Nouriel Roubini's Global EconoMonitor

Are Capital Controls in Fashion Again?

Currency appreciation in emerging markets has been particularly strong this year both because of external conditions, including high liquidity, a weak US dollar and strong risk appetite, and domestic factors such as strong fundamentals, high potential growth and wider interest rates differentials. With portfolio investments to EM countries also rising, policymakers need to figure out how to avoid losing international competitiveness while also containing asset inflation and the emergence of asset bubbles. So far this year, most countries have opted for or maintained either verbal intervention or reserves accumulation. Others have kept or chosen more aggressive administrative measures, including capital controls mostly targeting portfolio investments rather than FDI.

The imposition of capital controls on capital inflows as well as currency intervention tends to be ineffective in reversing the appreciating trend of the local currencies, especially if the latter are primarily driven by external factors. However, capital controls may be helpful in easing volatility and the pace of the trend itself. The risk is that capital controls are seen as punitive measures against capital markets. They raise uncertainty about future policy actions, hurt the credibility of the central bank, and increase the costs of external funding for local businesses. Overall, policymakers’ actions to contain the appreciating trend of their countries’ currencies depend on how fast capital is flowing in, sterilization costs, and monetary policy flexibility. Consequently, EM countries where currencies and equity markets have surged over the course of the year are the most likely to impose some sort of limitations on capital inflows.

On October 20, Brazil surprised investors with a 2% tax on capital inflows to both equity and bond markets. Likewise, in March 2008, Brazil used a 1.5% tax on fixed income inflows only to contain the Brazilian real’s appreciation at the time. The tax was eventually lifted in October 2008 shortly after the Lehman collapse. This time around, taxation on equity investment was included to contain short-term capital flows, while FDI was exempted. Although emerging market currencies may continue to strengthen against the U.S. dollar, other EM policymakers may be more reluctant than Brazil’s to introduce capital controls in an effort to stem the currency appreciation and protect exporters. Below we examine how countries have been dealing with strong capital inflows and which country, if any, is likely to be the first to follow Brazil.

Capital Controls Alone May Not Be Enough

It is important to recognize that the use of capital controls is not uniform and neither are the results. In addition, their impact can be subdued by global conditions. In today’s economy, EM currencies are up against a weakening dollar. The dollar is down 6.3% YTD as measured by the US Dollar Index and down 14.3% from its March peak. The EM currency rally this year is even stronger than that of the US Dollar Index with five different currencies gaining over 10% YTD. Only the Argentine peso has posted a significant loss against the dollar YTD.

Governments are best served implementing measures aimed at smoothing currency appreciation as opposed to halting or reversing trends. This can be done in part by identifying and targeting areas of volatility and hence vulnerability. By addressing areas of greater volatility, countries can smooth currency flows without endangering macroeconomic stability. The recent tax in Brazil targets volatile portfolio flows as opposed to FDI. Portfolio investments fled Brazil following the Lehman collapse only to flow back this year. Meanwhile, FDI has remained relatively stable.

Given the extraordinary flow into emerging markets, it is unlikely that capital controls or intervention alone will be able to put the brakes on EM currency appreciation. Indeed, the Brazilian real gave up 3% against the dollar following the announcement of the tax before appreciating 3.7% after four days. That said, Brazil and other governments may find themselves in a position where they need to tap a greater arsenal if their desire to stem appreciation is strong. With that in mind, look for central bank intervention to be a greater theme in the coming months.

Who in the World is Next?

Latin America:

Most of the largest Latin American countries have experienced strong appreciation pressures on since the end of Q1 2009; some have responded by intervening aggressively in FX markets. What other Latin American governments may come to the table with capital controls similar to Brazil? Through October 26, the Chilean (CLP) and Colombian (COP) peso appreciated 19% and 17%, respectively, versus the dollar. The Peruvian new sol (PEN) is also a top performing EM currency, gaining nearly 10% this year. Mexico’s peso is one of the laggards in the region and capital inflows there are recovering slowly. Moreover, despite positive external factors, uncertainties around passing the 2010 fiscal budget and reforms in Mexico have kept the local currency without much investor support. Therefore, Mexico is not a candidate for any implementation of capital controls.

Chile is no stranger to capital controls, having imposed a 20% unremunerated reserve requirement on foreign loans from 1991-98. Chile’s foreign exchange regime is free floating; however, policymakers have intervened in the FX markets when the currency moved too far from macroeconomic fundamentals, most recently in 2008. Chilean authorities tend to let the markets know of their intentions well in advance, and their mechanisms are very transparent in length and quantity. For instance, until the end of the year, the central bank is currently selling the U.S. dollar on a daily basis (US$50 million a day) and the currency is considered to be near its ten-year moving average, in real terms. Thus, with the Chilean peso currently trading around 530, we believe Chile is still considerably above a level that would drive the government to intervene and/or introduce capital controls. As we highlighted in our regional outlook, RGE does not anticipate any kind of intervention unless the peso falls well below 500 and closer to the 450 level. Even then, we believe Chile would prefer intervening in FX markets and/or maintaining copper earnings abroad over outright capital controls.

