and even Africa) to use her currency as an international reserve.

China’s fixed currency has partly been accused for such relationship. But China’s currency has been fixed since 1994. If fixing currency to the US dollar has been about stealing jobs…

…then all these countries have been guilty

But then again, currency fixing or pegging has been adapted by these countries mostly to promote stability.

According to Investopedia.com

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Other reasons have been for expanding trade network externalities and importing policy credibility, (University of California) aside from lack of depth in their respective domestic and sophistication in domestic financial markets. 

Bottom line: As I have been pointing out, US trade balance, aside from the conditions of the US dollar has mostly been a function of domestic boom bust cycles, the Triffin dilemma (frictions arising from the collision of international and domestic interests based on short and long term objectives) and many other domestic interventionists policies. 

There has not been a single factor. (Fallacy of a single cause)

Financialization of the US has been an outgrowth of these from which trade deficits have been funded through the growth of financial industry. Wikipedia points to the “greater role arising from the issuance of fiat currency untethered to gold or other commodities, as well as the “end of the post-World War Two Bretton Woods system of fixed international exchange rates and the dollar peg to gold in August 1971”. 

Neither has supposed trade imbalances been deliberately caused by China.

Boom bust cycles, for instance, draw in lots of resources and labor to malinvested areas where during a booming phase distorts the price mechanism and distribution and production process via overvaluing wages, the domestic currency, asset prices, welfare (pensions), fake profits and etc....

Once a bust arrives these policies induced boom becomes key sources of retrenchment.

Mercantilists have been flagrantly blind to this.

Finally as I pointed out, Ben Bernanke has not been targeting the exchange rate for his latest QE. This means, if you believe his uprightness, then he acknowledges that the issue has been local, particularly putting a floor on asset prices and hardly about foreign (devaluation).

Seeing things from reality (than from political biases) gives us a better chance at being right in our investment positions.

The Third Breakout Of 7,400: The Risk Of Complacency And Self-Delusion

There are many recognised short-term risks in today’s global economy: new financial crises in highly indebted emerging market economies (EMEs), a bond yield snapback in advanced economies (AEs), old and new geopolitical tensions disrupting a fragile recovery or even an “unknown unknown” new event. There are also important long-term issues such as the environmental consequences of our present growth model, which might affect climate change. But perhaps the most significant risk for financial markets now is the risk of complacency and self-delusion. Some of this is partly related to markets’ hope that short-term policies at odds with well established economic principles are sustainable. But it is also partly related to markets’ bet that muddling through policies in increasingly fractured societies without undertaking sustainable structural reforms can still produce interesting short-term returns—Luiz Awazu Pereira da Silva and Előd Takáts of the Bank for International Settlements, The risk of complacency and self-delusion

In this Issue

The Third Breakout Of 7,400: The Risk Of Complacency And Self-Delusion

-High Valuations are Symptoms of a Disease

-7,400 Breakout Involved Seismic Scale of Price Instability!

-Questionable PSE Foreign Trade Statistics, Has the SM Group Been Responsible for the Breakout Pump?

-Have Stock Market Pumps Been Financed by Surging Non-Bank Financials Loans?

-Has Domestic Car Sales and Leveraging Hit the Proverbial Wall?

The Third Breakout Of 7,400: The Risk Of Complacency And Self-Delusion

High Valuations are Symptoms of a Disease

From Bloomberg (April 6): “Shares in the Philippine Stock Exchange Index are trading at 17.8 times 12-month estimated earnings, the most expensive in the region and almost a fifth above their 10-year average. The MSCI Asia Pacific Index is valued at 13.4 times, while a gauge of emerging markets trades at 12.1 times.” (Bold mine)

High valuations do not exist in a vacuum.

Please keep in mind: Estimated earnings have usually been significantly OVERRATED by the establishment, thereby resulting in “the most expensive stock market in in the region”. 

