Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts.
An independent central bank is supposed to maintain the value of the currency and prevent inflation. In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten.
People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.
It's beginning to happen again. Unlike the response of wages and prices in the low inflation 1990s, expectations of rising inflation now delay or stop price and wage adjustment, inhibiting growth.
One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.
Economic forecasts are not very accurate; still, the International Monetary Fund, the Congressional Budget Office and even the Federal Reserve do not forecast recession in 2008. The Fed thinks that the unemployment rate may rise to 5.3%, below the postwar average. In any event, it cannot do much to change economic activity or unemployment experienced in the next few months, and the Fed anticipates stronger growth in the second half of the year. Why the haste to cut interest rates drastically?
The freezing up of short-term financial markets called for more borrowing. The Fed's response was creative and correct. It recognized that its responsibility as lender of last resort required bold action to maintain the payments system; and it delivered.
But the rush to bring real short-term interest rates to negative values is an unseemly and dangerous response to pressures from Wall Street, Congress and the administration. The Federal Reserve became "independent" in 1913 so that it could resist pressures of that kind. And in the postwar years, although it often failed to do so, it was expected to safeguard the purchasing power of our money and maintain economic growth.
For Wall Street, the pressure for lower interest rates is based on a hope that bond and mortgage yields will decline and their losses will be limited. Often long-term rates fall when the Fed lowers short-term rates -- and since bond and mortgage prices rise when their rates fall, the losses of investors in these instruments will be reduced. For Congress and the administration, there is a need to show "concern" by doing something in an election year. These are not the concerns that should influence an independent central bank.
Surely Mr. Bernanke and his colleagues remember what happened in the 1970s. They console themselves with the belief that they will respond to any inflation that occurs by promptly raising interest rates. That repeats the commitments made repeatedly in the 1970s, which the Fed was unwilling to keep. The blunt fact is that there is rarely a popular time to raise interest rates. And with the growing streak of populism in the country, it will become more difficult.
The Fed's recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn't shift back and forth from one to the other. The Fed should do the same. In the 1970s, because the Fed shifted from one goal to the other and back again, it achieved neither. Both inflation and unemployment rose on average, then fell together in the 1980s -- after the Fed controlled inflation.
After 1985, Fed policy kept inflation and unemployment low. The result was 20 years of growth, and three of the longest peacetime expansions punctuated by short recessions.
We should not throw this policy away. Federal Reserve independence is a valuable right which should not be discarded. The Fed should insist on its obligation to prevent inflation and sustain growth, not sacrificing inflation to lower unemployment before the election.
Mr. Meltzer is a professor at Carnegie Mellon and the author of the forthcoming "A History of the Federal Reserve."
All these crises are different. But many have shared common features. They begin with capital inflows from foreigners seduced by tales of an economic El Dorado. This generates low real interest rates and a widening current account deficit. Domestic borrowing and spending surge, particularly investment in property. Asset prices soar, borrowing increases and the capital inflow grows. Finally, the bubble bursts, capital floods out and the banking system, burdened with mountains of bad debt, implodes.
Economists have a term to describe what it means when things keep going from bad to worse: negative-feedback loop. One day's problems create a broad set of behaviors that only make the problems worse.
![[Chart]](http://s.wsj.net/public/resources/images/MI-AP160_AOT_20080219193227.gif)
Consider housing. As home prices fall, more families see the values of their homes decline to less than the amount of money they have to pay back on their mortgages. That gives them an incentive to walk away from their mortgages and leave their homes empty, which puts more downward pressure on home prices, drawing more households into the loop.
Housing turmoil, in turn, causes consumers to pull back, hurting the broader economy, which puts more downward pressure on home prices. Banks, worried about mortgages going bad, tighten lending standards, shutting some new buyers out of the market and further depressing home prices.
Negative-feedback loops can be pernicious when an economy depends heavily on borrowed money. Total outstanding household debt rose to $13.6 trillion by the third quarter of 2007 from $7.2 trillion at the beginning of 2001 -- a 10% annual growth rate. Mortgage borrowing more than doubled in this stretch. One out of every seven dollars of disposable income earned by Americans now goes toward paying down debt -- near a record.
Corporate borrowing was modest for most of the decade, then started rising at double-digit rates in 2006 and 2007, amid a wave of private-equity buyouts and debt-financed share buybacks. Meantime, Wall Street juices returns by making investments with borrowed money.
Yale economist John Geanakoplos's concept of the leverage cycle shows how negative-feedback loops are driving today's economy. When times are good, credit is ample, causing the economy to heat up. When the cycle shifts, lenders tighten standards and become more demanding about the collateral they hold, feeding into the negative-feedback loops hitting the economy.
