Comment 46: The liquidity crisis and the stagnating US trade deficit
The global liquidity squeeze has turned into a global financial panic. It has started with the subprime mortgage woes in the US. Many of those subprime mortgage loans require no down-payment at all, and carry a very low introductory interest rates for the first few years, call the “teaser rate”. After the period of the teaser rate expires, the interest rates on those subprime mortgage loans will move in tandem with the prevailing short-term market interest rates. As the short-term interest rates have risen substantially, those subprime borrowers suddenly face an unbearable monthly interest payments after the expiration of the teaser rate period. Thus many subprime mortgage loans end up in delinquency and then in default. Since most of those subprime mortgage loans are packaged into mortgage backed securities, the defaults of subprime mortgage loans have thus damaged the values of those mortgage backed bonds. Due to the invention of complicated financial derivatives, the damage on the price of those mortgage backed bonds is further amplified. Those subprime mortgage backed bonds are held widely by financial institutions and hedge funds around the globe so many entities have run into trouble by holding related bonds and derivative instruments. However, this kind of woes are not limited to subprime mortgages. In the non-subprime category a substantial fraction of newly granted mortgage loans also are adjustable rate mortgages that carry very low teaser rates and with scant down-payments. At a very low interest environment financially sound people will borrow 30 year fixed rate mortgages to lock in very low interest rates. In the non-subprime category, only those with good income but financially stretched will borrow adjustable rate loans with a teaser rate even substantially lower than the already low rates of the fixed rate mortgages, apparently in the hope that future interest rate will stay low or the rising housing prices will bail them out. As those scenarios failed to develop, the default rate in the non-subprime sector is also rising. Then there are home equity loans that are also adjustable rate loans. The default rate of home equity loans is rising, too. Those non-subprime adjustable rate mortgages and home equity loans are also widely packaged into mortgage backed or real estate equity backed bonds. Thus the pains of mortgage woes are quickly spreading beyond the subprime region. At the same time of mortgage woes the liquidity in the markets of junk bonds that are issued mainly to finance the frenzy of takeover booms in the hands of private equity firms is also drying up. Though some are trying to play the word game and called the spread of the financial pain and the drying up of liquidity as “the reassessment of financial risks”, the reality of diminishing liquidity finally hit and the financial pains has turned into a global financial panic in the last two days, on Aug. 9 and 10 of 2007. In order to understand the true nature of this liquidity crisis we will discuss in this comment the origin of the liquidity squeeze, the future course that this crisis will likely to take, and how this crisis will affect the global economy.
The global liquidity is pumped up by the global trade imbalance, not by the total amount of global trades. The majority of the global trade imbalance is due to the runaway US trade deficits. Let us consider first the situation of USA. As the US runs trade deficits, US dollars are handed over to foreigners. Since US dollars are not legal tenders in foreign countries, those dollars related to the trade deficit (we will call them trade-deficit-dollars from here on) must flow back to the US markets, mainly via the Wall Street. A portion of those returned trade-deficit-dollars will purchase US based assets like stocks and real estates, but the majority of the trade-deficit-dollars will be lent out in the form of purchasing dollar denominated debt instruments, ranging from US treasury issues, mortgage backed instruments, corporate bonds and so on. As lending generates more lending, the trade-deficit-dollars balloons to a large amount of liquidity. In 2005, the US current account deficit, the broadest measure to gauge the trade situation, has topped 600 billion dollars. Thus we may expect that the total liquidity originated from trade-deficit-dollars has already reached tens of trillions of dollars. It is this liquidity glut that is supporting the US government spending, the local government spending, the consumer spending, the mortgage lending, the borrowing by private equity firms to finance their buyout frenzy, and the borrowing by hedge funds to engage in speculative activities. However, the US trade deficit has stagnated for more than a year, and thus the liquidity squeeze. We will look into the actual data to give supports to this argument in the following paragraphs.