Inspired by the feel-good storyline of G-R-O-W-T-H, market participants have been programmed orconditioned to pump up prices of domestic equities over the past few years. And where expectations fail to meet reality, even more tall tales have been impressed or foisted upon the public. Such hope predicated feel-good themes have been designed to fire up prices, or at the very least keep lofty prices afloat.

 

Figure 1: PSEi Pricing Imbalances and the 7,400 Jumping the Rope

And the unabashed contraptions used frequently to “game the system” in order to further inflate prices, have only compounded or exacerbated the grave mispricing and misperceptions in the marketplace. 

Hence, domestic markets (or price fixing mechanism) have significantly DEVIATED from the “10-year average”, and from “region’s performance or peer (emerging market) standards” (see upper window figure 1).

Cause and effect.

And the establishment thinks or relentlessly feeds upon the public that there will hardly be any adverse consequences from the systematic deformation of market price actions.

Yet the untold story behind this has been the issue of invisible redistribution channeled through the BSP’s easy money “trickle down” policies which continues to benefit the establishment at the expense of the average citizenry.

7,400 Breakout Involved Seismic Scale of Price Instability!

In an awesome display of the desperation to rekindle or reignite the fading bullmarket, the Phisix flew by an amazing 3.72% to break past the 7,400.

As I wrote during the week, this would signify the third time 7,400 has been taken out.

The establishment will sell the idea that the price uptrend (see lower window, figure 1) from 2013 will continue. But that would be cherry-picking of reference points.

And such idea ignores the effects of the massive market manipulations (which means current prices are not market prices) and of valuation risks.

They also dismiss the idea of risks from prices artificially constructed from credit inflation.

People fail to realize that it is the QUALITY rather than the quantity that matters.

Said differently, the issue will not be whether the current run up will hit 8,000, 8,100 or more but rather, of the sustainability of the runup and the consequent risk of a much bigger decline (or a crash) as ramification to such mounting contortions.

From the perspective of asset allocation, it would be the tradeoff between risks and returns.

Ultimately, market trends depend on the market’s underlying structure. Or it is not the chart, but the underlying market conditions which determine the trend.

And to provide some evidence. Ever since the first breakout of 7,400 in January 2015, heightened volatility has afflicted the PSE.

It has been no coincidence that “marking the close” became a widespread and rampant practice in the second semester of 2014. Taken together, the repercussions from the brazen price fixing process began to impact the Phisix via magnified volatility.

Likewise, accentuated volatility has been expressed via vertical price movements.

Hence the similarities, or the seeming formation of cyclicality in price pumping seen in two successive January interim troughs of 2016 and 2017. In both instances, the PSEi rocketed by 11.2% and 12.2%, respectively. The latter has become MORE vertical than the antecedent.

In the same token, all three 7,400 breakouts were at least half as aggressive or violent than their bottom pumps. As initial thrust in the incursion of 7,400, it took a 6.5% move in 2015, a bigger 7.8% in 2016 while the present impetus at 6.12% which has yet to see a conclusion (lower pane)

 

Figure 2: Amplified Volatility via Weekly Performance

And this week’s 3.72% rampfest best illustrates the paragon of price instability.

With 26.02% of the share of the PSEi’s market cap weighting, the incredible price spikes of SM (+5.88%), SMPH (+5.1%) and ALI (+7.11%) cemented the 7,400 breakthrough.

Even more outrageous is the distribution in the degree of price changes. For a terse backdrop, 25 issues advanced as against 5 decliners. From these, 11 securities or 36.7% had price changes of over 5%! 13 firms or 43.3% registered price changes of over 4%! 14 issues or 47% had 3%! And 19 or 63% posted prices changes of over 2%!

How’s that for price stability?

Recall that I mentioned of the asymmetry in price performance which centered on Sy owned firms? See Phisix 7,310: A Journey to the Bullmarket or Perdition? April 3, 2017

And while Sy owned companies have been flirting with new records, and where others have joined them, prices of several companies slumped back to their December 2016 levels or have drifted in proximity to such levels, e.g. GTCAP, JFC, MPI, MEG, DMC, AP, AGI, FGEN, RLC and PCOR (the latter has broken the December 2016 lows).