Colombia is more likely to step up its actions against currency appreciation. Already the Colombian government pledged to leave roughly US$500 million in dividends from the state-oil company Ecopetrol overseas and sell local currency bonds domestically to compensate. But the government continues to hold off on implementing capital controls, perhaps acknowledging that such an action should be a last resort, especially since strong FDI rather than portfolio flows are driving the Colombian peso’s appreciation. Instead, after its policy meeting on October 23, the Central Bank of Colombia (Banrep) announced it would spend roughly US$1.6 billion to purchase dollars and peso-denominated government bonds. Given that inflation and interest rates are low and the economic recovery is likely to be slow, sterilizing the intervention is an option rather than a necessity at this point.

In Peru’s case, the central bank has stepped up the intervention over the last couple of months in order to contain currency appreciation rather than reverse it. Similar to Colombia, inflation and interest rates are low in Peru while the economy is growing well below potential. Therefore, sterilization costs are low and outright capital controls are not necessary. Moreover, because Peru is a heavily dollarized economy, managing U.S. dollar flows is key to maintaining macroeconomic stability.

Asia / Pacific:

Despite a flood of portfolio investments into many of the region’s asset markets since early 2009, Asia still needs foreign capital to stimulate investment and finance its current accounts. Therefore, facing a sluggish export recovery and a pegged Chinese renminbi, most countries have opted to contain currency appreciation via verbal and actual interventions to avoid losing competitiveness. Intervention in the foreign exchange market has led to record reserve growth of over US$70 billion in Q3 alone in emerging Asia ex-China. Although most Asian countries are expected to keep intervening amid some currency appreciation, several countries may impose restrictions on foreign currency transactions. Given buoyant equity markets, attractive carry trades and the U.S. dollar weakness, policy measures will not contain the impact of capital inflows on Asian currencies, meaning that some appreciation from the least trade-dependent countries is to be expected. Taiwan is the country where capital controls or new restrictions are most likely to be implemented.

Of developed Asia-Pacific economies, only Japan, Australia and New Zealand have resorted to verbal intervention so far. Australia views currency strength as a reflection of its economy’s resilience and is unlikely to officially intervene, especially after the failed intervention in October 2008. Monetary tightening could spark more inflows. Japan will continue to rely on verbal intervention to dampen yen appreciation, albeit less frequently than the previous pro-export administration, as a stronger yen will help rebalance the economy toward domestic demand. Meanwhile, New Zealand officials are more apprehensive that the kiwi’s strength may abbreviate the economy’s rebalancing away from debt-fueled domestic demand. A revival of carry trades that pushes the New Zealand dollar out of alignment with economic fundamentals could prompt a reprisal of 2007 when the Reserve Bank of New Zealand resorted to currency intervention.

The relatively open Asian Tigers are likewise unlikely to impose capital controls. Singapore and dollar-pegged Hong Kong will delay rate hikes and depend on FX intervention to contain currency appreciation. Taiwan may take a similar stance, especially since its currency is still competitive relative to South Korea and Japan. However, the Taiwanese government is considering the possibility of capital controls in the face of strong portfolio investment. RGE continues to believe that the Taiwanese government is likely to stick to intervening in the FX market, further adding to its US$330 billion in foreign exchange reserves.

Based on the pace of reserve growth, hot money (short-term portfolio inflows) again began flooding into China even as domestic monetary conditions have led to an appreciation of domestic real assets, especially property. China’s quasi dollar peg suggests inflows will persist. China never lifted pre-existing capital controls. Rather than impose further controls on inflows, China is expected to improve enforcement of existing measures and to continue encouraging capital outflows, both of government investment vehicles and more recently of retail investors through the revived Qualified Domestic Institutional Investment (QDII) program.

Low export dependence, reliance on energy imports, inflation risks and improving investment will allow South Korea, India and Indonesia to tolerate some currency appreciation despite continuing with FX intervention. These countries will be among the first ones in Asia to hike interest rates. But instead of capital controls per se, South Korea may use regulatory measures to mediate capital inflows by foreign investors and domestic borrowers and to check asset bubbles. India already has capital controls in place but may tighten restrictions on foreign institutional investors and external borrowings by companies if asset bubbles become a concern. Indonesia’s reliance on foreign capital for deficit financing will discourage capital controls. But in the case of excessive currency appreciation, Indonesia restrictions on currency transactions are a possibility.

