Introducing the FED Carry Trade

“The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns's borrowings were largely secured--that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.” - Chairman Ben S. Bernanke At the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming
August 22, 2008. Reducing Systemic Risk.


Intervention into markets always has consequences. The interventionist has specific objectives and plans the intervention to achieve those objectives. The narrowly defined objectives are actually achieved more often than not but as “the market” is a collection of infinite variables and infinite interactions between those variables, it is a given that most consequences will never be known in advance. The interventionist will attempt to anticipate consequences and will mitigate in the planning against undesirable consequences. No matter how much care is taken, intervention always produces unintended consequences. Liquidity intervention suffers from the same unintended consequences as all interventions must. However, do not fall into the trap of believing unintended consequences were necessarily unknown or unexpected. Interventions are powerful counter forces inside a market already crowded with forces and counter forces. Picture exploding a bomb inside a SSHS code 5 tropical cyclone to alter some of the forces already unleashed. The monetary powers of the FED are similar when bombing market forces.

Let’s not hesitate to also describe the credit crisis as the spawn of previous monetary interventions. The credit bubble was anticipated and identified by many informed writers including this author. Systemic banking failure happened recently in Japan and was a known outcome of easy monetary policy. As such it should have featured as a known consequence of this monetary intervention in both the quantity and price of money. Most unintended consequences are known potential outcomes but dismissed as improbable.

We need to distinguish between unintended consequences which came as no surprise and unintended consequences which were truly not foreseen as a possibility. Can one really make the assumption that the FED and all the monetary policy hacks could not have contemplated a credit crisis outcome as a result of the applied monetary policies? I have read commentators claiming the credit crisis was a market failure. Which masters are they trying to please when clearly the Fed dictates the price of money (interest rates) and its supply (liquidity)? This policy failure can never by any stretch of imagination be called a market failure. Any analysis of the behaviour of the FOMC will show that it engages in price fixing based on an objective (intended consequence) as opposed to the market’s price discovery process derived from the behaviour of all market participants. They do not propose to guess at what the economic version of the price of money should be. They simply fix the price for a targeted outcome. The price fixing activity disregards market supply and demand for money as the FED has monopoly power on creating money and control money supply at the margin where it matters most. The FOMC even names the target FED rate as the “Intended Rate”. Price fixing is a particularly blunt policy approach and by application, disregards the known negative consequences of such blunt policy tools.

The following is a short summary of the interventions by the Fed since the collapse of the credit bubble.

Step 1: Reduce interest rates as fast and as low as possible. The FED reduced the FED rate by 3.25% from 18 September 2007 to 30 April 2008, over a period of only 5 months, in 7 increments ranging from 0.25% to 0.75% to the current 2%pa. That is an interest rate more than 3% below the inflation rate. It is important to place the reductions into perspective. There has been only one 0.75% interest rate adjustment in the 17 year period from June 1990 until September 2007; an increase of 0.75% on 15 November 1994. Two increments of 0.75% reductions in the FED target rate took place in the 5 month period of the latest down cycle; on 22 January 2008 and again on 18 March 2008.



Source: FOMC - Intended federal funds rate (Target Rate)

Step 2: Provide liquidity in conventional and unconventional ways in unlimited quantity (no FED internal constraint or limit) to conventional and unconventional participants against collateral where the quality terms and conditions of collateral accepted are expanded and the terms of collateralisation are eased to maximise liquidity distribution. The actual policy tools can be studied on the website of the FED as provided hereunder by those interested. The headings also provide us with a descriptive list of the policy tools which is reproduced hereunder with links to each.


The “Tools” can be found at http://www.federalreserve.gov/monetarypolicy/default.htm

Policy Tools
Open Market Operations
The Discount Rate
Reserve Requirements
Term Auction Facility
Primary Dealer Credit Facility
Term Securities Lending Facility

Lesser reported tweaks were driven by a very real desire to maximise the liquidity distribution impact. It includes measures such as reducing the System Open Market Account ("SOMA") securities lending program minimum fee by half and accepting securities maturing in more than 6 days from more than 13 days (that neatly brought 7 day securities into the discount window). How does these measures impact banks and can early unintended consequences be identified?

The basic operational premise of banks is often misunderstood. Lending out money (credit) is the product that banks sell. Turnover or Total Sales, as with any business, is very important to banks. Turnover growth is an important growth variable.

