Global Imbalances post QE The Third Pole Advantage Financial - - PowerPoint PPT Presentation

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Global Imbalances post QE – The Third Pole

Advantage Financial Group’s annual conference on “Global Economic Perspectives” - Milan, May 18, 2011

Paulo Vieira da Cunha

Tandem Global Management, L.P. 500 Fifth Avenue 37th Floor New York, NY 10110 private & confidential

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Same pattern, new twist (already there before but now more visible)

• China/US imbalances … now also China/EM (Brazil)
• Why?
• BRAZIL: Fiscal + Monetary + Credit (Public Banks) = 4-5% GDP (2009/10)
• Terms of Trade (external wealth transfer)
• RESULT: Expansion in domestic absorption (10-12%pa 2009/10) esp. Consumption

FX-appreciation & boom in imports (impact on global demand)

Global imbalances, post QE? They are back!

US ZIRP + Fiscal + QE + Wealth Effects CHINA Accelerated FAI + Fiscal (9% GDP-2009) Global liquidity & growth Commodity demand & prices

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Brazil, Trade Balance, USA (RHS) China, Trade Balance, USA, USD (LHS) United States, Trade Balance (LHS)

Source: Tandem Global Partners

Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 05 06 07 08 09 10 11

• 1000
• 900
• 800
• 700
• 600
• 500
• 400
• 300
• 200
• 100

100 200 300 400 500 600 2008/IV = 100 52 64 76 88 100 112

Implications? US Trade Balance

• US: Trade deficit Mar/11=$522.4bn, Mar/07=$745.0bn (Narrowing during recession,

widening (again) in recovery – mainly due to widening deficit with China!)

• US/CHINA: Trade deficit Mar/11= $281.6bn, Mar/07= $243.7bn
• US/BRAZIL: Trade surplus Mar/11=$12.6bn, Trade deficit Mar/07=$5.9b

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Implications? BRAZIL Trade Balance

• BRAZIL: Trade surplus Mar/11=$22.5bn, Trade surplus Mar/07=$45.9b
• CHINA: Imports Mar/11=$32.8bn, Mar/07=$8.8bn
• CHINA: Exports Mar/11=$37.9bn, Mar/07=$8.7bn

Huge ToT effects reverse surpluses to deficits

Exports Value Imports Value Exports Volume Imports Volume

Source: Tandem Global Partners

Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 05 06 07 08 09 10 11

2006/I = 100

50 100 150 200 250 300 350 400 450 500

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Brazil: Large capital inflows

Current Account FDI Portfolio Investment Enlarged Basic Balance Source: Tandem Global Partners 00 01 02 03 04 05 06 07 08 09 10 11 USD (billions)

• 75
• 50
• 25

25 50 75 100 125 150 Enlarged Basic Balance

79.2G Current Account

• 50.0G

FDI 64.8G Portfolio Investment 64.4G

• 2007: Strong balances – CAB surplus
• 2008: Weakening balances – CAB deficits & collapse in K-flows (loss of reserves)
• 2009: Return to strong balances – Widening CAB deficits & recovery in K-flows
• 2010: Record strong balances – CAB deficits approaching 3% GDP & booming K-flows

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Brazil, Foreign currency reserve, total China, Foreign exchange reserves

Source: Tandem Global Partners

Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 05 06 07 08 09 10 11 2008/IV = 100 25 50 75 100 125 150 175

Brazil: Accumulating reserves … China speed

• CHINA: Reserves Mar/11= $3,044.7bn, Mar/07= $1,202.0bn
• BRAZIL: Reserves Mar/11=$317.1bn, Mar/07=$109.5b
• WORLD: Reserves Mar/11=$9,381.5bn, Mar/07=$5,065.4b

Growing at app.. 20%pa

• - last 2yrs

Elasticity(Brazil/China) ≈ 1

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Brazil, NEER China, NEER United States, NEER

Source: Tandem Global Partners

Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 05 06 07 08 09 10 11 2008/IV = 100 70 80 90 100 110 120 130 140 150 160 170 180 190

Exchange rates: CNY peg = extreme vol in USD/BRL

• CHINA: Appreciating path 2006-07; Re-peg = Q2/08
• BRAZIL: Strong appreciation Q1/07-Q2/08; crash Q3/08-Q1/09

– Recovery Q2/09+ … beyond Q2/08 peak!