Well, with SM on a fresh record high along with the outperformance by BDO relative to JGS, Sy firms have now captured 3 of the top 4 biggest market cap weightings!

Even more, the biggest weekly gains, outside the top 3, were channeled to the most of the major laggards I mentioned! MEG +16.57%! MPI +8.97%! AGI +7.26! JFC 6.53%! DMC +5.26% and RLC 4.78!

The above list excludes MBT which also saw a vertical run through a 9.12% weekly flight!

Wow! Eruptions in volcanic proportions! BW-SSO!

Because divergent prices would be alot burdensome for Operation Break 8,100, whoever spearheaded the run wanted to make sure of a rising tide lift all boats phenomenon!

Or Operation Break 8,100 requires broader participation not limited to the top 10.

It appears that these guys have learned their mistakes in 2015 and 2016.

The key problem is IF they will be able to generate enough number of “greater fools” for them to unload their recently acquired inventories.

And though it may be partly true that the Phisix may just be reflecting global events (Has the Fed “Fallen Behind the Curve”? March 11, 2017), as perhaps evidenced by the somewhat improved but puffed up foreign buying activities, this week’s run-up means that the Philippines has regained the tiara as Asia’s best performer (lower right).

This puts into context the momentum based yield chasing phenomenon: The most expensive in Asia will get even more expensive!

As one would observe, this is NOT a normally functioning stock market. Instead, the stock market has transmogrified into a loaded casino, if not a price fixing platform—totally unhinged from reality.

Since it would be inadequate to say that this has been a mania, considering that retail trade has hardly been a factor, instead the stock market have been about banks, buy and sell side institutions, the best description is one of GREED for more free lunches!

Questionable PSE Foreign Trade Statistics, Has the SM Group Been Responsible for the Breakout Pump?

This brings me back to foreign trade.

When 7,400 was taken out last week, I said “This suggests that foreign buying was more about the special block sales. And this is where I suspect that special block sales could be about international satellite offices.”

Well, what would one discern of transactional statistics presented as “foreign” when it is in reality “local”?

The kernel: The meat of April 4’s supposed foreign buying Php 4.08 billion was due to 2GO’s special block sales by SM. Period. The difference may have been technical but foreign money was, in reality, local money.

The facts.  For that date, special block sales posted a huge Php 3.84 billion. Meanwhile, Php 3.48 billion or 91% of this figure was due to 2GO wherein SM bought 30% share of the firm

Total volume turnover for the day was at Php 11.941 billion. Hence, NET board trade was at Php 8.104 billion (outside total special block sales)

The net foreign buying was at Php 4.08 billion. Yet the published foreign trading activities for the 30 PSEi firms had been a net buying of ONLY Php 576 million. The difference between the two was Php 3.5 billion.

Total board trade of 30 PSEi firms was at Php 6.03 billion or 74.4% of the Php 8.104 billion board trade peso turnover. Seen from another angle, the ex PSEi 30 board trade was at Php 2.08 billion.

Presented differently, if the PSEi 30 registered Php 576 million of net foreign buying then just where did the Php 3.5 billion come from to attain a total of Php 4.08 billion of, again net foreign buying?

Even from a common sense perspective, Php 3.5 billion of ex-PSEi foreign buying relative to Php 2.08 billion net board transactions of ex-PSEi issues does not compute.

What actually tallied was the Php 3.48 billion of declared special block sales of 2GO with the Php 3.5 billion of net foreign buying net of the PSEi.

So it may be technically true that the registered buyer was a foreign affiliate or satellite of SM, but it was still SM that bought. SM just provided the statistical “foreign” cover.