Where does a bank get “product” to sell? Money placed with a bank on deposit is the undifferentiated answer. One step deeper is a differentiation on four levels. Retail deposits, wholesale deposits, interbank liquidity and FED liquidity. Retail deposits are usually a stable source of liquidity but not readily available in quantity. Wholesale deposits are available in quantity but can be more unstable and movements have more liquidity risk effects. Large single deposits can be fatal. Banks have each other on radar in the interbank market all the time and any increased funding requirements by an individual bank is cause for suspicion. Suspicion very quickly turns into a loss of interbank limits. Bank defaults inevitably follow this sequence:

1. Loss of interbank funding.
2. Loss of wholesale funding.
3. Loss of retail deposits. A classic “run” on the bank is an extreme development in banking and supposed to be an extremely rare occurrence.

It becomes vitally important, for understanding FED activity, to know the process of “product” distribution. Banks use the absolute levels of existing deposits and their maturities only as a guideline for new loans. Capital constraints would dictate absolute size of asset portfolios. Liquidity provision is a dispensation entirely attributable to the “lender of last resort” function inherent to all central banks. There is a timing disconnect between granting a loan and when such a loan is drawn down. Consider for example your credit card. You will normally use your credit inside a “limit” as and when you wish to access your credit. The bank has no knowledge in advance of such a drawdown or even repayments. The bank would only know that you have the ability to use a certain quantity of credit at any time over the next 12 to 24 months. Generally a bank would advance all requests for money and attempt to manage liquidity in such a way as to always be able to meet any drawdowns. The fact is that a bank will never balance its books without a balancing mechanism. The balancing mechanism is located in the interbank market and access to FED liquidity.

The bottom line is that a bank would on any given day be short (lacks sufficient deposits to cover drawdowns) or long (have taken in more deposits than is required to provide product). The extent to which a bank is short or long will directly impact profitability. The marginal funding required to cover a shortfall is inevitably a little more expensive than retail or wholesale deposits. Still, banks prefer to be marginally short provided that they can cover the shortfall with relative inexpensive interbank money or with the FED at an interest cost lower than the interest rate to be earned on the loan. This is the crux of the matter.

The presence of cheap FED money allows banks to push credit with inherent protection against the risk of being unable to fund a shortfall. The cheaper the FED money and the more ready the availability, the more credit will be pushed. The consequence is a credit bubble.

The opposite is expensive money at the FED. We all know that the outcome of providing expensive liquidity to banks is rising interest rates. The FED has to supply commensurate liquidity when the FOMC fix the price of money low.





The second round (September 2007 to April 2008) in doing more of the same introduces some complications. The first round of approaching the zero bound was from January 2001 (6.5%) to June 2003 (1%). The advent of the busting credit bubble normally grinds the interbank market to a halt. A dysfunctional interbank market drives banks to balance their books with the FED rather than amongst themselves. The credit tap is forced wide open when the FED lowers quality standards for collateral to access FED liquidity. One very undesirable consequence originates from the principle that access is indiscriminate with regards to purpose. Therefore banks can use the liquidity for any purpose, for instance to fund losses, while unsecured creditors (read retail deposits and wholesale deposits not covered by deposit insurance) are compromised with a FED holding all potential collateral. Contemplate the quality of assets that unsecured depositors must collect to achieve repayment in case of a bank’s failure and understand why wholesale money runs fast. The lower the liquidity access standards fall, the more other creditors will be compromised when banks are allowed to carry losses via the FED.

The income search alternative is that banks will look for new asset classes (other than already deflating credit bubbles) within which to deploy the cheap liquidity and turn a profit. The greater the margin, the more encouraged banks will be to take up cheap funding and distribute it. Selling credit is a bank’s reason for existence. The best outcome is distribution against credit which will be in a form acceptable as collateral to the FED with perceived acceptable credit risk. Say welcome to emerging market debt.

Investing in emerging market debt is not without problems but easy options exist. Emerging countries will often obtain funding by selling US$ denominated securities. These have lower currency risk and interest rate risk but margins are not nearly as attractive as those issued in their own domain and currency. These are more challenging investments where the most obvious risks are exchange rate movements and interest rate mismatches. These risks would be considered manageable and capable of managed hedging by any fair sized multinational bank. Even smaller banks would not be without skills in managing these risks and may take on the challenge. The temptation is huge when margins as high as 8-10% can be achieved.