Brazil, IC-Br Index World, Reuters/CRB, Continuous Commodity Index (CCI), Close

Source: Tandem Global Partners

Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 05 06 07 08 09 10 11 2008/IV = 100 80 90 100 110 120 130 140 150 160 170 180 190 200

Brazil: Huge gains in Terms-of-Trade (commodities)

• CRB and BRAZIL ToT = close parallelism
• ToT and FX = close parallelism: Strong appreciation Q3/07-Q2/08; crash Q3/08-Q1/09

Recovery Q2/09+ beyond Q2/08 peak!

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Brazil, SELIC Target Rate - FED Funds Rate China, 20 Day Reloan Rate - FED Funds Rate

Source: Tandem Global Partners

Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 05 06 07 08 09 10 11 Percent 6 7 8 9 10 11 12 13 14 Percent

• 2.0
• 1.5
• 1.0
• 0.5

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Brazil: Large rate cuts post-Lehman (Q4/08)

• CHINA and BRAZIL: 2007: Accelerated growth & commodity shock and pass-through =

Tightening when FED was loosening – Q4/07 to Q1/08!

• BRAZIL: Late and slow to normalize post Q4/08 (but given ZIRP, IRdiff ≥ 8%!

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• World produces two assets: A="safe" assets (low yield); B="risky" asset (higher yield)
• EM grows faster, saves more and buys reserves = A assets
• DM supplies A assets and has greater capacity to "select" B assets (venture capital)
• QE: Reduces price of B assets & post-risk aversion transfers wealth back to B assets

(stock market) → restores consumption & income; investment (lower asset prices)

• QE1 = direct impact on B assets (purchases of MBS)
• QE2 = "leak in demand" for B assets (purchases of A assets) → "search for yield"

What is the effect of the "wall of liquidity" – QE2?

US Supplies "safe" assets and recycles capital to "risky" projects CHINA Supplies savings, buys "safe" assets and develops "risky" projects FDIUS-China

VS.

TSYChina-US QE2 Lowers rA (return

• n "safe" assets)

and induces flows to B ("risky" assets) EM Lower relative risk (post crisis) Solid supply of good but riskier projects (B) Portfolio flows

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• Model: structural VER – Jan/07-Feb/11
• Cointegrated variables (endogenous)

– BRLUSD – Terms of Trade – Interest rate differential (Brazil-US policy rates) – Non-tradable inflation differential (Brazil-US CPI-services)

• Effect variables (exogenous)

– Portfolio flows – FDI – FIXED EFFECTS

• Recession (NBER): Dec/07-Jun/09
• QE1: Dec/08-May/10
• QE2: Sep/10+

Is this the case with Brazil?

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• .010
• .005

.000 .005 .010

• .010
• .005

.000 .005 .010 5 10 15 20 25 30 35

Response of LFX_BRLUSD_12 to LTOT_IND_12

• .010
• .005

.000 .005 .010

• .010
• .005

.000 .005 .010 5 10 15 20 25 30 35

Response of LFX_BRLUSD_12 to LIRD_BRA_USA_12

• .010
• .005

.000 .005 .010

• .010
• .005

.000 .005 .010 5 10 15 20 25 30 35

Response of LFX_BRLUSD_12 to LCPI_BRA_USA_SRV_12

Response to Cholesky One S.D. Innovations

Cointegrated variables ≈ 80% of variance Shock to Terms of Trade ► appreciation, building up in the first 10mo, attenuating thereafter Shock to interest rate differential (higher rate in Brazil) ► initial strong appreciation with reversal after 10mo Shock to relative non-tradable inflation (higher inflation in Brazil) ► appreciation with long persistency (peak in 30mo)

Results: Impact of Terms of Trade, Interest Rate and Inflation Differentials on USD/BRL, as expected

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FED easing (cut rates in Oct/08 to 1% and in Dec/08 to 0.25%) vs. the late cycle in Brazil (BACEN was hiking rates through Sep/08 +75bp to 13.75% and kept it there with a cut

• nly in Jan/09 to 12.75%) → additional

appreciation pressure (about 12% additional) QE1 in directly reducing the yield of risky assets in the US (MBS + S&P) and making EM risky assets more attractive contributed to this additional appreciation pressure (joint effect of about 20%) QE2 targeted at safe assets in the US (TSY) but with huge spillover effects in the US (S&P) Did NOT contribute to additional appreciation In fact, the opposite (effect app -18%)

Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

QE-1 Recession QE-2

Capital flows: What about QE2?