Despite high export dependence, Malaysia and Thailand expect that delayed rate hikes and less attractive asset markets will allow them to contain currency appreciation largely by FX intervention. Malaysia maintained most of the capital controls imposed during the Asian crisis. In Thailand, dampened investor sentiment due to political instability and past capital controls will keep capital inflows modest. But Thailand may continue easing capital outflows to contain currency appreciation.

The Philippines will keep on engaging in competitive devaluation due to its dependence on remittances to drive economic growth. With capital controls already in place and a need for foreign capital to finance its current account deficit and build foreign reserves, the Vietnamese central bank may instead devalue and restrict currency transactions to manage its currency.

Europe, the Middle East & Africa:

The South African Reserve Bank has done little to curb the rand’s 25% gain YTD, resorting only to the occasional verbal intervention. Last week, the central bank had to issue a statement that it did not plan to “freeze” the currency. The central bank has allowed the currency to float, resulting in little change in foreign exchange reserves over the past year, despite an increase in South Africa’s SDR allocation. With its reliance on foreign capital to finance the country’s chronic current account deficit, capital controls are particularly unlikely. In the 2009-10 budget, the finance minister suggested loosening existing exchange controls. Given the sluggishness of South Africa’s economic recovery, the South African Reserve Bank will be slower to raise rates compared to some of its EM counterparts, potentially limiting the rand’s future climbs.

Russia has been steadily intervening in the FX market, lest the ruble climb too high. As such, its reserves have grown to US$420 billion by mid-October, despite the fact that Russia is spending the assets in its sovereign wealth funds. Prime Minister Putin has insisted that Russia would not impose controls on capital despite a doubling of Russian equities since the beginning of the year. In fact, Russian authorities continue to try to lure back foreign investors to its resource sector to maintain output.

Despite rumors of possible capital controls, the GCC governments did not impose new restrictions on capital in the wake of the financial crisis and the domestic credit squeeze. Doing so would have further impaired the regional economic union. Instead, government backstopping of the banking system and fiscal spending helped offset portfolio and direct investment outflows. Many countries, especially Saudi Arabia, continue to have significant restrictions on inflows to domestic equities, measures that cushioned asset markets. However, regulations to encourage direct investment are under consideration in the UAE, including the possible relaxation of the requirement that Emiratis maintain a majority stake in any project. As with other less liquid frontier economies, these countries are still seeking to attract capital, especially through debt markets, as evidenced by Dubai’s imminent return to the credit markets.


In contrast with the recent experiences of Brazil and certain Asian countries, which are taking steps to limit excessive capital inflows, Iceland has been attempting to stop outflows through strict capital controls, implemented in the wake of the country’s banking system collapse in late 2008. Payments related to exports and imports of goods are allowed, but capital transactions are controlled. The controls have served a number of purposes. For one, they have allowed the central bank to lower the policy rate to 12%, down from the 18% peak in October 2008, without destabilizing the currency. Two, the controls provided a stable environment to restructure the island’s failed banks.

The general idea behind the controls was to give the economy time to heal, but as history has shown, capital controls can at best provide a temporary respite. Over time, people find ways to circumvent the controls. In August 2009, the central bank announced plans to gradually remove the controls over the next two to three years. The danger, of course, is that even when controls are removed, capital inflows will not return. However, as economist Willem Buiter noted in February: “The example of Malaysia, which imposed capital controls during the Asian crisis of 1997 suggests that foreign capital either has a short memory or can be convinced.”

7 Responses to “Are Capital Controls in Fashion Again?”

MM CAOctober 28th, 2009 at 9:37 am

So who exactly are these anaylysts that predict all this BS.. I’m telling you, this so called recovery is an illusion, based on nothing more than the PTB pushing thier agenda to take every last cent from Average Joe. Anyone who believes anything from the mainstream press or people on Wall street are fools….there are NO JOBS and the Big Banks Are INSOLVENT!Consumer Confidence Declines in U.S.THE ASSOCIATED PRESSPublished: October 27, 2009Consumers’ confidence about the United States economy fell unexpectedly in October as job prospects remained bleak, a private research group said Tuesday, fueling speculation that an already gloomy holiday shopping forecast could worsen.The New York TimesThe Consumer Confidence Index, released by the Conference Board, sank unexpectedly to 47.7 in October — its second-lowest recording since May.Wall Street analysts predicted a reading of 53.1.A reading above 90 means the economy is on solid footing. Above 100 signals strong growth.The index has seesawed since reaching a record low of 25.3 in February and climbed to 53.4 in September.Shoppers have a grim outlook for the future, the Conference Board said, expecting a worsening business climate, fewer jobs and lower salaries. That is particularly bad news for retailers who depend on the holiday shopping season for a hefty share of their annual revenue.“Consumers also remain quite pessimistic about their future earnings, a sentiment that will likely constrain spending during the holidays,” said Lynn Franco, director of the Conference Board’s Consumer Research Center.Economists expect holiday sales to be at best flat from a year ago, when sales experienced their biggest declines since at least 1967, when the Commerce Department started collecting the data.The Consumer Confidence Index survey, which was sent to 5,000 households, had a cutoff date of Oct. 21.

GuestOctober 28th, 2009 at 9:42 am

October 27 2009: US home prices ready for a freefallIlargi: While today’s Case/Shiller Index numbers (home prices rose slightly from July to August, even as they’re still down 11.3% compared to August 2008) are interpreted as positive by the obvious suspects, what I see in it is a fast growing unmitigated disaster for Americans across the board.A 1% increase in prices is not exceptional in any way, as we can see in this Mark Hanson graph::What the graph also shows is that an estimated 4 million homes will still be sold in 2009, and that is not good news, unless you’re trying to offload unwanted properties and/or your income depends on loan transaction fees of one kind or another. If you’re a buyer, you pay too much for the home. If you’re a taxpayer, you get stuck with guarantees for loans and securities based on home prices that are too high.How much too high? Goldman Sachs said recently that the homebuyer tax credit, modification programs and foreclosure moratoria pushed US housing prices up by 5%. While that looks to be a very low estimate in itself, it doesn’t really matter, because it pales in comparison to the price increases caused by the ever more extreme presence of the government in the market.This graph from San Francisco Fed senior economist John Krainer shows that Fannie Mae, Freddie Mac, and the fast rising star Ginnie Mae (which provides blanket guarantees for FHA securities), who not so long ago were responsible for less than 50% of securitizations, now are left with about 95% of them. They can’t sell them to China anymore, those days are over, so the Fed has bought well over $1 trillion of the stuff just in the past year. It’s in this graph that the real market-distorting perversity can be found, as well as the reason why the government needs to get out of housing as fast as it can.You see, it’s starting to look as if the homebuyer tax credit might not be renewed as is, nor even extended. Instead, we’re in for a phase out. Which probably means that those people on the Hill that are up for re-election actually have begun to listen to some of the voices critical of this particular tax break. Reports have now come from multiple sides which suggest that the cost per newly purchased home of the credit is anywhere between $43,000 and $292,000, once you exclude the 85% of buyers that would have bought a home regardless of the credit.Still, while those reports are convincing and damning at the same time, they tell but a tiny sliver of the real story. Which is that of those 85%, precious few would have been able to purchase a home without the ever-present ever-willing assistance of a full slew of governmental or semi-governmental agencies and corporations eager to buy up and securitize any and all mortgage loans the banking system can lure their dumbfounded and unsuspecting clientele into.It would seem reasonable to assume that 85% out of those 85% wouldn’t be able to get a mortgage if the government were not so hungry to put the tax revenues it receives from its citizens and voters into a housing (equals mortgage equals banking) market that is guaranteed to collapse someday soon regardless of what amounts of public funds are injected.That is at issue here: the US housing market is way beyond any shape or form of salvation. And that in turn means that the only thing the government achieves with its tax credits and other attempts at stimulating or stabilizing the market, or whatever politically palatable term may be found, is an under the radar stealth transfer of real estate losses from the private to the public sector. And I for one don’t believe for a moment that Washington doesn’t know that.So why can we be so sure that US real estate is pining for fjords and pushing up daisies? This weekend’s Miami Herald provides a good answer.’Shadow market’ clouds housing recovery[..] an analysis of the so-called shadow market done for The Miami Herald suggests the number of homes and condos in the pipeline to come on the market in South Florida is nearly five times larger than all residential properties currently listed for saleIt’s the sheer number of properties available, and the avalanche of foreclosures and walkaways in the pipeline. There is no way the government can buy them all, or provide and guarantee the credit for 10-20 million new homebuyers to purchase a home. And certainly not at today’s elevated prices.Oh, and at the same time that the homebuyer tax credit will be phased out, did you hear that the Federal Reserve is about to start phasing out its securities purchases? There’ll be no buyer left. It’s hard to predict what other tricks Wall Street’s Treasury Department has up its sleeve, but rising or stabilizing home prices are out of the question. It has cost the American people trillions of dollars to prop up the market to the present day, where general price levels have fallen “only” 30%. All attempts to keep the market alive have failed miserably, at least, that is, from the point of view of ordinary Americans.With the government support about to vanish, the future prospects for home prices and the building and mortgage industries are Halloween material, while Bank of America (which bought Countrywide) and Wells Fargo (the country’s largest mortgage lender) face increasingly shaky days. Home prices are ready to go into a freefall. When the smoke clears prices will be down 80-90% from their peak. Needless to say that will cause such a chaos it’s hard to predict what America will look like.Oxford AnalyticaHousing Prices May Fall FurtherOxford Analytica, 10.27.09, 06:00 AM EDTA number of factors suggest housing prices could drop another 10%.Over the past few months, there have been suggestions that the U.S. housing market might finally be bottoming out. Since July, the decline in sales of both new and existing homes has moderated. Moreover, over the past three months, there has been a very modest increase in home prices at the national level as measured by the 20-city S&P/Case-Shiller home price index.However, the high inventory of unsold homes, continuing foreclosures, and double-digit unemployment could mean that housing prices have further to fall.–Inventory reduction. Whereas housing starts are presently estimated to be running at a 600,000 annual rate, underlying U.S. household formation is presently running at an annual rate of approximately 1.5 million units. Lower residential construction relative to household formation is allowing excessive home inventories to be gradually worked off.–Cheap mortgages. As a result of the Federal Reserve’s highly accommodative monetary policy, and the activity of the government-sponsored home lending enterprises, mortgage rates have declined to more affordable levels. For example, 30-year fixed-rate mortgages have fallen below 5% for the first time in many years.–Increased affordability. The slide in home values has brought prices more into line with their long-run fundamentals. Since September 2006, U.S. home prices have fallen 27%, bringing prices back to the level prevailing in mid-2003. As a result, the ratios of home prices to rents and of home prices to incomes are now much more in line with historic levels. The index of housing affordability now stands at its most favorable level in the past 20 years.Reasons for doubt. Despite these “green shoots,” there remain a number of factors that suggest that U.S. home prices have not quite hit bottom:Oxford Analyticagreat stuff after this give us some more. We need these at the times when politicians steal and we have to explain. At time I feel I am plying Monopoly and the Snakes and Ladders at one time, I the c….Inventories historically high. Despite small declines in recent months, the inventory of unsold homes at the national level remains at close to its historic high. A key indication of the degree of excess home inventory is that the number of vacant homes, in which neither an owner nor a renter presently dwells, exceeds its normal level by nearly 1 million units.–Foreclosure crisis. The United States is presently suffering from a foreclosure crisis that is further adding more homes to a market already characterized by excess inventories. Forward-looking indicators, such as the number of mortgages that are more than 90 days delinquent (i.e., behind payment) suggest that the pace of foreclosures could increase in the months ahead.–High unemployment. A very weak labor market situation inhibits households from making the long-term financial commitments, such as buying a home. The Labor Department estimates that approximately 16.5% of the labor force is either unemployed or in involuntary part-time employment. At the same time, the huge slack presently affecting the labor market is exerting downward pressure on wage income growth. Most economists–including White House Council of Economic Advisers Chair Christina Romer–do not foresee much improvement in the labor market in 2010.–Mortgage resets. Next year, approximately $200 billion in “Option ARM” mortgages (adjustable rate mortgages) are due to reset to higher rates. This is likely to add to the foreclosure problem, since these resets will produce a sharp jump in debt service payments.Dugg on Forbes.comRussia will not sell gold in 2009 – Forbes.comExtreme Takeover, Washington Edition – Forbes.comWhy You Shouldn’t Hire A Perfect Job Candidate – Forbes.com13 Top Earning Dead CelebritiesVisit The Digg Channel–Default incentive. Finally, another factor adding to the foreclosure problem is that a growing number of U.S. households now have “negative equity” in their homes (i.e., their mortgage debt exceeds the value of their homes). Since mortgages in most U.S. states are “non-recourse loans” (the lender cannot pursue the borrowers’ other assets, beyond the home), negative equity gives homeowners a strong incentive to default on their mortgage loans.Outlook. The present high level of unsold housing inventories, the poor state of the labor market and the current wave of foreclosures suggest that home prices may have a further 10% to fall (in real terms). This will add to the financial distress facing the banking sector, inhibiting a return to above trend GDP growth in 2010.