He says shifts in this cycle can happen suddenly, catching investors and policy makers off guard. "When the world seems more uncertain, everyone wants a lot of collateral and the economy goes from highly leveraged to no leverage very quickly," he says.
"When things go bad, people have to sell assets to raise collateral," says Gregg Berman, co-head of the risk management unit of RiskMetrics Group. Selling reduces the value of the very assets borrowers have used as collateral against loans -- such as homes. "The more leverage is built into the system, the more the cascade effect is magnified," Mr. Berman says.
Individual banks might be acting rationally when demanding more or better collateral. Trouble is, when every lender does this at once, it becomes self-destructive, triggering shock waves that threaten the banks themselves.
The trick for policy makers is to break the loop. "A macroeconomic downturn tends to diminish the value of many forms of collateral...reinforcing the propagation of the adverse-feedback loop," Federal Reserve Governor Frederic Mishkin said in a January speech. Aggressive Fed interest-rate cuts help by reducing the cost of all of this borrowing.
The psychology of risk aversion behind these negative loops is hard to alter once it sets in. That is why breaking the chain this time could be harder than anyone expected.
The stock market is peppier than the credit market. One of them might be in denial.
The Dow Jones Industrial Average has fallen about 8% since credit problems first started bubbling up last June, but has rebounded lately as investors bet on a recovery in the second half.
![[Chart]](http://s.wsj.net/public/resources/images/MI-AP175_AOT_20080220184013.gif)
The credit market's pain, meanwhile, has been far deeper and is getting worse. Markit's CDX investment grade index, which tracks the cost of insurance against investment-grade corporate defaults, has swollen more than 330% since June. Spreads on leveraged loans, which are made to companies with junk ratings, are at their worst levels of the crisis, having widened by about 184% since June, according to the Standard & Poor's/LSTA Leveraged Loan Index.
Swap spreads, another measure of risk aversion in credit markets, are pointing in the same direction. Swap spreads are essentially a measure of the difference between buying a safe government bond and making a riskier loan to a bank. The gap widens when lenders are pulling in their horns.
For example, the 10-year swap spread -- the gap between 10-year Treasury yields and market rates derived from the London interbank offered rate -- has ballooned above three-quarters of a percentage point, what Michael Darda, chief economist at MKM Partners, calls "crisis" territory. The spread hit that level last July and November, heralding credit-market meltdowns and, a little later, stock-market swoons.
That chain of events may not unfold again this time, Mr. Darda suggests, saying stock prices already reflect fairly dismal credit conditions. The Federal Reserve has flooded the system with money, and a viable bond-insurance rescue plan could shrink spreads and improve credit conditions.
The trouble is that neither the Fed nor would-be bond-insurance rescuers can magically make lenders feel giddy about lending money again. Big bubbles tend to end badly, take time to unwind, and claim a lot of victims. That applies to credit bubbles, too.
The credit market could be ringing false alarms. But it could also be foreshadowing more damage yet to come in stocks.
THE past year has seen a lively debate among economists about China's rapid economic growth. Some, such as Brad Setser from the Council on Foreign Relations, believe that exports have been the main generator; others, like UBS's Jonathan Anderson and The Economist, think that domestic demand—spending on roads and railways, cars and clothes, and the like—has been the driving force. Just now, a lot turns on this argument: both how badly China's economy could be hurt by an American recession and also the extent to which Chinese spending could help to prop up the rest of the world economy. Some new figures suggest Chinese demand is rising strongly enough to help offset the increasing weakness in China's export markets. That could be good news for the world at large.
It is certainly true that China's current-account surplus rose to a record 10% of its GDP last year, which means that it produced a lot more than it consumed and so relied on foreigners to buy the excess. But it is the change in a country's trade surplus, not its absolute size, which matters for GDP growth. The increase in net exports (exports minus imports) has never been the main source of China's growth. It contributed two to three percentage points to annual GDP growth between 2005 and 2007, whereas domestic demand (consumption and investment) added eight to nine percentage points. But the latest figures show that exports have become even less important as a driver of growth. The World Bank's latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year to the fourth quarter of 2007 (see left-hand chart). Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points.
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The significance of all this is that although China's headline GDP growth is widely tipped to slow to 9-10% in 2008, if a bigger chunk of this growth comes from domestic consumption and investment, then in absolute dollar terms China could well contribute more to global demand this year than in 2007.