The current account deficits are not adjusted for inflation, so we always consider the ratio of the current account deficit over the nominal GDP, expressed in percentages, as a proper measure to gauge the trade situation. This ratio is called trade-deficit-to-GDP ratio in short. The four quarter moving averages of this ratio are plotted as the blue curve in the graph at the right. Four quarter moving averages of the growth rate of real GDP are plotted as the green curve, and four quarter moving averages of the growth rate of real (means inflation adjusted) debt are plotted as the red curve in the graph respectively. Since the onset of the globalization process in the early part of 1980's, there have been three bursts of US trade deficits as can be seen as three sharp rises of the blue curve. The first burst of the trade deficit occurred in the period from 1983 to 1986, and the growth rate of real debt (the red curve) far exceeded the growth rate of real GDP (the green curve) in this period, creating the debt bubble of 1980's. It was this debt bubble that generated the real estate bubble of 1980's and induced frenzied merger and acquisitions by issuing junk bonds to finance such activities. The US trade deficit at that era were mainly due to the trade deficits with Japan. Thus in early 1985 major powers agreed to let Japanese Yen appreciate against US Dollar; Japanese Yen rose almost 100% in the succeeding years. This great devaluation of US Dollar took about 2 years to be translated into the stagnation of US trade deficit and then the decline. As can be seen from the blue curve of the trade-deficit-to-GDP ratio, it started to stagnate in 1986 and had turned to an explicit decline near the end of 1987. With this retreat of the US trade deficit, the red curve, the growth rate of the real debt, had turned down sharply from 1986, indicating the steep drop of the rate that liquidity was created. As the liquidity squeeze due to the slowing trade deficit advanced, the merger and acquisition activities came to an abrupt end, withdrawing an import support for the stock markets. As the ratio of trade-deficit-to-GDP started to turned down at the end of 1987, stock prices crashed and the growth rate of real GDP slowed substantially. The three curves tumbled together toward the nadir of 1991, until the growth rate of real GDP became negative and an official economic recession was declared. This series of events shows how the flows and ebbs of trade deficits induced the rise and the bust of the debt bubble, and how the fate of the debt bubble pushed around the growth of the real GDP.
As the ratio of trade-deficit-to-GDP fell to its nadir, US Dollar regain the power to rise against Japanese Yen. Thus the US trade deficit started to expand again from its nadir of 1991. However, the second burst of the US trade deficit needed to wait Japan's near zero interest rate policy that unleashed yen carry trades to push US Dollar sharply higher against Japanese Yen. During this second burst of US trade deficit, a debt bubble did not emerge. Instead the trade-deficit-dollars flew into stock markets and created a stock price bubble. The debacle of US Dollar in 1998 and 1999 caused US trade deficit to decline in 2000 as can be seen from the peak of the blue curve in 2000. As the ratio of trade-deficit-to-GDP came down, so was the growth rate of real GDP. The third burst of US trade deficit has started in 2002, though temporarily disrupted in 2003 by the SARS scare. By the time of this third, or the current burst of trade deficit, China has replaced Japan as the major contributor to the US trade deficit. The movement of Dollar vs. Yen becomes less a factor in dictating the movements of the US trade deficit. Chinese Yuan has been pegged to US Dollar until the middle of 2005, and is allowed to float up slowly since the middle of 2005. Thus the drop of dollar against other currencies except Chinese Yuan from 2002 has a much less effect on the US trade deficit than used to be. Only from the beginning of 2005 US trade deficit less energy has started to stagnate, but the overall trade deficit was kept rising through 2005 due to the rapid rise of the price of crude oil. Only when the oil price stagnated, the US trade deficit has ceased to rise, and the blue curve has peaked and started to fall in 2006. During this current burst of the trade deficit, a debt bubble developed as the substantially higher debt curve (the red one) than the growth rate of real GDP (the green curve) indicates. As the trade deficit starts to fall, the growth rate of debt, the red curve, is falling in tandem, indicating the rapid disappearance of the liquidity glut.
