Saturday, 19 March 2011

After the tsunami - Chaos theory in real life


Chaos theory in real life

I was at an IMF conference on capital flows in Bali when the Japanese earthquake and tsunami occurred. As the tragedy unfolded over the weekend, it became clear that the crisis was complicated by nuclear considerations. All of our sympathies and condolences go with our Japanese friends as they go through this terrible natural disaster, possibly larger than the Kobe earthquake.

When the Year of the Rabbit ushered away the Year of the Tiger, there was a false spring in February when financial markets were buoyant as everyone thought recovery was in the air. Even the Nikkei stock market index reached a recent peak. The US economy seemed to be on the upswing as unemployment numbers declined one percentage point. The earthquake shattered that illusion of recovery.

Chaos theory is always introduced by the idea that the flutter of a butterfly's wings can cause a hurricane the other side of the world. We now see Chaos theory in real life. A tsunami in Japan can hit the west coast of the United States, but financial markets immediately reacted around the world, as everyone tried to assess what the largest net foreign asset holder in the world would do. Will the Japanese sell off their foreign assets to finance their own post-earthquake reconstruction? If they do so, will they sell off foreign currencies and buy back yen, which will make the yen stronger?

On the other side of the world, there was another earth-shattering pronouncement, not immediately comprehensible by ordinary investors, but very significant in terms of financial markets.

On Oct 15, 2010, Pimco, the world's largest bond fund manager, with probably US$1 trillion under management, announced that their Total Return Bond fund was cutting their holdings in US Treasuries as a result of quantitative easing. Most retail investors probably did not notice that announcement.

But on March 9 this year, the head of Pimco, Bill Gross, announced that at the end of February 2011, the fund had sold off all its US Treasuries and agency debt. To me, that is as significant as a tsunami in financial markets.

I did not fully digest the significance of that event because I was travelling from Washington DC to Bali. But after I downloaded Gross' comments, available at, I began to understand his thinking. He showed a fascinating chart on who was and will be holding US Treasuries. In the past, the Federal Reserve only held 10%, foreigners 50% and US institutions and individuals held 40%. Since the beginning of QE2, the Fed has been buying 70% and foreigners are buying 30%, while US institutions are staying on the sidelines.

So why are US funds like Pimco not buying? Part of the reason is that “Treasury yields are perhaps 150 basis points or 1.5% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%.”

In other words, the US dollar is violating the second of the three pillars which give it the most-favoured-currency status, according to Barry Eichengreen, professor at University of California at Berkeley, who has a great understanding of the special role of the US dollar from the span of economic history.

On March 2, 2011, Prof Eichengreen wrote an article in the Wall Street Journal arguingL: “Why the Dollar's Reign is Near an End”. The three pillars are firstly, the depth of US dollar-denominated debt securities, secondly, the dollar is the world's safe haven, and thirdly, the dollar benefits from a dearth of alternatives.

Currently, 42.5% of global foreign exchange transactions are conducted in US dollars, compared with 19.5% for the euro, 8.5% for the yen and 6.4% for sterling. This is because commodities like oil and gold are priced in dollars. Moreover, a large chunk of foreign exchange reserves are held in US dollars, the largest being Asian and Opec central banks and sovereign wealth funds.

The preliminary report on foreign holdings of US securities as at the end of June 2010 was published at the end of February 2011 by the US Treasury. Foreign holdings increased US$1 trillion from a year ago to US$10.7 trillion, of which US$2.8 trillion was in equities and the balance in debt securities. Out of the US$10.7 trillion, China held US$1.6 trillion (15%), Japan US$1.393 trillion (13%) and Middle East oil producers US$350bil. So, the real fear of Bill Gross is the question: “Who will buy Treasuries when the Fed doesn't?”

More important, what happens if the foreigners decide like Pimco not to buy any more Treasuries, especially when they decide to bring their money home for their own domestic purposes?

Consequently, we are even closer to the edge of higher currency volatility than what the market is telling us. One of the big lessons of the recent past is that the price of money and risk spreads (and credit rating agencies) have not warned investors of the inherent risks in financial securities.

With QE2 and near-zero interest rates in the major reserve currencies, the spreads simply do not reflect the inherent risks that I have outlined above. This means that sooner or later there will be a spike in the price, or a sharp fall in value, if history is any lesson to go by.

Indeed, I have argued that even though the Dow Jones Industrial Average has doubled since the beginning of QE2 in 2008, if you deflate the index by the price of gold, the equity market has crashed already.

I would be the first one to hope that the current economic recovery in the United States and Europe will be sustainable. I strongly hope that Japan will recover quickly from this sudden shock and tragedy. But I would not be responsible if I did not think that the financial markets are once again not reflecting the risks out there. Just like Bill Gross, it is legitimate to ask “whether Quantitative Easing policies actually heal, as opposed to cover up, symptoms of an unhealthy economy.”

Watch this space.

Andrew Sheng is the author of the book “From Asian to Global Financial Crisis”.