• Effects variables (K-flows) ≈ 20% of variance
• Complicated interaction between FDI and Portfolio. Portfolio clearly dominant

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Sample (adjusted): 2007M01 2011M 02 Included observations: 50 after adjustments t-statistics in italics (*=1%level) CointEq1

• 0.099 -7.721*

D(LFX_BRLUSD_12) 0.661 7.759* D(LTOT_IND_12)

• 0.018 -0.111

D(LIRD_BRA_USA_12) 0.102 5.600* D(LCPI_BRA_USA_SRV_12) 0.090 0.127 BOP_PORT_12 0.000 4.614* BOP_FDI_12 0.000 -2.259* DUM _REC 0.004 2.447* DUM _QE1 0.001 0.373 DUM _QE2

• 0.006 -1.948*

R-squared 0.958 Akaike AIC

• 8.449

Schwarz SC

• 8.067

F-statistic 101.187 Log likelihood 221.236 Endogenous Exogenous

Structural Error Correction: D(LFX_BRLUSD_12)

Sample (adjusted): 2007M 02 2011M 02 Included observations: 49 after adjustments White heteroskedasticity-consistent standard errors & covariance t-statistics in italics (*=1%level **=5%level) Standardized Coefficient C 0.000

• 2.698*

COINTEQ01(-1) 0.896 31.082* BOP_PORT_12 0.211 6.140* BOP_FDI_12

• 0.044
• 1.650**

DUM _REC 0.122 5.301* DUM _QE1 0.082 1.929* DUM _QE2

• 0.175
• 7.236*

R-squared 0.985 Adjusted R-squared 0.983 F-statistic 455.855 Durbin-Watson stat 1.136 Akaike info criterion

• 6.366042

Schwarz criterion

• 6.095782

Dependent Variable: COINTEQ01

A currency model: Capital flows and QE*

* All variables, except "dummies" for time-effects are 12 month moving averages

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A currency model: Capital flows and QE

VEC Granger Causality/Block Exogeneity Wald Tests

Sample: 2006M01 2011M03 Null hypothesis: Excluded variables do not Granger Cause Dependent variable Included observations: 50

Chi-sq df Prob. Dependent variable: D(LFX_BRLUSD_12) Excluded 32.891 3 0.0% Reject Dependent variable: D(LTOT_IND_12) Excluded 5.186 3 15.9% Cannot reject Dependent variable: D(LIRD_BRA_USA_12) Excluded 0.062 3 99.6% Cannot reject Dependent variable: D(LCPI_BRA_USA_SRV) Excluded 4.883 3 18.1% Cannot reject

Directionality of Granger Causality is as expected: Terms of Trade, Interest and Inflation differentials "Granger cause" the Exchange Rate "Granger causality" is not significant in the other directions

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The cointegrated variables (ToT, IRdif and INFdif) account for about 80% of the variation in the sample The capital flows variables (Portfolio and FDI flows) for the other 20% — As expected, an increase in flows leads to additional appreciation The dynamics of the effects of FDI and Portfolio are complex (lag structure) Given the sub-sample structure, Portfolio flows have a positive and large, FDI a negative and smaller coefficient Coefficients are stable — at the margin the impact of Portfolio flows increases over time and that of FDI decreases

.80 .84 .88 .92 .96 .80 .84 .88 .92 .96 M10 M11 M12 M1 M2 2010 2011

Recursive C(COINT-EQ(-1)) Estimates ± 2 S.E.

3.0E-13 4.0E-13 5.0E-13 6.0E-13 7.0E-13 8.0E-13 3.0E-13 4.0E-13 5.0E-13 6.0E-13 7.0E-13 8.0E-13 M10 M11 M12 M1 M2 2010 2011

Recursive C(BOP_PORT-12) Estimates ± 2 S.E.

• 8.0E-07
• 6.0E-07
• 4.0E-07
• 2.0E-07

0.0E+00 2.0E-07 4.0E-07

• 8.0E-07
• 6.0E-07
• 4.0E-07
• 2.0E-07

0.0E+00 2.0E-07 4.0E-07 M10 M11 M12 M1 M2 2010 2011

Recursive C(BOP_FDI_12) Estimates ± 2 S.E.

A currency model: Capital flows and QE

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