FT ‘Insight’ column, 26 June 2007
There are growing concerns that the credit cycle may be turning down but so far the impact on stock markets has been fairly limited. Investors take comfort in three misguided beliefs. They believe that equities are not expensive and that there is no sign of any diminution in the flood of global ‘liquidity’. Furthermore, they believe that if the worst happens the Fed will come to the rescue.
Each of these beliefs represents a failure to understand the unique nature of this global credit bubble and the consequences of its inevitable collapse. The financial markets have become closely intertwined in ways that we have never seen before. Some of these links are obvious, such as private equity’s arbitrage between the credit bubble and the equity markets. Others, such as the role of the global currency carry trade – the financing of leveraged positions in higher yielding assets from low interest rate currencies such as the yen and the Swiss franc – are less well understood.
A symptom of the bubble is that high interest rate currencies have been soaring to multi-year or multi-decade highs against the yen. The New Zealand dollar, for instance, is approaching 21-year highs against the yen, despite that over those 21 years the price level in New Zealand has doubled whereas in Japan it has risen by only 12%. A simple purchasing power parity exercise suggests that the New Zealand dollar is 20-25% overvalued against the US dollar, while the Turkish lira, another example, is about 65% overvalued. The yen meanwhile is roughly 30% undervalued.
Huge currency misalignments are leading to enormous current account imbalances. The Turkish and New Zealand current account deficits, for instance, are likely to be well into double-digits as a percent of GDP by 2009 while Japan is likely heading for a record surplus of 6-8% of GDP over the same time frame. The Swiss current account surplus is already about 17% of GDP. Ultimately there must be a very sharp convergence of exchange rates with fair values, inflicting heavy losses on carry trades. My estimate is that the size of the global carry trade is at least US$1.5 trillion and losses from a convergence of currencies with fair values could total about US$550 billion, with most of these losses accruing to leveraged speculators.
Given the very close linkages between markets today, intuitively we can be confident that these unprecedented deviations from currencies’ fair values resulting from the carry trade are reflected in credit, equities and real estate markets also. For the US this is confirmed by consideration of the ratio of personal sector net worth (at market values) to GDP. Prior to the beginning of the ‘Greenspan bubble’ in 1995, this ratio tended to fluctuate around an average of 3.4. Now, despite the paucity of savings in the US economy, the ratio stands at 4.1. A return to the long-run average would imply a fall in US personal net worth of approximately US$10 trillion. With similar trends mirrored across much of the world, total global losses from the coming financial meltdown could easily reach US$25-30 trillion.
Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK and Euro Area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.
The solution would have to involve massive unsterilized intervention by the Japanese authorities, which would have the effect of inflating Japanese consumer prices to a relative level consistent with the current yen exchange rate, thereby alleviating huge upward pressure on the yen as the carry trade unwinds. Combined with a similar inflation in the US this ‘solution’ would require roughly a doubling of the Japanese price level, destroying the real value of Japanese savings. If the losses are to manifest purely in real terms – via inflation – then they must occur mostly where the savings have been, which is certainly not in the US. If the Japanese authorities baulk at the prospect of such a huge inflation then global deflationary collapse will be inevitable once the credit bubble bursts.