Thursday, February 17, 2005

On Wednesday, Andy Xie of Morgan Stanley summed up the current global financial condition with his missive "Free Money Reigns Supreme".
Asian interest rates have barely budged since the US Federal Reserve began to raise its policy rate. The enthusiasm of global investors towards Asian growth has kept capital inflow strong despite the rising Fed funds rate. The capital inflow has kept Asian interest rates low, which supports booming Asian growth. This, in turn, validates the global enthusiasm towards Asia, which keeps the funds coming. The fairytale continues.

Asia, in particular China, appears to be experiencing the biggest liquidity bubble in its history. The hot money inflow totaled US$656 billion in 2003�04, which has made money cheaper in Asia than in the US. The hot money turns into demand, primarily through property speculation. . . .

The axis between the Fed and China has created the current bubble, in my view: The Fed keeps money supply loose, and China keeps inflation down. The excessive liquidity pumps up property prices in the US, which keeps US consumption strong, which, in turn, keeps China�s exports strong, in turn keeping China�s investment strong, which finally keeps commodity prices high
Xie contends that China is the very heart of the global liquidity bubble, but it's too bad he didn't include Japan in his comments. Granted, hot money is hardly flowing into sluggish Japan, but the BOJ plans not only to keep interest rates at zero percent (although persistent Japanese deflation makes real rates slightly positive) but also
"Expect the BoJ to maintain the current reserve target range of Y30,000bn to Y35,000bn for the foreseeable future.� This target range floods the markets with liquidity.
If Japanese deflation comes to an end, as recent trends suggest, real rates will fall in Japan, too.

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