A prime target in the current economic environment would be resource based economies. Sovereign risk is the defined credit risk for “other countries”. The same principles that encouraged and perpetuated credit deployment in mortgage bonds are driving credit into emerging debt. Well known historical rules of deploying credit to emerging countries are ignored. One of the most reliable and time tested measures is limiting debt deployment to countries with significant trade deficits. The economic ratio is expressed as the size of the Current Account of the balance of payments expressed as a percentage of the GDP of that country. This is in theory much the same as the loan to income (LTI) ratio applied to mortgage debt. Bankers ignored the safe levels of LTI and even accepted unreliable “proof” of income to overcome prudent credit deployment based on safe LTI ratios. We now see the same development taking place on Sovereign risk with regards to the Current Account deficit to GDP ratio. Observe how far the “safe” deficit limit of 3% of GDP is exceeded by the following countries. Access to “international” funding is the only way in which such excesses can be financed.



Source: International Monetary Fund (IMF) *IMF estimates.

It is clear that the tried and tested ratio of 3% of GDP is not applied in the above cases. The temptation is also very clear. Accept the Sovereign risk of for instance South Africa and earn the interest rate differential on assets priced around a 12% Central Bank benchmark rate. Ignore the danger signals of a 7.3% CA deficit to GDP ratio. Turkey at 16.75% Central Bank benchmark rate and “only” a 5.7% CA deficit to GDP ratio must be an attractive target. Pushing current account deficits into danger territory can only be blamed on the availability of easy credit. Japan and the USA share a need to encourage their banks in need of income margin to finance such Current Account deficits. This encouragement may be an unintended consequence but surely cannot be an unexpected consequence. However, where will today’s troubled banks with access to cheap credit turn to for “yield pick-up”, if not to emerging markets?

The Current Account surplus developing countries are not necessarily “safe” or excluded form this process. They are, for now, producing the income to provide for repayment of debt channelled into their economies. How long will it take before the access to cheap and easy credit is tied up in malinvestment? How long will reliance on a high commodity prices allow the Current Account surpluses to be maintained? Take a look at the graphic depiction of the US$ carry trade and note the bubble blowing cycle inherent to this development.


The US$ Carry Trade Cycle




The four steps in the cycle will be self reinforcing. It is no wonder that the level of international reserves have been sky rocketing. The new zero bound unlimited liquidity monetary policy has added the USA as a significant player in the carry trade where previously only Japan engaged in the this banking rescue by stealth activity. It did not work particularly well for Japan. The final verdict is still out on Sovereign risk as Sovereign defaults and debt standstills are long forgotten concepts. Where will the financiers of carry trade stand when the 3% of GDP deficit rule re-asserts itself? Who and by what means will a new round of Sovereign defaults and debt standstills be mitigated? Already the first warning bells are ringing in Eastern Europe.




Cheap and easy money as a policy tool to repair the ravishes of a previous monetary policy of cheap and easy money will not heal the income streams of banks, nor will it heal the capital destroyed by bad debts. A repetition of such a policy will blow new credit bubbles in expected but ignored and unexpected places and repeat another cycle of bad debt explosions. The credit crisis outcome of easy monetary policy is known and probable and therefore should never be granted the status of an unintended consequence. A mature credit bubble already exists in emerging market debt. The Fed may bail out Freddie and Fannie but who will bail out emerging markets? Nobody.




Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
September 2008




References:

1. Reducing Systemic Risk. Chairman Ben S. Bernanke at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming. August 22, 2008.
2. Economic Projections and Rules of Thumb for Monetary Policy. Athanasios Orphanides and Volker Wieland. Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 307-24.
3. Open Market Operations in the 1990s. Cheryl L. Edwards, of the Board’s Division of MonetaryAffairs, prepared this article. Gerard Sinzdak provided research assistance. Federal Reserve Bulletin November 1997, pp. 859-74.
4. Alternative Instruments for Open Market and Discount Window Operations. Federal Reserve System - Federal Reserve System Study Group on Alternative Instruments for System Operations. Board of Governors of the Federal Reserve System, Washington, D.C., December 2002.


Comments are welcome. E-mail me at ccpt@iafrica.com or comment on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster 2008.

Praxeology of Commodity Repricing.

Zimbabweans must be wondering what comes after trillions since the recent introduction of a 100 billion Zimbabwean Dollar bill. I have been wrestling with the concept of rising prices particularly in commodities and factors of production while simultaneously having the economy in the grips of a Japan-like economic crash combined with stagnation, banking systemic failure and destruction the of the wealth and savings of the middle class. Could it be that prices of factors of production continue to rise when other parts of the economy are in a downward spiral?

Just looking back upon the last six years shows us that asset classes experienced extreme levels of inflation in contrast with official inflation levels remaining very benign. Clearly these economic dichotomies can coexist at the same time. It becomes somewhat more complicated to fixate on one harmful development when its economic counter force is also in play. Can inflation and deflation manifest at the same time? Can commodity prices, such as the oil price, continue to rise when consumption slumps? What impact has the money creation monopoly power of State and is its effect only inflationary?

I will use the technique of constructs to isolate the creation of money activity and to gain understanding of complex economic principles. Ludwig von Mises gives an excellent explanation of praxeology, which can be found by following this link to a recently published article by the Mises institute; The Scope and Method of Catallactics.


© Sarel Oberholster

Here is a simple static construct of a ten unit economy with ten units of money available to buy the oil. Thus one unit of money will buy one barrel of oil (price formation). The next step is to introduce motion into the static construct.

Farmer buys the ten barrels of oil, adds his labour and produces 20 units of grain. Farmer use 10 units of grain to feed himself and his family and sells 10 units of grain to Oil producer for 10 units money. Oil producer feeds himself and his family and uses his labour to produce another 10 barrels of Oil. This is now a perpetual and stable economic construct.


© Sarel Oberholster

Next we introduce a State as another economic participant. We do not give State the power to tax but we grant the power to create money. State uses this power and openly creates ten more units of money. State enters the economy with the new money and competes with the old money for the available ten barrels of oil.

The entry of State as an economic participant with new money has very significant consequences for the stable economic construct. First look at what happens to the static construct of Exhibit 1. We add the new money and observe the effect. We also make the assumption that State consumes the Oil for its own purposes (for example to make war or consuming it as a source of energy). The result is shown in Exhibit 3.


© Sarel Oberholster

The equilibrium in the economy has been disturbed. The presence of twenty units of money competing for the same ten barrels of oil has the effect of changing the price of oil from 1 unit of money to two units of money (100% inflation). State now receives 5 barrels of Oil for its 10 units of money while Farmer receives the other 5 units of Oil.

Who has won and who has lost? State has gained 5 barrels of Oil and walks away an outright winner. Oil producer still received all the money in the economy so perhaps Oil producer is no worse off, but we shall see. Farmer has clearly lost 5 barrels of Oil as Farmer held all the money when half the purchasing power of the total money in the economy was transferred to State through its action of creating 10 units of money. It is only when we assess the impact of State's money creation behaviour on the dynamic but stable economic construct that we see the extent of damage done to this very simple economy. State has managed to acquire the total production surplus in the economic construct through its money creation action.

The construct must remain constant but for the behaviour of State and the consequences thereof. State has created money and vested half the economic product on itself. The new money had competed on an equal footing with the existing money in the economy and has reduced the purchasing power of Farmer by half. Farmer can now only purchase half the production inputs (5 barrels of Oil) needed for his farming production. Farmer can only produce half the grain on half the production inputs. However, Farmer uses this half of his farm product to feed himself and his family and no longer has a surplus product (sellable grain) to sell to Oil producer. Pity Oil producer, holding all the money in the economy yet cannot buy any food. Oil producer will starve. Yet Farmer earns no money to purchase any Oil (production inputs) from Oil producer for the next production cycle and will therefore starve when the next production cycle arrives. See Exhibit 4 hereunder.


© Sarel Oberholster

I can hear the critics saying this is an artificial construct, an over simplification. It may be expressed in simple, easy to understand terms but it is irrefutably the outcome of an isolation of the money creation activity of State. Its purpose is deliberate in its isolation of the activity of State without allowing that activity to hide behind a myriad of other variables ever present in a fully functional economy. It is also intolerable to have a stable in-equilibrium economy but it is in the form of this extract that one can focus on the consequences of State's money creation behaviour. The construct can be expanded to add productivity improvements or any other concept which can alter the economic outcome of the construct. For instance Oil producer may realise that Farmer must have 10 barrels of Oil and increase his labour to produce 15 barrels of Oil, yet the price mechanism will still be out of balance until Oil producer has increased production to 20 barrels of oil. At 15 barrels of Oil State will compete equally for 7.5 barrels of Oil. Only at 20 barrels of Oil will the Oil crisis be over. One can add innovation, capital improvements, State exchanging Oil for grain or any of the variables that vest with the ingenuity of humans to improve their economic circumstances, especially in the face of something as devastating as starvation. A magnitude of potential interventions to fix the imbalances opens up a magnitude of consequences. The fact remains that the impact of State's money creation on the production surplus in the economy can ultimately only be remedied through economic behaviour of Oil producer and Farmer.

Money creation via credit expansion, low interest rates and almost unlimited liquidity provision to banks have unleashed an explosion in competing new money in all economies of the world. The competing new money jumped like a wild fire from one asset class to another as it circled the globe. As expected, it had to reach the units of production of which Oil became a focal point. Oil, a strategic production input, faced supply constraints and could not adjust easily to the demand created by the new money. The result was that Oil in particular had to adjust mainly through price increases to the presence of competing new money. The outcome is similar to Exhibit 3 where the competing new money and the old money had to share the existing production, thus the price continued to increase and will continue to increase until new money stops competing for existing production or production is expanded to accommodate the new money or a combination of the two options. The prices of scarce resources will continue to adjust upwards for as long as new money competes for its acquisition. It is altogether possible for competing new money to overwhelm the effects of falling demand arising from high prices. The impact of State's money creation was also not restricted only to inflating prices.

The effect of rising prices stands apart from the hardships introduced to the economic participants other than State. The prices will rise but the rise may be mitigated through the actions and sacrifices of consumers and producers. Farmer and Oil producer had to share the burden of replacing the production surplus required to restore balance in the economy. Similarly will consumers and producers other than State have to shoulder the burden of restoring that portion of the production surplus lost to the creation of competing new money. That burden translates into bad debts, over extended consumers and weak purchasing power parallel with rising prices in the factors of production (for instance scarce commodities) which, in the case of substantial volumes of competing new money, will wreck the banks in systemic paralyses and destroy corporate profits until the rebalancing process has been completed. Any attempts by State to intervene in a monetary manner to further increase competing new money in the economy will perpetuate the adjustment process. Bail-outs, nationalising banks, easy liquidity access against questionable collateral to all and sundry and re-capitalisation of GSE's (Government Supported Entities) would all qualify as monetary interventions injecting competing new money into the economy.

"The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time." USA FOMC statement" 25 June 2008.

Translates into low interest rates and lots of new money should help growth.

"At the Monetary Policy Meeting held today, the Bank of Japan decided, by a unanimous vote to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will encourage the uncollateralized overnight call rate to remain at around 0.5 percent." 2008 Jul 15, Bank of Japan - Statement on Monetary Policy

Translates into we will provide as much new money as needed to keep our ultra low interest rate at 0.5%.

"To maintain price stability is the primary objective of the Eurosystem and of the single monetary policy for which it is responsible. This is laid down in the Treaty establishing the European Community, Article 105 (1).

"Without prejudice to the objective of price stability", the Eurosystem will also "support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community". These include a "high level of employment" and "sustainable and non-inflationary growth". Objective of monetary policy, European Central Bank website http://www.ecb.int/ , Monetary Policy. 28 July 2008.

Translates into we say one thing and do another (See also "Notes" at the end of this essay).

"There had been a positive reaction to the co-ordinated announcement of central bank actions on 11 March, designed to relieve liquidity pressures in money markets. But the funding crisis at Bear Stearns in mid-March, leading to a Federal Reserve supported buy-out of the firm by JPMorgan, had temporarily heightened concerns about counterparty credit risk further. The functioning of money markets remained heavily impaired, with interbank lending still concentrated at very short maturities. Term spreads had risen again and market prices suggested that they were expected to remain higher than normal throughout 2008 and beyond - longer than expected at the start of the year." 23 April 2008, MINUTES OF MONETARY POLICY COMMITTEE MEETING 9 AND 10 APRIL 2008, Bank of England.

" ... co-ordinated announcements of central bank actions ... designed to relieve liquidity pressures in money markets" sure sounds like more competing new money entering the economy. This is Central Banks working together to maximise the new money effect. Do not chase after speculators, greedy hoarders, naked short sellers or stingy producers for they have not the power to alter the reality of competing new money. Watch for new money and follow its progress into repricing commodities upwards to the dismay of interventionists. Only in the absence of competing new money will the rebalancing process complete. If not, start counting towards the still unfamiliar Quadrillion even as asset deflation bites.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
August 2008


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Notes:
1. Latest on Zimbabwe money is that the Central bank has knocked off 10 digits from the currency converting a 10 billion Zimbabwe dollar into 1 Zimbabwe dollar. I suppose they no longer need to worry about quadrillions in the short term.)

