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March 20, 2006

Competitive Tightening - Part II
by David Yu

Please read Competitive Tightening Part I first.

Table below shows recent rate tightening by 9 major central banks. Except for Australia, these rate increases all took place within the last 100 days. Collectively, they added 225 basis points to the cost of borrowing.

Every region or country on the list, except for Canada, is either running a current account deficit or a budget deficit. New Zealand, with interest rate at 7%, has one of the largest current account deficit and net foreign debt. For the year ended September 2005, New Zealand's current account deficit grew to 8.5% of its GDP, from 6% a year ago. Australia also has high level of foreign debt and current account deficit that's over 6% of its GDP. India is running a current account deficit that's 3% of its GDP. The 25-member European Union has a current account deficit of 21.8 billion Euros.

While the impact of budget deficit on interest rate remains to be controversial among economists, current account deficit's positive relationship with interest rate leaves little room for controversy.

In a study collaborated by Central Bank of Taiwan and Dr. Yuli Su, an Associate Professor in the Department of Finance at the San Francisco State University, they found evidence supporting the Ricardian Equivalence hypothesis that there's no direct relationship between budget deficit and interest rate. However, there's evidence of a significant INDIRECT effect of budget deficit on interest rate and therefore on currency value. These indirect effects are inflation expectation, risk premium, and rate of return expectation. This indirect effect differs between the Asian and the Euro-currency countries samples. This difference could be attributed to the fact that Asian countries tend to have higher inflation rate, lower government debt ratio, and lower government consumption while the Euro-currency countries tend to have higher government debt ratio. This study helps explain interest rate increases in Hong Kong and South Korea. Both Asian economies are running budget deficits while experiencing current account surpluses. Nonetheless, their current account surpluses may have more to do with Asia's overall declining investment.

A country's current account balance is the difference between its investments and its savings. In a speech he made in Hong Kong last year, Raghuram Rajan, Economic Counselor and Director of Research at International Monetary Fund, explained that the increase in the U.S. current account deficit in the mid 1990s is due to private sector investment, not a fall in saving. However, since 2000, the increase in the current account deficit has reflected mostly a decline in public saving that's due to growing fiscal deficit plus further decline in an already low household savings rate. Private investments in the U.S. remain below its level of the mid 1990s.

The decline in savings in the U.S. therefore made it necessary for the U.S. to import savings from abroad to finance its investment. But the U.S. is not alone in this endeavor. Competitions around the globe are arising.

Raghuram Rajan further presented his case that the increased current account surpluses resulted from a decline in investment in Asia was largely a reaction to the excessive investment prior to the 1997-1998 Asia financial crisis. Japan, for example, sees its investment falling steadily following the bubble years. The savings rate didn't change much in these countries. The decline in investment started to rack up large surpluses, that is, except China. China's investment continues to grow, but it runs a large surplus because savings have grown even faster than investment.

While overcapacity is one reason for the global investment decline, the decline also has to do with the unregulated capital flows. A speech made by ex-chairman of the Fed, Alan Greenspan, on November 14, 2005, via videoconference, before the Banco de Mexico's 80th Anniversary International Conference, was based on the implication that global savings are inefficiently distributed to investment, meaning that savers are bearing too much risk for the returns they achieve and that countries with high-potential investment projects are getting less financing than they could productively employ. Savers tend, to their own detriment, to over-discount foreign returns. Such suboptimal allocation of capital lowers living standards everywhere.

Given the freedom to create money from thin air, one would be surprised to find that the central banks of the world may be scrambling and competing for investment capitals. But that's what appears to be happening right now, Competitive Tightening.

In order to compete for global savings, higher expected rate of return is offered to the savers by the central banks of these economies. And, when "the forces of banking and finance succeed in maintaining the rate of interest", diminishing aggregate demand resulted from income inequality follows. The continuing interest rate hike in the U.S. has already started to hurt American households, but it further enriches the financial sector, which is part of the Fed's family of private banking cartel. You can see that the rise of the 10-year Treasury bond yield (green curve) has not hurt JP Morgan Chase a bit. Its stock price has skyrocketed more than 27% since October.

Chart 1

Mega banks have diversified into areas such as insurance, trust, brokerage, investment banking, and commodities. Their profit margins are no longer as sensitive to rising interest rates, provided that the yield curve spread does not remain inverted for a prolonged period of time. Under the circumstances of global Competitive Tightening as well as inflation expectation, the Fed has little choice but to continue the short-term rate hike. And, one way to avert an inverted yield curve is to have rising long rates, or falling bond prices.

The Fed's fully aware that the deteriorating U.S. housing market and subsequently the sustainability of the U.S. consumers spending spree have raised level of concerns among foreign investors of the U.S. Treasury Bonds. But, that's just part of the grand design. The unloading or the "portfolio-switching" by global bond investors, as so termed in a research paper - International Capital Flows and U.S. Interest Rates - prepared for the Fed in September by Francis & Veronica Warnock, associate professor at the Darden School and assistant professor in the School of Architecture, respectively, has thus far caused the 10-year bond yield to rise 20% since June, 2005 (Chart 2).

Chart 2

Pease stay tune for Part III of Competitive Tightening...

David Yu,
Davids Stock Market Chartmentary
email: david_3011 @ yahoo.com
Space before and after @ was left intentionally to avoid spamming. Please remove this space when sending your emails.

Copyright © 2005-2008 David Yu

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