Please, click here to read this article in pdf format: january-21-2009

Yesterday’s action was actually very “timely”. Yesterday, I had written that the non-neutrality of money was one of the forces shaping the market scene. But also, I wrote that the other force or dimension was “time”.
In 2008/09, practically every country witnessed a transfer of losses/risk from the private to the public sector. Each country, at the same time, was embarked on different fiscal deficit paths (sustainable or unsustainable), if it was a debtor country, or monetary imbalances paths (sustainable like Canada’s or unsustainable, like China’s), if it was a creditor country.
Embedded in Keynesianism, is the belief that when output increases after a slump and prices rise, we need to increase the quantity of money to maintain a given rate of interest. Therefore, once liquidity has been injected, all we have to do is wait until activity picks up, driven by a positive marginal return on capital. And waited we have and continue to . However, when Keynes explained this view, the world was not as global as it is today. There is only one interest rate. If we oversimplify the current situation (with a bit of a physiocratic taste), we can think of today’s global exchanges in terms of three factor-competitive monetary zones:

These zones are characterized for being competitive in supplying the global economy with production factors: There are
competitive raw materials exporters, labor exporters and knowledge exporters. In the chart above, the arrows indicate flows, affected by the respective foreign exchange crosses. Some of these zones are encountering different problems.
Relevant to the knowledge exporters, within Europe, we find institutional problems, between its Central bank and members’ fiscal deficits. Because this zone should be competitive in terms of its “institutional infrastructure (i.e. rule of law, developed capital markets), when the institutional infrastructure is affected as in Greece, there is room for an intra-zone arbitrage. Hence, the Euro is sold and the USD is bought. Why not? Interestingly, if such infrastructure weakness took place in Latin America, nobody would care, because Latin America is not competitive at exporting it.
In the case of China, I think that what happened yesterday after reading the statements of Mr. Mingkang (Chairman of China’s Banking Regulatory Commission), was the product of cultural misconceptions. We, in the West, are used to democracy. But China is not a democracy. When China ordered to stop increasing new loans, we were taken by surprise. The surprise was twofold. Firstly, it is hard for us to grasp the degree of authority this measure carries. A suggestion like this somewhere else would immediately bring smiles. (We would quickly see that there would be a segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore). Secondly, this measure is surprising because of its absurdity. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest. For a creditor country like China, a central bank that prohibits new loans sounds like a manufacturing company that asks its distributors to keep buying its output, while at the same time does not allow them to further sell it to their respective customers.

I don’t think China ignores this, which is proof that all China seeks is to delay the appreciation of its currency, very much in line with what the Bank of Canada is doing with its open market operations and its interest rate policy. Hence, the timing dimension referred to above…Back to my first point, every policy maker today believes in leaving monetary conditions as steady as possible, until activity matches outstanding liquidity. In some zones, activity has grown faster than expected. In others, it is growing more slowly. In the meantime, foreign exchange crosses correct and generate volatility, as “A View from the Trenches” had anticipated and as is reflected in the break of correlation between USD weakness and US stocks markets.

But in the end, I remain optimistic that the non-neutrality of money that I discussed yesterday will prevail as the dominant force. The credit markets seemed to agree with this view yesterday. In the investment grade space, for instance, the widening was smooth, with the IG13 index up only 2 ½ bps intraday. That to me was very telling…

Martin Sibileau