Foreign “flows” depend on the source of the payment for the transaction. If the transaction was settled with USDs based on local account of SM that was paid to 2GO’s owners, then there would not have been any “inflow”.

Statistical smoke and mirrors.

And even more interesting was that the supposed foreign buying on that day was “coincidentally” timed with the volume feeble breakout.

The takeaway: Has the SM group been responsible for the 7,400 breakout???? If so, why the desperation???

The other lesson: one cannot trust statistics.

As a side note, the average weekly notional peso volume for this week’s breakout at Php 9.645 billion was the smallest of the three, namely January 2015’s Php 13.195 billion and May 2016’s Php 10.78 billion (see figure 3 upper left window). However, the picture changes when based on a net of special block sales. This week’s Php 8.42 billion would be in the middle of 2015’s 3-day average of Php 7.7 billion and 2016’s 4-day average of 10.23 billion. When 7,400 (7,392.2) was first hit on May 15, 2013, net peso volume was Php 10.31 billion.

The dearth of volume likewise signals the shortcoming of this week’s run.

Peso Bound for a Rebound Based on PSE Strong “Foreign Buying”?

Figure 3: PSEi’s Peso Volume on Breakout, Net Foreign Trade and GIRs

More on foreign buying.

The PSE absorbed net inflows of Php 8.366 billion (which included SM’s external affiliates), the largest since the week of May 27, 2016 or two months prior to the July 2016 PSEi 30 peak. (see upper right figure 3)

Theoretically, this translates to an increased demand for the local currency. US dollar holders exchange or sell their US dollars for (or buys) the peso which would be used to pay for recently acquired PSE securities.

This extrapolates to an outsized demand for the peso. And this similarly means that demand will temporarily eclipse the supply side factors of the peso.

This is regardless of whether such supposed statistical foreign inflows have been for real or had been meant as props. If it is the latter, then the markets should figure this misperception soon and accordingly adjust.

In the meantime, the implication is that the peso is bound to firm up over the short term.

There is a recent precedent. The May 2016 surge in foreign buying resulted in a significant peso rally of about 1.9% in two weeks. So a similar scenario may playout.

This week, the peso closed marginally stronger to Php 50.08 and placed second to India’s rupee as the best performing currency in the region.

Futures point to a breakdown of the USD peso 50 level. The USD peso could possibly trade around 49.8-49.9 next week.

Curiously, the Bangko Sentral ng Pilipinas reported that its Gross International Reserves (GIRs) dropped $570 million to a $ 80.87 billion in March that almost reached the December low at $ 80.7 billion. Most of the decline came from foreign investments. FX derivative positions were slightly down but still hovered at record highs.

With public sector deficits financed by the BSP and with stocks of government USD reserves being strained by a global US dollar shorts, up to what extent will the peso rally?

We will find out soon.

Have Stock Market Pumps Been Financed by Surging Non-Bank Financials Loans?

This brings us back to the risk of credit fueled stock market inflation (bubble).

 

Figure 4 BSP’s Non-Financial Intermediary Bank Loans and Car Sales and Leverage

It has also been fascinating to see how bank loans correlate with actions at the PSE. In particular, bank loans to the non-bank financial intermediaries (NBFI) [Figure 4 see upper window].

The rapid growth from NBFIs loan portfolio impacts the PSEi with a time a lag.

Last February, the growth rates of banking loans to the NBFIs jumped 28.39% to rip past the July 2014 high of 27.05%. It was the second month of over 20% growth rates (January clocked in at 25.14%)

For a clue, let’s have a pithy flashback.

In 2014, the consequence of 8 consecutive months (May to December) of 20% growth clip helped power the PSEi to its first 8,127.48 record in April 2015. When the growth rates fell below 20%, the eventual impact was for the PSEi to wither and crash into the bear market level.

In 2016, growth rates of bank loans to NBFI surged anew to a high of 22.9% in March. Three months after, the Phisix peaked for its second time at 8,100. Thereafter, the Phisix began to cascade and its second collapse.

