James Bevan: Global capital flows, the Fed and echoes from the past

It looks as if Euroland has suffered a net capital account balance of minus $300bn (€265bn) over the last 12 months – so no surprise that the euro has been softer.

Digging into the detail of the data, we can observe that around a tenth of this deficit may have been due to non-euro residents removing deposits from European banks and a similar amount seems to have been due to (recent) outflows by foreigners from European bond markets.

The bulk of the outflows have however been caused by a significant outflow of domestic funds into foreign debt markets, which will of course have been inflationary for these markets, even as the weak euro imparted a deflationary bias to the global economy.

As to what we can attribute all of these events to; prime suspect is the actions of M. Draghi and his colleagues. Indeed we can argue that the ECB’s QE, in so far as it was ‘designed’ to do anything specific, was aimed at encouraging these outflows so as to weaken the euro.

At the same time, published data show that Asia in its entirety has suffered an unprecedented net capital outflow of around $800bn over the last 12 months, and the bulk of this has come from China.

Although we have no real way of knowing, we can guesstimate that around half of these flows have been the result of Chinese/Asian savers diversifying their existing savings into alternative assets outside of the region.

And it looks as if the remainder of the flows have been the result of the (enforced) deleveraging process that has been caused by the (so far only partial) demise of the volatility-adjusted carry trade phenomenon.

In Latin America, the net capital account has been relatively more balanced while Eastern Europe has witnessed a modest net inflow, as has Australasia.

The UK meanwhile has experienced inflows of c.$160bn, while Japan has exported a net $12bn-$15bn of capital over the last 12 months.

The implication of this arithmetic is that the US dollar (both in ‘onshore’ and ‘offshore’ markets) may have witnesses implied ‘inflows’ of close to US$1tn over the last 12 months.

While it was not perhaps unusual for emerging markets to experience implied capital account surpluses of close to 7% of GDP during the mid-2000s and the early years of this decade, for the world’s largest economy to experience such a magnitude of (net) flows is almost unprecedented from a historical perspective.

It is of course true that as central banks of the emerging markets have sought to defend their currencies, they have sold perhaps around $150bn of US Treasury bonds over the last year and it has been suggested that this could adversely impact bond prices – and potentially even US mortgage rates with a detrimental impact on the US consumer sector.

However, we would note that the (primarily) private sector sums that have been flowing into the US dollar have been six or seven times this amount and that some (probably quite significant) proportion of these funds will have flowed directly into Treasuries. Perhaps even more of these funds will have flowed into the T bonds through more circuitous routes (such as a US resident selling a house to a PRC resident, and then investing the proceeds in T bonds).

We can therefore view the likely impact of this flows/FX intervention situation on the Treasury bond markets as being essentially indeterminate, or perhaps even positive.

The impact of the original acquisition of T bonds by foreign central banks on bond prices was difficult to discern in the 2000s and early 2010s and we suspect that the same will be true in reverse, at least from a ‘flows basis’.

However, what we can say with a degree of certainty is that, with close to a trillion dollars ‘looking for a home’, it is not surprising that we find that, despite weak profits and the threat of higher interest rates, the US financial markets, and of course the local property markets, have fared perhaps surprisingly well this year. The total flow of funds into the US financial system this year from abroad will have been immense.

Perhaps of more interest in the longer term is the topic of just what can the world’s largest economy do with such massive capital inflows?

Clearly, the implied tendency towards a (chronic) balance of payments surplus implied by the arithmetic above suggests that the US dollar’s real exchange rate should be appreciating, which of course it has been over the last year. But this then poses the question of just how will the US dollar’s real exchange rate appreciate from here – either by nominal appreciation of the currency or via the US experiencing relatively rapid (non-traded goods price) inflation?

We can expect that the answer to this question will determine global asset market trends over the medium term.

In terms of historical precedents, we can identify just two episodes in which a major global economy experienced such large inflows.

The first example occurred in Germany in the pre WW1 Gold Standard fixed exchange rate era, when out-sized war reparations paid by France to Germany in the 1870s had the effect of flooding the nascent German financial system thereby causing a credit boom, asset price inflation, general resource mis-allocation and an eventual sharp deterioration in German competitiveness that ultimately allowed ‘vanquished France’ to win the subsequent economic battle.

The initial impact of the flows on German liquidity and asset prices created a near term boom that was doubtless welcomed by markets but the longer term bust was painful for the recipient country.

The second historical precedent concerns the repayment of war debts by Europe to the US in the mid-1920s, a process that was subsequently given added impetus and, of course, scale by the European banking crisis of the late 1920s (which caused a process of capital repatriation back to the US dollar that was very similar to the carry trade unwind that we are witnessing at present).

Initially, the newly formed Federal Reserve allowed the large capital inflows to create a domestic credit boom in the US which contributed to the ‘Roaring 20s’ and of course the asset price bubble that formed.

It is also clear from the data, and the writings of Keynes and others, that the US also started to experience a relative inflation of its cost base despite the arrival of the then new ‘industrial economy’.

That said, part of the US relative inflation story was the result of the deflation that the donor countries were experiencing but the US was clearly losing competitiveness in the late 1920s. This, together with some (indefensible) personal reasons led the Fed to act to control the credit boom and hence the banking system’s ability to recycle the, by then, huge flows that were occurring into the US dollar.

Unfortunately, as domestic credit growth slowed, not only did the US economy lose the stimulative impact of the credit boom, but also the onus of the dollar appreciation process fell onto the nominal exchange rate. This dramatically increased the deflationary pressures in Europe as these countries were forced to defend their currencies until the Gold Standard thankfully broke apart.

To re-cap, large capital inflows into the US led to a credit and economic boom in the mid to late-1920s but when the Fed tightened, the US credit boom stopped and the US dollar soared as the forces involved tore the Gold standard apart. The result was a global depression.

Returning to the present day, we can observe that the US economy is once again receiving a (so-far mild) stimulus from the capital inflows via their (presumed) impact on domestic money and back credit growth, and perhaps more importantly via their probable impact on the corporate bond markets.

Although the ‘price action’ in the corporate bond market has not been particularly positive this year, it is true that the corporate sector is succeeding in issuing massive amounts of new debt that it is primarily using to finance equity buy-backs, M&A activity and share-option schemes.

We might quibble that the stimulus that the economy is deriving from these flows may be quite narrow and contained within a particular subset of the economy (i.e. the beneficiaries of zaitech) and the vendors of the properties that foreigners are buying but nevertheless there is an implied stimulus contained within these systems.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla