Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Friday, September 22, 2006

Brad Setser on Similarities Between Amaranth and the People's Bank of China...

He writes:

RGE - Unintentional irony watch (hedge fund edition): Risk management standards do seem to be slipping. Davis, Sender and Zuckerman in the Wall Street Journal:

The risk models employed by hedge funds use historic data, but the natural gas markets have been more volatile this year than any year since 2001, making the models less useful. They also might not predict how much selling of one’s stakes to get out of a position can cause prices to fall.

The models broke down because this year has been more volatile than any year since 2001? That isn’t so long ago, except in hedge fund time... I suspect Mr. Geithner won’t be happy if stress tests -- and risk management models -- don’t look a bit further back. 1998 might be a relevant data point. Certainly for anyone betting on emerging markets, the yen/dollar (or the yen/ euro, since the dyanmics of an unwinding carry trade are similar) or the Treasury market. 1998 also might be a relevant data point for a few commodity markets. Mr. Geithner also wants – I suspect – those lending to hedge funds to assume that liquidity will dry up when their clients need it the most. Getting out when you don’t need to is easy. Getting out when you absolutely have to is hard. Especially if you have a large concentrated position...

That lesson may be relevant for another set of institutions with large positions. A few central banks might also want to ponder the impact large, sustained purchases can have on market dynamics. Davis, Sender and Zuckerman, again.

According to natural gas investors who traded alongside Amaranth, Mr. Hunter repeatedly used borrowed money to double down on his bets. Buying more futures contracts of the kind his fund already owned supported their price by increasing demand, propping up paper gains, these traders say. But the support only lasted so long as Amaranth and its lenders were willing to spend cash to buy more contracts. Such trades may also have masked growing weakness in market fundamentals.

Substitute dollars, Treasury bonds and Agency bonds for “futures” and “contracts,” and substitute the PBoC (and a few others) for Amaranth...

China is making a huge bet that Stephen Jen and Friedrich Wu are right, and the RMB isn’t really undervalued (and the dollar and euro are not overvalued against the RMB). It is betting that the RMB wouldn’t really rise if it stopped buying. That is a rather large gamble though.

Especially since Chinese productivity is growing faster than US productivity (see the graphs on p. 13 of Feng Lu’s presentation), so a key “fundamental” is moving against China’s financial position...

I think Fan Gang at least understands as much. Yu Yongding as well. And Zhou Xiaochuan.

The Politburo and the State Council? I am not so sure.

The Politburo and State Council may understand it. They may be thinking as follows: "We grow at 8% per year as long as we can keep export-led industriallization going. When export-led industrialization stops and we have to substitute domestic-demand-led industrialization, our growth rate is likely to fall to 5%. Thus each year we keep this juggling act going raises China's GDP--permanently--by about RMB 500 billion a year, an increment to the present value of China's total national wealth of RMB 10 trillion. To keep the juggling act going requires that we spend RMB 3 trillion a year buying dollar-denominated securities that will be worth only RMB 2 trillion when we sell them. That looks like a benefit-cost ratio of 10:1. So let's keep juggling as long as we can.

That maybe what they are thinking in the Politburo and the State Council.


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