Optimal Response to the Fed Printing Dollars

What should be China’s course of actions, given that it’s large external reserve is mainly held in US currency, in the form of treasury bonds etc. With US printing more money to ‘rescue’ it’s financial institutions, there are many views being expressed for the Chinese government to diversify it’s holdings. Andy Xie, a well respected economist, think that China should convert its reserves to cash for easy investment and shrink the trade surplus to ‘unteather’ itself to the US dollar.


Andy’s view on the current stock market rally is also of immense interest to me  ….. "The stock market rally we are seeing is a bear market rally. As I wrote at the beginning of 2009, a credible bank rescue plan would start a bear market rally. It won’t last. The reduction of leverage after a credit bubble bursts takes a long time, which prevents a vigorous economic recovery. The current bear market that began in the fall of 2007 will likely last at least three years. It could be longer than five years. Even after leverage is normalized, the global economy still needs to find a new growth model, and we are not seeing the structural reforms that would take it there."


So, the bear market could last between 3 to 5 years. I think Warren Buffet, Lee Kuan Yew and even George Soros also made similar forecast. Lets’see …


04-01 12:08 Caijing
By Andy Xie, guest economist to Caijing and board member of Rosetta Stone Advisors

(Caijing Magazine) The Fed announced recently that it would buy US$ 1.25 trillion of Treasuries, commercial papers and mortgage papers. Its balance sheet has doubled from the pre-crisis level of about US$ 900 billion. This program could triple its balance sheet from the pre-crisis level. The Fed has promised to contract its balance as soon as the economy is strong enough or inflation shows up. But it is unlikely that the expansion could all be reversed. If at the end the Fed’s balance sheet merely doubles rather than triples, the dollar’s value would still halve, ceteris paribus.

However, if other central banks print money to keep their currencies from appreciating against the dollar – a likely scenario – other currencies would experience downward pressure. The equilibrium for the global currency market could end up being rotating devaluation, which would anchor inflation in all major economies. I still think that the central path for the global economy is stagflation. Fiscal stimulus and inflation may trigger a bounce in the global economy in the second half of 2009. However, it is a head fake. The global economy could have a second dip in 2010 when inflation emerges to blunt the effectiveness of monetary stimulus. In particular, bond yields could surge around the world. The real bottom for asset prices may be in 2010.

After the Fed announcement the dollar made a record weekly drop, treasury yield and mortgage interest rate dropped sharply. The market responses were what the Fed intended. As long as the market think that the Fed’s monetary expansion is bound by its announcement, i.e., the dilution of the dollar is limited, the market can price in the new value of the dollar. Other asset prices move according to what the Fed does with the money from diluting the dollar.

The motivation for the Fed’s policy is to stabilize property price. The Fed has so far focused on stabilizing the financial system through guarantees on the assets held by and loans to troubled financial institutions. Even though it has achieved some success in that regard, it has had no meaningful benefit for the economy. The U.S. economy continues to deteriorate as reflected in surging unemployment. The Fed has concluded that it must try to stop property price from falling to stabilize the economy. The U.S. household property value has contracted by US$ 4 trillion, or 20 percent from the peak in 2006. The wealth reduction from the stock market decline is much bigger at US$ 6 trillion. But as massive amount of financial products are backed by property value, the multiplier effect from the property price decline is at the center of economic and financial turmoil.


The U.S. Treasury released its plan for purchasing US$ 1 trillion of toxic assets from the troubled banks. Under the plan, for every one dollar of equity capital invested by a private investor – e.g., Pimco, Blackrock, or hedge funds – in a special vehicle to buy toxic assets, the U.S. government will co-invest one dollar of equity. The vehicle could then borrow US$ 12 under the government guarantee, i.e., borrowing at zero interest rate for short-term debt and 2.75 percent for ten year debt. The subsidy for the program essentially comes from the guarantee. The debt bears little difference from equity in terms of taking downside risk but gets no upside. The private investor gets to magnify his or her returns six times with the government guarantee. This is why private investors are interested in the program.


But this program is not different from what the former Treasury Secretary Henry Paulson proposed when the Troubled Assets Relief Program was set up. His program didn’t fly because the market prices for toxic assets were too low for banks to survive. Indeed, at the current market prices, major big banks are bankrupt several times over. The hope for the new program is the built-in leveraging for private investment. It might motivate private investors to bid up the prices for toxic assets that will allow banks to survive. But I am not sure that it will be so. If the prices for toxic assets don’t go up, the U.S. government may have to come back to nationalization as the way out.

The bailout program is about who will pay the check and how soon the banking system can recover to provide normal services. The former is an equity issue and is highly political. Popular sentiment wants bank shareholders, bondholders, and managers to pay before taxpayers pitch in, while the government leans towards preserving the capability of the banking system. The U.S. government is using this debt guarantee to hide its subsidy for the people who created the crisis. We will see if the American people will tolerate this.