In order to guage the future course of the liquidity squeeze, we must first understand the direction of the US trade deficit. Considering the dominance of foreign made, especially Chinese made, consumer goods in the US market, the trade deficit of the consumer goods sector is probably near saturation. The trend in automobile sector is for Japanese brands to manufacture cars within USA and gradually replace American brands. This transition of power will not cause the trade deficit of the automobile sector to increase sharply. As liquidity bubble bursts, the Wall Street people that have profited mightily from the bubble will be poorer, and will buy less imported luxury cars, and thus the trend of deficit in the automobile sector is a stagnation at best. The capital goods sector is sensitive to the value of dollar. At the dawn of the globalization era, the US enjoyed a substantial trade surplus in this sector. After experiencing waves of runaway trade deficits, this surplus in the capital goods sector had turned into a deficit of 17 billion dollars a year by 2005. The falling dollar from 2002 is narrowing the deficit in this sector fast. As a whole the US trade deficit less energy will continue to stagnate unless unexpectedly US dollar strengthens against the currencies of its trading partners, including Chinese Yuan, by a substantial amount. Barring such an unlikely currency exchange rate movement, only hope for a rising US trade deficit is for the price of crude oil to jump sharply from here. If that happens, the blue curve will turn up again, the red curve will bottom out, the liquidity squeeze will ease, stock prices will rise, but the growth rate of real GDP will fall further due to heightened inflation rate. If the oil price does not come in to rescue, the ratio of trade-deficit-to-GDP will continue to fall, and the growth rate of debt (the red curve) and the growth rate of real GDP (the green curve) will follow the blue curve down in a measured pace. Thus the liquidity squeeze will continue for quite a while.
Some claim that if only FED lowers interest rates and replenish the lost liquidity, everything will be fine. Let us look into this theme in details. Greenspan FED took the radical action of lowering interest rates to the 1% level in 2003, and ignited the housing bubble that is now deflating painfully. US Dollar tumbled from the level of 115 Yen/Dollar toward the level of 100 Yen/Dollar. Japanese government stepped in and bought up more than 400 billion dollars to prevent US dollar to collapse below 100 Yen/Dollar. As Japanese Government's dollar buying spree ends, FED was forced to raise interest rate rapidly and steadily until the Federal Fund's rate reached 5.25% to prevent the demise of dollar. This steady rise of the short-term interest rate is now boomerang back to intensify the pain of the mortgage woes. If FED lowers short-term interest rates substantially to replenish the lost liquidity and to prevent the deflation of the debt bubble, Japanese Government probably needs to buy up nearly one trillion dollars this time to prevent a whole sale collapse of US dollar. Even if Japanese Government is able to perform such a feast again, FED will be forced to raise interest rate again after Japan's dollar buying spree ends in order to defend the dollar and to fight off the inevitable inflation in such a scenario, and thus the financial crisis will reemerge in a few years.
There are people who naively claim that a whole sale collapse of US Dollar will only inconvenience some American tourists in overseas, but will achieve the desirable effect of shrinking the US trade deficit in a few years without any pain. Such a shrinkage of the US trade deficit will apparently force the further shrinkage of the global liquidity and makes the situation worse, rather than ease the crisis. Then there is an immediate and enormous danger overlooked by those claims. The danger is due to the existence of “derivatives”. The derivatives we are talking about here are not those exchange traded put and call options nor the exchange traded futures contracts. They are off the market financial contracts granted among large financial institutions, life insurance companies, hedge funds and so on. Those derivatives carry fancy names like interest rate swap, currency swap, credit risk swap, barrier options, lookback options, chooser options, knock-in and knock-out options, forward or delayed start swap options, index-amortizing swaps and so on and so on in addition to the familiar names similar to the exchange traded options. Those derivatives make the hedging of long financial positions possible, and thus encourage various entities to hold financial positions far beyond their reasonable means; such positions are called leveraged holdings. The leveraged and vastly expanded holdings of various long positions then in turn further escalates the trading of derivatives. It is reported that the total amount of the exiting derivatives already exceeds 50 trillion dollars globally. The values of a substantial portion of those derivatives depend on the value of US dollar. When US dollar collapses, a sizable loss, like 10 trillion dollars will be incurred in a sector of the participants of the game of derivatives. Many losers in the game naturally have no means to sustain such an outsize loss and will inevitably go under. Derivatives are a zero sum game. If there are losers, there will always be the matching winners. However, as losers go bankrupt, the paper wins of the winners also disappear. Most of those winners are probably using the derivatives to hedge their highly leveraged holdings that will lose value as dollar plunges. Thus those so called winners must realize the full amount of loss in their over-extended holdings once their insurance derivatives evaporates, and will go under along side with the losers. The bankrupted losers and winners of the derivatives tied to the value of dollar probably are also playing the game of derivatives tied to interest rates. As they go down, interest rate related derivatives will also evaporate, and expose the holders of outsize interest rate instruments directly to the rapidly gyrating market force. In a very short time span the shock wave of collapsing dollar will spread and will bring down the whole derivative house of cards, along with the whole global financial system. If that kind of scenario unfolds, due to the sheer size of losses involved, the whole world's central banks, IMF and the world bank combined will be utterly powerless to combat such a whole sale disaster. The best we can hope is that FED will not succumb to the temptation of lowering interest rates in a haste, and not to test the jinni of Dollar and derivatives.