It was almost the same in 1Q 2013 (not in the chart), where the average growth rate climaxed at 31.65%. More than two months after (in May-June), the Phisix had its first taste of the bear market.

Fast forward to the present. The likely effect of the colossal jump in the growth of bank loans to NBFIs in January and February has most likely spilled over to the Phisix…TODAY!

This week’s price spikes must have likely been due to the delayed effect from the NBFI balance sheet gearing with an asset buildup via the equity markets.

Or, NBFIs have bought the PSEi with borrowed money.

As I have been saying here since the PSEi is mainly driven by banks and NBFIs, and hardly by retail participants, the scorching series of loan growth must have been used to finance the wild punting binge and price fixing activities in the stock market.

What this posit to is that once loan growth to the NBFIs peter out, this should eventually reflect on the PSEi (again with a time lag).

A market that stands on credit expansion will fall on credit contraction.

Has Domestic Car Sales and Leveraging Hit the Proverbial Wall?

And here’s more.

Bristling growth rates of car sales have popularly been attributed to G-R-O-W-T-H.

Most seem blind to the fact that whatever G-R-O-W-T-H experienced in car sales have hardly been about economic prosperity but about CREDIT expansion. One can take home a car with only as much as Php 30,000 down payment. Easy money has allowed the leveraging of private sector balance sheets to artificially heave up demand for car sales.

Credit expansion has thus been confused with to G-R-O-W-T-H.

Such fiery growth rates, the average for two years at 23.82%, would not have been attained without interest rate subsidies provided by the BSP. Thus, output, earnings, profits, incomes, jobs and wages for the sector have principally been dependent on sustained easy money policies.

From a different slant, take away the punch bowl of interest subsidies, all these would fall like a house of cards.

Interestingly, the Chamber of Automotive Manufacturers (CAMPI) reported that sales growth rate of automotive vehicles plunged to 7.5% in February. This marks the second below 10% growth in the last 5 months (Figure 4 lower window)

The first one was in October 2016 which had an 8.6% growth rate. One international media outfit explained this as having been influenced by stricter rules on car registration and deliveries.

Perhaps.

But growth trend rates of both car sales and BSP’s bank loans to consumer auto purchases seem to have simultaneously culminated in the end 2Q of 2016.

October’s dive in sales growth rate was conjunctly reflected on BSP data via bank loan portfolio on consumer auto purchases. While the following months did register bounces, both have failed to hit previous levels. To the contrary, both appear to be losing momentum.

The Philippines has entered a milestone of the easiest money policy in history, yet car sales financed by leverage may have reached an inflection point.

The government has yet to implement an automotive tax hike in 2018. The tax hike will likely be passed onto consumers via higher prices. So this should provide incentives for consumers to chase current prices before it goes up. In marketing, this is called “selling the price increase”. And yet the slowdown.

Has car sales been manifesting a turning point in the big ticket consumer sales similar to real estate?

If so, then just what would happen to the tremendous amount of existing and planned capacity expansion for the sector?

And what even caught my eye in the February data was of the enormous disparity between auto sales (+7.5%) and consumer auto loans (+34.57%).

This shows that February auto loans sales may have been distorted (via delayed postings, again possibly due to new rules). Or that the persistent (still) blistering growth rates meant that borrowed money had been diverted to the other areas.

But the question is where? To stocks? To property?

As one can see, whatever asset pumping being done today have hardly been supported by the evolving economic dynamics.

And this comes in the face of the easiest money policy in Philippine history where the BSP has used both asset purchases and interest rates to enable and facilitate invisible subsidies or transfers in favor of the government and the elite at the expense of everyone else.

Yet much of borrowed money or systemic leveraging is being diverted inordinately to chase asset prices, which have been showing increasing signs of fatigue as balance sheet risks continue to mount.

All these are lucid symptoms of what the BIS officials warned above as “the risk of complacency and self-delusions”.