However, if the banks can get back to normal operations quickly, it will minimize collateral damage to the economy. From that angle, the government should compromise to resuscitate the banking system as soon as possible, which is the justification for subsidizing crooks and criminals that created the mess.


The stock market rally we are seeing is a bear market rally. As I wrote at the beginning of 2009, a credible bank rescue plan would start a bear market rally. It won’t last. The reduction of leverage after a credit bubble bursts takes a long time, which prevents a vigorous economic recovery. The current bear market that began in the fall of 2007 will likely last at least three years. It could be longer than five years. Even after leverage is normalized, the global economy still needs to find a new growth model, and we are not seeing the structural reforms that would take it there.


I have argued that, in the aftermath of a property-cum-credit bubble bursting, there are three possible outcomes: (1) bankruptcy, (2) inflation, and (3) government bailout. The former forces lenders to accept losses beyond what borrowers can pay. The second allows borrowers to retain assets by inflating away their debts. The U.S. accepted the first scenario in the 1930s. Germany did the second in the 1920s. Japan did the third in the 1990s. It kept the interest rate at zero to decrease debtors’ carrying cost to zero and allowed them to pay down debts gradually over a decade. During the meantime, the government ran massive fiscal deficits to give debtors a chance to make money. It was a gradual assumption of private sector debt by the public sector. Japan’s government could have just assumed half of the private sector debt at the beginning of the 1990s. The country would have been far better off than going through the kabuki of ‘fiscal stimulus’ to slowly take over private debt.

The dominant force after a bubble bursts is normalization. For example, in a normal economy, income is 100, property price is 100, and debt is 60. During a property-cum-debt bubble, property price rises to 200 and debt to 150, but income remains at 100. When the bubble bursts, property price wants to fall to 100, but the notional value of debt can’t decline. In the bankruptcy scenario, the property owner goes bankrupt. The creditor repossesses the property, sells it for 100, and books loss of 50. In the inflation scenario, income rises to 200. The property owner retains the property. The credit gets 150 back in full, but its real value declines by 50 percent. The creditor loses 75 in real terms in the inflation scenario. In the third scenario, the creditor pretends that the debtor hasn’t gone bankrupt, stretches the repayment, and foregoes interest. Overtime the creditor gets 150 back. However, as money in future is worth less than money now, the creditor suffers losses from the discount factor. Indeed, one can prove that the creditor gets maximum 100 in this scenario.

The dynamic of a bubble bursting complicates the process. Either property price declining or inflation engenders collateral damage. The most important is rising unemployment, which is net loss rather than redistribution, i.e., idle workers could have produced something. Policymakers like the Fed are usually motivated by the desire to minimize the collateral damage. I don’t think that the Fed has a clear plan. It sees the falling property price as enemy number one and is trying to stop it. Hence, it wants to print money to purchase mortgage assets, which depresses mortgage interest rates. As mortgage interest rates fall, they decrease the bankruptcy risk of borrowers and, hence, they decrease sales. Of course, lower mortgage rates increase property demand. Through curtailing supply and boosting demand, the Fed wants to stabilize the property price and the economy.


Let’s assume the Fed succeeds. What would the world look like? U.S. property prices have declined by about half on the way to normalization. The Fed’s policy could replace further decline with inflation. Hence, relative to a normal path, the U.S. economy would have 20 to 25 percent more inflation. Ceteris paribus, the dollar would drop by 20 to 25 percent from here. The dollar dropped by roughly 5 percent during the week of the Fed’s announcement. I think the dollar’s weakness story has way to go.


But we should not look at the U.S. side alone. Other economies are experiencing similar problems. For example, UK property was 200 percent overvalued at the peak compared to 100 percent for the U.S.’s property. It is experiencing even worse downward pressure. It is a matter of time before the Bank of England will be forced to do the same as the Fed is doing now and on a bigger scale. Hence, the dollar may drop against the pound sterling initially but may rise when the Bank of England imitates the Fed.


The Bank of Japan may need to monetize for different reasons. Japan didn’t have a property bubble, but its economy benefited from the credit bubble. For example, cheap credit exaggerated car demand. As credit cost rises, consumers will respond by changing cars less frequently. Hence, the total car demand will drop sharply, possibly by half. Half of the auto factories in the world may shut. The U.S. government is moving to support the Detroit Three, which puts pressure on the Japanese automakers to shut factories. The Bank of Japan is responding to the situation facing its industries by lending them money, and it gets that cash by printing money. We could see the Fed and the Bank of Japan dueling it out by supporting their industries to see who will blink first and shut factories.