The best way to understand why the problem of liquidity is globally connected is to look at the case of China. Chinese economic growth is based on the rapidly growing influx of dollars. The major source of the influx is from its rapidly expanding trade surplus. In order to slow down the pace of the rise of Chinese Yuan vs. US Dollar Chinese Government must buy up those influx of dollars. In the process of dollar buying a matching amount of Chinese Yuan must be sold into the market. It is this huge amount of Yuan flooding the domestic market that powers the growth of China's economy. Currently China's trade surplus is expanding by taking away the share of export markets of other countries. However, as the US trade deficit continue to stagnate as discussed before, the growth of China's trade surplus will gradually come to a hold, and China's economic expansion will also slow down unless Europe will expand its trade deficit sharply to shoulder a portion of the role that the US trade deficit used to play.
Europe's economy has benefited from the dynamic rise of new EU members. The low labor costs of those developing EU member states boosted the manufacturing in EU as a whole. However, if EU let its trade deficit to expand rapidly and shoulder a portion of the burden to let China continue to expand, then their newly industrializing members will suffer. EU is also benefiting from the influx of oil money. Many oil producing countries do not want to deposit their oil money into USA due to political reasons, and choose Europe as the target to pour their money into. Thus European financial institutions become the conduit of oil money to be reinvested into USA. Those European financial institutions and hedge funds are exposed to the same financial risks as their US counter parts. Actually the financial panic of Aug. 9 has originated from Europe. If the derivative market collapse, European financial system that is tightly integrated into global system will also be destroyed just like their American cousins. It is difficult to envision that Europe can really serve as the economic locomotive to pull up the whole global economy if the US economy stumbles.
Japan's economy is in a peculiar shape. In the middle of 1990's when Japan has embarked for the policy of very low interest rate, their central bank, The Bank of Japan, was still tightly controlled by the bureaucrats of MOF (the Ministry of Finance). It was the idea of the mercantilistic MOF bureaucrats to use the very low interest rate to suppress the value of Yen so that Japan can sustain a sizable trade surplus. This policy has wiped out the interest income of Japanese consumers that are known to be heavy savors. With this blow, the consumer spending has withered and the deflation has set in. This more than a decade long hardship of Japanese consumers is still continuing today. As Japan's job situation worsens, Japan's economy can only grow by increasing exports, utilizing the idled labor resources. That is what is happening today in Japan. As the US trade deficit stagnates and the ratio of trade-deficit-to-GDP comes down further, Japanese economic growth will also vanish.
The claim of soothsayers that the US has nothing to fear since the global economy is strong is simply dubious at best. The safest course for FED to take is to adhere to its current interest rate target, and steadfastly defend this target. If needs arise, FED can continuously inject sufficient amount of liquidity into the financial market to prevent the Federal Funds rate to go above 5.25%. After a while the financial market will get used to the gradually shrinking liquidity bubble, and the panic stage will be over. As the liquidity bubble withers away, the US economic growth rate will come down further and the job market will become worse, but the ratio of trade-deficit-to-GDP will keep declining. As the ratio drops to a certain level, US Dollar will regain the power to bounce up without the artificial stimulus like yen carry trades. It is at that juncture FED will be able to lower interest rate gradually and jump start the economic growth again. Only after such a soft landing is accomplished, policy makers should seriously consider ways to address the means to prevent the reemergence of global trade imbalance and to rein in the run away leverage and the explosion of derivatives even at the cost of scaling back the irresponsible and ill-thought-of globalization process. Otherwise the financial crises will reoccur again and again until the big bang that destroys the global financial system as well as the global economy.