MM CAOctober 28th, 2009 at 9:53 am

Duh!!!!! New home building is a mirage these days… ther is no way the home builders can survive… From almost 2 million annual starts 2 years ago to this… and i wouldnt beleive these these numebrs either… you cant be building new homes when there are almsot 20 million unoccupied single family housing units…Same goes for the auto makers too… Chyrslar is toast and GM is not far behind… these idiots in Congress and wall street have destroyed this country… BTW everyone in america with a credit card will soon see there interest rate at 29.9% no matter your ccreidt rating…. and Bank fees are going through the roof… if people dont wake up, those with bad credit will see thier interest rates at over 50%… they are no wheres done sticking up Average Joes you know what…New Home Sales Fall Off The CliffJoe Weisenthal|Oct. 28, 2009, 10:10 AM | 252 |1Here’s your hangover and it’s worse than expected.Analysts had been expecting a GAIN of 2.6%. Instead new home sales slipped 3.6%. Stunning.The full announcement can be found here.

MM CAOctober 28th, 2009 at 9:57 am

finally someone saying something realistic!Bill Gross: Assets Are $15 Trillion Overvalued And Fed Will Keep Rates At 0% Forever To Keep The Fantasy AlivePIMCO’s Bill Gross with a great monthly letter. Here are the key points:Over the past 30 years, paper asset prices rose 2X as much as they should have based on economic fundamentalsThis was the result of leverageThe asset price rise in turn pumped up the economy’s fundamentals (Soros’s reflexivity)The government wants to restore the “old normal” (2007) not the “new normal” (slower growth as asset prices return to trend)Therefore… The Fed will keep rates at 0% for at least 18 months into sustained 4% growthNext year, when the inventory restocking effect wears off, 4% will be toughInvestment OutlookBill Gross | November 2009A cold wind from the future blows into my nighttime bedroom, more often than not during those midnight hours when fear dominates and hope retreats to a netherworld. This wind is a spectre, an oracle of darkness and eventual death, not easily dismissed. Once merely a whisper, its decibels intensify with the advancing years. It will be heard, this reaper – this grim reaper, yet in the nights when it howls the loudest I fight back, silently screaming for it to get out, to leave me alone, to let it all be a bad dream. It never is. Shakespeare’s Macbeth expressed it more subtly: “Out, out, brief candle!” Yet the finer words provide no solace; the final act is always the same.Those of you in your sixties and older know of what I speak; even during daylight hours you read the obits and notice that contemporaries have passed into the beyond. Those of you much younger must wonder what has come over me, yet I was young once too. I remember as a teenager camping out under the stars with friends wondering aloud at the mystery of it all, knowing the reaper was far off in the distance, so far away that death was more a philosophical discussion point than an impending reality. In my thirties, I recall standing in front of a mirror in my physical prime and instructing my image that I would never grow old, that I somehow would live forever, that I, the me, the ego, would be eternal. Now when I face the glass my eyes avoid the unmistakable conclusion: I am everyman – everyone that ever was and ever will be. This world will outlast me.What to do? Enjoy these senior years and take advantage of the gifts I have been given – a healthy 65-year-old body, an amazing job where I can still make a vital contribution, a wonderful wife who shines brightly and muffles the sound of my nighttime intruder. Still there is no acceptance of Macbeth’s or any of our “dusty deaths.” At midnight there is only fear and rage – rage against this night whose wind will one day take us all.An investment segue is a tough one this month: markets whistling past the graveyard? A vampire economy? A ghostly correction ahead? Pretty lame, so I’ll jump straight into a discussion of why in a New Normal economy (1) almost all assets appear to be overvalued on a long-term basis, and, therefore, (2) policymakers need to maintain artificially low interest rates and supportive easing measures in order to keep economies on the “right side of the grass.”Let me start out by summarizing a long-standing PIMCO thesis: The U.S. and most other G-7 economies have been significantly and artificially influenced by asset price appreciation for decades. Stock and home prices went up – then consumers liquefied and spent the capital gains either by borrowing against them or selling outright. Growth, in other words, was influenced on the upside by leverage, securitization, and the belief that wealth creation was a function of asset appreciation as opposed to the production of goods and services. American and other similarly addicted global citizens long ago learned to focus on markets as opposed to the economic foundation behind them. How many TV shots have you seen of people on the Times Square Jumbotron applauding the announcement of the latest GDP growth numbers or job creation? None, of course, but we see daily opening and closing market crescendos of jubilant capitalists on the NYSE and NASDAQ cheering