2. "Stocks jumped as the European Central Bank, the U.S. Federal Reserve and the Swiss National Bank announced an enhancement of their dollar liquidity-providing operations to ease credit strains that have weighed on the global economy. The central bank actions were intended to ease persistent global financial instability as institutions write down losses from exposure to risky U.S. mortgages." FTSE up as central banks act to boost liquidity - Reuters, July 30 2008.

© Sarel Oberholster - 2008

Consuming the Carry Trade

"Reagan proved that deficits don't matter." Dick Cheney, Jan 2004.

An urban legend claims that one has the protection of an angel when you drive your car at 100kph (about 63mph) or less. Accelerate and the angel gets out while the devil gets in. Exceed 200kph (about 125mph) and the devil also gets out. Long has the rule of thumb in economics been that a country should not exceed 3% of GDP as a Current Account deficit, a country's overdraft with the rest of the world so to speak. Exceed 3% and the devil gets in. However, some countries are now exceeding even 6% of GDP as a Current Account deficit and even the devil has deserted them. Surely driving your economy at a deficit of 6, 7 or 9% (or more) is an accident waiting to happen. Such deficits would normally have been punished severely in exchange rate depreciation. Carry trades and extreme provision of liquidity by Central Banks behind it, has facilitated a growth in deficit trading without the pain of sudden and severe exchange rate depreciations. Countries can and do live beyond their means while consuming the carry trade. Much like mortgage borrowers could consume fictional real estate values for a while. Who are these countries?

Chart 1

© Sarel Oberholster Data Source: International Monetary Fund - Current account balance; Percentage of GDP 2007. (*IMF 2007 Estimates)



In identifying the countries I have eliminated those countries with a GDP of less than US$100billion for the same period. Australia, South Africa, New Zealand, Portugal, Spain, Greece and Romania are driving their Current account deficits in serious crash territory. Poland, Ireland, UK, Pakistan, USA and Turkey are way beyond responsible Current account management. Moving on to the relative importance of each of these countries requires quantifying each deficit in a single currency.

Chart 2

© Sarel Oberholster Data Source: International Monetary Fund - GDP in USD Billions 2007 (may include IMF 2007 Estimates).


The relative size of the deficits in a single currency unit must be established to discern the relative importance of each country's deficit on a world economy scale.


Chart 3

© Sarel Oberholster Data Source: International Monetary Fund - 2007 GDP in USD Billions multiplied by the Current account balance; Percentage of GDP 2007 (may include IMF 2007 Estimates).


Chart 1 shows the extent to which these countries live beyond their means. Chart 2 shows the relative importance of each of the deficit countries in the global economy and Chart 3 shows the relative usage of current account deficits again in a global context. These charts do not deal with the compounding of deficits. They only deal with what happened last year. One further detail is required to complete the picture. How much are these countries paying? Countries pay in currency depreciation which shows up as imported inflation in their countries and more directly, they pay in interest.


Chart 4

© Sarel Oberholster Data Source: Central Bank benchmark rates have been obtained from the respective Central Bank websites.

Romania, South Africa, Pakistan and Turkey have to pay for the privilege of living beyond their means and to protect the relative exchange rates of their countries while they live the high life courtesy of the carry trade. The UK, Poland, Australia and New Zealand get an easier ride. Spain, Portugal, Ireland and Greece have the best of both worlds driving solid Current account deficits while under the protection of the EU. Nobody has a sweeter deal than the USA. It gets to drive a reckless 5.3% of GDP deficit and consumes 58% of the total share of the identified deficit living group (the rest get less than half!). Best of all it comes at a bargain basement price of 2%pa interest. Perhaps the world reserve currency status of the USD will continue to protect the USA. Perhaps I can drive my car at 600kph and not crash.

Somehow I think it is simply too good to be true and each of these countries will face the consequences, some sooner than they may expect. Do they also believe that Regan had proved deficits do not matter? I know I need a currency hedge, how about you?


Sarel Oberholster
BCom (Cum Laude), CAIB(SA).
August 2008

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Charts showing the trend in Current Account Deficit accumulation for each of the individual countries discussed in this article have been posted on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster - 2008

Who is consuming the Carry Trade? (USA)

This is the last one on the alphabetical list:
Australia
Greece
Ireland
New Zealand
Pakistan
Poland
Portugal
Romania
South Africa
Spain
Turkey
United Kingdom
United States

The rest of the research into the Carry Trade will follow in my next post "Consuming the Carry Trade". Enjoy.

Who is consuming the Carry Trade? (UK)

More to follow.