The European Central Bank is not immune to printing money. Among the three central banks the ECB has been most cautious in terms of loosening monetary policy. But its banking system has lost huge amounts of money. Its economy depends on exports. If the euro is strong, Europe’s industrial sector will suffer horribly, and its banking system will hemorrhage more on rising bad debts. The ECB may be forced into printing money to support its banking system and industries.


As the Fed embarks on the unprecedented policy of printing money to bail out debtors, the best outcome for the world is stagflation. A worse outcome is that markets panic over endless supply of dollars and sells dollars at any price. It would cause a dollar collapse like what happened to ruble in 1998. The outcome is hyperinflation. The resulting chaos would plunge the global economy into turmoil.


How should China react to the Fed’s policy? It is not possible for China to pressure the Fed to change its policy to protect China’s foreign exchange reserves. The Fed does what’s best for the U.S. China has to do what’s best for China. It is pointless to hope the U.S. will do what’s in China’s best interest. As I have argued before, as the yuan is linked to the U.S., China’s foreign exchange reserves must be kept mostly in dollar assets. The only alternative to treasuries is the stock market. Stocks are better than bonds during a weak dollar environment. They have triple protection against inflation and weak dollar.


First, half of S&P 500 earnings are from abroad. If the dollar goes down, the earnings in dollar terms would rise. Further, U.S. companies gain competitiveness from a weak dollar and their stocks may become more valuable. Second, if the Fed succeeds in improving the U.S. economy, improving domestic demand would boost corporate earnings. Third, companies have assets like brands and technology that would appreciate during inflation.


The best way to get into the stock market is to buy S&P 500 index. It is the only asset with liquidity comparable to the treasury. It has performed better than 90 percent of the fund managers and would certainly do better than Chinese government officials picking stocks. Plus, it avoids the political controversy of Chinese government trying to control American companies.


I am not advocating the Chinese central bank sell treasuries now and buy stocks. The first step is to make the treasury portfolio as close to cash as possible by shrinking duration, i.e., buying shorter and shorter maturity treasuries. The U.S. stock market will make more lows in the next twenty months. The book value of S&P 500 is 517. Its current price is 823 or 1.6 times book. The historical average price of S&P 500 is 2 times book value. The current price is 20 percent discount against the historical average and is insufficient for the current environment. During the last structural bear market between 1972 and ’82 it averaged 1.3 times book value. On price earnings ratio, the current price is not low either. The earnings for S&P 500 in 2009 are likely to be 50. The current PE ratio is 15.4. This is high by bear market standard. It should be 11 to 12. The downside for the U.S. stock market is considerable. I think there are better entry points for China’s foreign exchange reserves.


In addition to protecting the value of existing foreign exchange reserves, China should try to stop increasing foreign exchange reserves. The only way is to boost domestic demand to cut trade surplus. Even though China’s exports are declining at about 20 percent, imports are declining more. Trade surplus may not shrink at all. It would force China to buy more dollar assets, as China’s currency is linked to the dollar. I think that there are two policies available to cut trade surplus quickly.


First, China could boost fiscal deficit to 1.5 yuan from 1 trillion yuan for 2009’s fiscal year. The extra fiscal stimulus should be on the household sector rather than investment. Cutting taxes, for example, would boost household spending power. The value-added tax, for example, could be cut significantly. It is an excise tax and is regressive, i.e., taxing the poor more than the rich proportionally.


China also should cut the top marginal income tax from 40 percent to 25 percent – the same as the corporate income tax. The current high rate is bad for revenue collection. Personal income tax revenue is too small in the overall fiscal revenue. The high rate has incentivized tax dodging. Also, most entrepreneurs book their personal spending as company expense to avoid taxes. Making corporate and income tax rates the same would obviate this incentive. Taxing the rich doesn’t always mean protecting the poor. High tax rates benefit the poor if the money is collected.


Second, the government can distribute the shares that it holds in state-owned enterprises to the population to boost consumption. My rough calculation is that such a program would boost consumption by 500 billion yuan. As the economy improves on rising consumption, the share prices would rise and there would be a further increase of 500 billion yuan in consumption.

Cutting taxes and distributing SOE shares among Chinese population would roughly eliminate China’s trade surplus, obviating the need to buy dollar assets. It will lay the foundation for China to float its currency and become an independent force in the global economy.

The U.S. government is trying to do what’s best for its economy. China must do the same. Wishful thinking, hoping the U.S. to do what’s best for China, is daydreaming. It is not about what’s fair. In a modern world everyone must optimize for itself.

Full Article in Chinese: http://magazine.caijing.com.cn/2009-03-29/110129709.html


About kchew

an occasional culturalist
This entry was posted in Economy and business. Bookmark the permalink.

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