Perspectives on the Current International Financial and Macroeconomic Situation

1. Perspectives on the Current International Financial and Macroeconomic SituationCelebrity Speakers Ltd., London, May 14, 2007 Jeffrey Frankel Harpel Professor of Capital Formation and Growth Harvard University

2. Four points to be covered • Emerging markets are now in the boom phase of the 3rd consecutive 15-yearemerging-market cycle. “Is this time different?” • China: the miracle is real but the RMB is wrong • Commodities and carry trade • Twin deficits: Is US losing economic hegemony?

3. We are now in the 3rd big consecutive cycle ofcapital inflows to developing countries It’s the biblical rule: 7 fat years followed by 7 lean years 1) Recycling petrodollars: 1975-81 • 1982 international debt crisis, then 7 lean years: -1989 2) Emerging market boom: 1990-96 • 1997 East Asia crisis, then 7 lean years: -2003 3) Current boom, 2003-

4. The cycles show up in capital flow quantities

5. They also show up in prices: sovereign spreads.EMBI was up in 1995 & 98; down in 2003-07Calvo, BIS, 2006The Economist 2/22/07

6. Is “this time different”? • Ken Rogoff* says “no.” • Some things are different this time: • Current accounts are stronger (esp. Asia) • Reserve holdings are much higher. • Exchange rates are more flexible. • More countries issue debt in domestic currency, vs.$ (in part due to exchange rate volatility) • More debt carries Collective Action Clauses • More openness to trade and FDI. * ”This Time It’s Not Different,” Newsweek International, Feb.16, 2004

7. Most large emerging markets are not usingthe capital inflows to finance CA deficitsas much as they did in the 1990s CAD 2000-04 < in 90s CAD 2000-04 > in 90s

8. Instead, countries are using the inflows to build up forex reserves

9. Export/GDP ratios 2000-04 > than in 1990s More open Less open

10. New emerging market crises will come; but • they won’t necessarily take currency crisis form (vs., e.g., crashes in land & securities markets). • they won’t necessarily be soon: • Emerging marketsnot yet ripe for a new crisis round • Memories are still fresh. • Traders’ jobs have not yet turned over. • Global monetary policy has been easy (as in the boom phases of the late 1970s & early 1990s). • Commodity prices are still near historic peaks

11. China • China, in its own interest, should let the RMB appreciate. • Despite July 2006, the regime has not genuinely changed. • A global cooperative deal would simultaneously appreciate the RMB & other currencies among Asian and oil-exporters, while the US raised national saving. • IMF could broker the deal. But it won’t happen. • The Chinese growth miracle will probably encounter a crash somewhere along the road – the banking system, real estate, or stock market. • Every new economic power goes through a rite of passage: financial bubble and crash.

12. Every new economic power goes through a rite of passage: financial bubble and crash

13. Why did prices of oil & other commodities rise so much 2001-06? • E.g., Copper, platinum, nickel & zinc all hit record highs in 2006 • Mankind has to live in the physical world after all ! • Many causes. One neglected cause is monetary policy: • high real commodity prices can reflect low real interest rates. • High interest rates reduce the demand for storable commodities, or increase the supply through a variety of channels: • By increasing incentives for extraction today rather than tomorrow • By decreasing firms’ desire to carry inventories • By encouraging speculators to shift from commodities to T bills

14. Statistical relationship 1950-2005.

15. Results of regressing $ real commodity prices against US real interest rates • Statistically significant at 5% level for all 3 major price indices available since 1950-- from Dow Jones, Commodity Resources Board, & Moody’s -- and significant for 1 of 2 with a shorter history (Goldman Sachs). • All are of hypothesized negative sign. • The estimated coefficient for the CRB index, -.06, is typical. => when the real interest rate goes up 100 basis pts., real commodity price falls by .06, i.e., 6 %.

16. UK regression: real commodity prices in £ on real interest rates Short Rates Long Rates US r r differential US r r differential Coeff. -0.053* -0.086* -0.106* -0.023* s.e. 0.010 0.007 0.007 0.006 * indicates coefficient significant at 5%. (Robust s.e.s)

17. Theory: Dornbusch overshooting model, with spot price of commodities replacing exchange rate, and convenience yield replacing foreign interest rate. • Implication: beginning in 2001, easy monetary policy & low real interest rates among the FRB, BoJ, ECB & PBoC sent liquidity into commodity markets, pushing up real prices. • Similar “carry-trade” arguments apply to other markets as well: has sent money not only into commodities, but also into housing, securities, and emerging markets. • This phenomenon may start to reverse.

18. It is still puzzling that long-term interest rates remained so low, even as short-term rates rose 2004-2006 • spreads on high-income corporate debt in particular have been inexplicably low. • Implied options price volatilities have been too low. • Private equity may also be overdone. • Part of a general pattern: private markets are underestimating risk • a result of 5 years of low real interest rates & of formulas that estimate volatility from lagged prices – which look calm – rather than from an intelligent assessment of the macro outlook & the odds of unexpected shocks. • Private markets may in particular be under-estimating future budget deficits. • In short, both risk curve & yield curve are too flat.

19. Medium-term global risks • Bursting bubbles • Housing market downturns, underway • Bond market crash, not yet • Possible new oil shocks, • e.g., from Russia, Venezuela, Nigeria, Iran… • Possible new security setbacks • Big new terrorist attack, perhaps with WMD • Korea or Iran go nuclear/and or to war • Islamic radicals take over Pakistan, S.A. or Egypt • Hard landing of the $: foreigners pull out => $ ↓ & i ↑ => possible return of stagflation .

20. The US Current Account Deficit:Origins and ImplicationsRevsied version of Our Fiscal Future, 2006

21. Trade balance is deteriorating

22. Trade deficit • Current account deficit for 2006 ≈ 6% GDP, arecord. • Would set off alarm bells in Argentina or Brazil • Short-term danger: Protectionist legislation, such as Schumer-Graham bill scapegoating China • Medium-term danger: • CA Deficit => We are borrowing from the rest of the world. • Dependence on foreign investors may => hard landing • Long-term danger: • US net debt to RoW now ≈ $3 trillion. • Some day our children will have to pay it back => lower living standards. • Dependence on foreign central banks may => loss of US global hegemony

23. The Bush Budget Bungle

24. Official forecast of US budget deficit vanishing by 2012 is fantasy

25. White House forecast of eliminating budget deficit by 2012 will not be met under their policies • WH and CBO projections still do not allow for • The full cost of Iraq and other “national security” spending • Fixing the Alternative Minimum Tax • Making permanent the tax cuts as it has asked for • More realistic forecasts of spending growth, e.g., in line with population. (Actually spending growth since 2001 has far exceeded that.) • More likely, deficits will not fall at all. • Just as the budget forecasts were predictably overoptimistic throughout the first Bush term. • The surplus of $5 trillion+ forecasted in Jan. 2001 over 10 years became a 10-year deficit of $5 trillion.

26. Further, the much more serious deterioration will start after 2009. • The 10-year window is no longer reported in White House projections • Cost of tax cuts truly explodes in 2010 (if made permanent), as does the cost of fixing the AMT • Baby boom generation starts to retire 2008 • => soaring costs of social security and, • Especially, Medicare