the movement of markets – either up or down. My point: Asset prices are embedded not only in our psyche, but the actual growth rate of our economy. If they don’t go up – economies don’t do well, and when they go down, the economy can be horrid.To some this might seem like a chicken and egg conundrum because they naturally move together. For the most part they do – and should. As pointed out in a recent New York Times article titled “Dow Bubble?,” stocks and nominal GDP growth should be correlated because profits and nominal GDP are correlated as well. Witness the PIMCO Chart 1, researched by Saumil Parikh, which covers a time period of 50 years. Granted the R2 correlation is only .305, but that is to be expected – profits are also a function of the respective entities that feed at the GDP growth trough – corporations, labor, government and other countries – and when corporations and their profits are ascendant they do well; when not, they fall below the best fit line appearing in the chart. Notice as well that in a normally functioning economy growing at 6-7% nominal GDP, that profits grow at the same rate. (At growth distribution tails there are substantial distortions.) And if long term profits match nominal GDP growth then theoretically stock prices should too.Not so. What has happened is that our “paper asset” economy has driven not only stock prices, but all asset prices higher than the economic growth required to justify them. Granted, one must be careful of beginning and ending data points in any theoretical “proof.” Such is the fallacy of Jeremy Siegel’s Stocks for the Long Run approach which begins at very low PEs and ends most long-term time periods with much higher ones, justifying a 6.5% “Siegel constant” real rate of return for U.S. equities over the past 75 years or so. It may also be a weakness of the New York Times “Dow Bubble” article where the authors claim that since the Dow Jones average was at 4,000 in 1995, that a 100% step-for-step correlation with nominal GDP growth since then would produce a reasonable valuation of 7,800 – not the current 10,000.Having said that, let me introduce Chart 2 a PIMCO long-term (half-century) chart comparing the annual percentage growth rate of a much broader category of assets than stocks alone relative to nominal GDP. Let’s not just make this a stock market roast, let’s extend it to bonds, commercial real estate, and anything that has a price tag on it to see if those price stickers are justified by historical growth in the economy.This comparison uses a different format with a smoothing five-year trailing valuation growth rate for all U.S. assets since 1956 vs. corresponding economic growth. Several interesting points. First of all, assets didn’t always appreciate faster than GDP. For the first several decades of this history, economic growth, not paper wealth, was king. We were getting richer by making things, not paper. Beginning in the 1980s, however, the cult of the markets, which included the development of financial derivatives and the increasing use of leverage, began to dominate. A long history marred only by negative givebacks during recessions in the early 1990s, 2001–2002, and 2008–2009, produced a persistent increase in asset prices vs. nominal GDP that led to an average overall 50-year appreciation advantage of 1.3% annually. That’s another way of saying you would have been far better off investing in paper than factories or machinery or the requisite components of an educated workforce. We, in effect, were hollowing out our productive future at the expense of worthless paper such as subprimes, dotcoms, or in part, blue chip stocks and investment grade/government bonds. Putting a compounding computer to this 1.3% annual outperformance for 50 years, produces a double, and leads to the conclusion that the return from all assets was 100% (or 15 trillion – one year’s GDP) higher than what it theoretically should have been. Financial leverage, in other words, drove the prices of stocks, bonds, homes, and shopping malls to extraordinary valuation levels – at least compared to 1956 – and there could be payback ahead as the leveraging turns into delevering and nominal GDP growth regains the winner’s platform.This 100% overvaluation from recent price peaks of course is crude, simplistic, and unrealistically pessimistic. It implies that stocks should be at – gasp – Dow 7,000 – and that home prices – gasp – should be cut in half from 2007 levels, and that commercial real estate (Las Vegas hotels, big city office buildings that are 20% empty) should likewise face the delevering guillotine. Some of these price adjustments have already taken place, and to be fair, corporate and high yield bonds as well, should be thrown into this overpriced vortex more resemblant of a black hole than American-style paper wealth capitalism. This is where it gets tricky, however, because policymakers, (The Fed, the Treasury, the FDIC) recognize the predicament, maybe not with the same model or in the same magnitude, but they recognize that asset prices must be supported in order to generate positive future nominal GDP growth somewhere close to historical norms. The virus has infected far too many parts of the economy’s body, for far too long, to go cold turkey. The Japanese example over the past 15 years is an excellent historical reference point. Their quantitative easing and near-0% short-term interest rates eventually arrested equity and property market deflation but at much greater percentage losses, which produced an economy barely above the grass as opposed to buried six feet under. The current objective of global policymakers is to do likewise – keep the capitalistic patient alive through asset price support, but at an “old normal” pace if possible, six feet or 6% in U.S. nominal GDP terms above the grass.That support, of course, comes in numerous ways. Financial system guarantees, TARP recapitalization of banks, TAFs, TALFs, PPIFs – and in Europe and the UK, low interest rate term financing, semi-bank nationalizations, and asset purchase programs similar to the United States. In the case of the U.S., the amount of the implicit and explicit financial support given by policymakers totals perhaps as much as $5 trillion, which goes part way to support the $15 trillion overvaluation of assets theoretically calculated in the PIMCO model (100% of nominal GDP). China, interestingly, is taking another approach, throwing equivalent trillions into their real economy to make things as opposed to support paper, if only because exports are at the heart of their economic growth and they haven’t caught the American virus or suffered, I suppose, a “paper cut.”At the center of U.S. policy support, however, rests the “extraordinarily low” or 0% policy rate. How long the Fed remains there is dependent on the pace of the recovery of nominal GDP as well as the mix of that nominal rate between real growth and inflation. My sense is that nominal GDP must show realistic signs of stabilizing near 4% before the Fed would be willing to risk raising rates. The current embedded cost of U.S. debt markets is close to 6% and nominal GDP must grow within reach of that level if policymakers are to avoid continuing debt deflation in corporate and household balance sheets. While the U.S. economy will likely approach 4% nominal growth in 2009’s second half, the ability to sustain those levels once inventory rebalancing and fiscal pump-priming effects wear off is debatable. The Fed will likely require 12–18 months of 4%+ nominal growth before abandoning the 0% benchmark.Here is another way to analyze it. It seems commonsensical that because of asset market value losses over the past 18 months, the Fed must keep future real and nominal interest rates extremely low. Because401(k)s have migrated to 201(k)s, and now 301(k)s, the negative wealth effect must be stabilized in order to reintegrate the private sector into the current economy. Renormalizing risk spreads – stock, investment grade, and high yield bonds among them – is another way to describe this hoped for foundation for future growth. PIMCO estimates that this process is perhaps 80–85% complete, which provides the potential for a sunny-side, right-side of the grass outcome, although still with New Normal implications. Still, investors must admit that without the policy guarantees of the Fed, Treasury, and FDIC, as well as the continuation of punitive 0% short-term rates that force investors to buy something, anything, with their cash, that risk spreads may widen again, not stabilize.This somewhat detailed analysis on Fed funds policy rates should return us to my beginning thesis as to why they need to stay low: Asset appreciation in U.S. and other G-7 economies has been artificially elevated for years. In order to prevent prices sinking even lower than recent downtrends averaging 30% for stocks, homes, commercial real estate, and certain high yield bonds, central banks must keep policy rates historically low for an extended period of time. If policy rates are artificially low then bond investors should recognize that artificial buyers of notes and bonds (quantitative easing programs and Chinese currency fixing) have compressed almost all interest rates. But while this may support asset prices – including Treasury paper across the front end and belly of the curve, at the same time it provides little reward in terms of future income. Investors, of course, notice this inevitable conclusion by referencing Treasury Bills at .15%, two-year Notes at less than 1%, and 10-year maturities at a paltry 3.40%. Absent deflationary momentum, this is all a Treasury investor can expect. What you see in the bond market is often what you get. Broadening the concept to the U.S. bond market as a whole (mortgages + investment grade corporates), the total bond market yields only 3.5%. To get more than that, high yield, distressed mortgages, and stocks beckon the investor increasingly beguiled by hopes of a V-shaped recovery and “old normal” market standards. Not likely, and the risks outweigh the rewards at this point. Investors must recognize that if assets appreciate with nominal GDP, a 4–5% return is about all they can expect even with abnormally low policy rates. Rage, rage, against this conclusion if you wish, but the six-month rally in risk assets – while still continuously supported by Fed and Treasury policymakers – is likely at its pinnacle. Out, out, brief candle.William H. GrossManaging Director

MM CAOctober 28th, 2009 at 10:11 am

and lest we not forget the total disaster out here in California, they are sticking it to the remaining 14 million workers out here starting next week. borrowing more by taxing them more… i knwo people who still have not gotten there 2008 Tax refunds out here… so good luck filing your taxes on time next april and expecting you refund money to come back to you… By then california will another 30 billion underwater…. i notifed my HR to increase my expemtions to 8 this morning, so in in fact I will now pay a lot less than i had been paying and i may just fedex my return and monies owed if any in pennies to them next year…California withholding tax increase November 1October 8, 1:17 PMSan Diego Headlines ExaminerJerrieCalifornia Governor Arnold SchwarzeneggerAB17 which was enacted by the California legislature and signed by Governor Schwarzenegger, requires the California Franchise Tax Board to adjust the payroll withholding table with an increase. The payroll withholding tables apply to pensions, as well as wages.AB 17 will increase payroll withholding by 10 percent, effective for wages paid after October 31, 2009. Withholding on supplemental wages increase from 6 percent to 6.6 percent effective for supplemental wages paid after October 31, 2009 and for stock options and bonus payments it will increase from 9.3 percent to 10.2 percent.To give you an idea what that will mean to you, as an example, if state income tax withholding is $500 a pay period on November 1, it will be adjusted to $550.00The law also increases the second quarterly estimated tax payment from 30 to 40 percent and the fourth quarterly installment from 20 to 30 percent.The AB 17 increases the payroll tax withholding and it does not increase California personal income tax rates.To help offset the extra money taht will be taken out of your paycheck, you can fill out a DE-4 form increasing your exemptions, for example from single 2 to single 3 and it will not change your federal exemptions, just your state exemptions. The form is available on the EDD website. If you would like to adjust your withholding click here to get the form.