Dragonomics, a Beijing-based economics-research firm, forecasts that the contribution of net exports to GDP growth will actually fall to zero during 2008, but this will be partly offset by strong growth in investment and consumption. After growing by an average of $80 billion during each of the past three years, China's trade surplus is likely to remain more or less flat this year. Export growth fell from 28% in the year to the first quarter of 2007 to 22% by the fourth quarter because of weaker American demand and the impact of a stronger yuan.
Meanwhile import growth surged from 18% to 26% on the back of strong industrial and consumer demand. In other words, Chinese imports are now growing faster than exports. China's trade surplus widened by only 12% (in dollar terms) over the year to the fourth quarter, compared with an increase of almost 90% in the first half of last year. This was partly due to higher oil prices that increased the value of imports, but even in inflation-adjusted volume terms the surplus stopped growing in the latter part of last year.
Not only did more of China's growth come from domestic demand late last year, but there were also signs of a "rebalancing" of the economy from investment towards consumption. Using figures from China's National Bureau of Statistics, Mark Williams, an economist at Capital Economics, a London-based research firm, calculates that in 2007 consumption accounted for a bigger slice of GDP growth than investment for the first time in seven years. Government restraints on bank lending caused investment growth to slow slightly, whereas consumer spending picked up. The often-quoted monthly figures on fixed-asset investment still show annual growth of over 20%, but these figures are misleading. Measured on the same national-accounts basis as GDP, to exclude property and land sales, real investment rose by a more modest 11% in the year to the fourth quarter, less than the growth in real consumption.
China's consumer-spending data are notoriously murky. The annual rate of growth in retail sales has surged from 13% in early 2006 to 20% in December of last year (see right-hand chart). Some sceptics argue that this increase is mainly due to a rise in inflation. However, the consumer-price index is not the appropriate deflator because it gives a much higher weight to food (the main source of the recent surge in inflation) than the share of food in total retail sales. Frank Gong, an economist at JPMorgan, argues that using a more appropriate deflator, real spending has clearly accelerated, especially on household goods. One important stimulus is that last year real urban disposable income per head rose faster than GDP for the first time in five years. This should help to keep consumption growing rapidly in 2008.
A growth rate in China driven more by consumption than by exports and investment is exactly what the American government has been demanding for several years. Indeed, it might be hoped that if China's trade surplus stops expanding and consumer demand plays a bigger role in growth, international trade tensions should subside. The snag is that even if net exports were no longer contributing to China's growth, its trade surpluses with America and Europe would continue to loom embarrassingly large. And, says Mr Williams, as Chinese exporters move into higher-value products, they will become more of a threat to Western producers.
In 2008 China will probably suffer its first slowdown in growth for seven years. But strong domestic demand should mean that an American recession would not bring the Chinese economy to a screeching halt. Indeed, to the extent that the economy was starting to overheat, a slowdown will be welcomed by Chinese policymakers. And if almost all of the slowdown comes from net exports, while domestic spending remains robust, then the whole world can cheer, too.
Although it is too soon to tell whether the United States has entered a recession, there is mounting evidence that a recession has in fact begun. Key measures of economic activity stopped growing in December and January or actually began to decline. The collapse of house prices and the crisis in the credit markets continue to depress the real economy.
The sharp reduction in the federal funds interest rate and the new fiscal stimulus package may, of course, be enough to avert a downturn. Many forecasters still predict that the economy will just slow in the first part of this year and then rebound after the summer. But the hope that monetary and fiscal policies would prevent continued weakness by boosting consumer confidence was derailed by the recent report that consumer confidence in January collapsed to the lowest level since 1992.
If a recession does occur, it could last longer and be more painful than the past several downturns because of differences in its origin and character. The recessions that began in 1991 and 2001 lasted only eight months from the start of the downturn until the beginning of the recovery. Even the deeper recession of 1981 lasted only 16 months.
But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.
In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy.
The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.
But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.
The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.
The collapse of the credit markets began last summer when the subprime mortgage crisis demonstrated that financial risk of all types had been greatly underpriced, that the market prices of complex financial assets overstated their true values, and that the credit scores provided by rating agencies are not to be trusted. Because market participants now lack confidence in asset prices, they are unwilling to buy existing assets, thus preventing current asset owners from providing credit to new borrowers.
The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions, impeding the extension of credit to those institutions. And because financial institutions do not even have confidence in the value of their own capital and in the potential availability of liquidity, they are reluctant to make new lending commitments.
It is not clear what can bring back the confidence in asset prices that is needed for credit to flow again. Some analysts suggest that confidence would return if the financial institutions declare the true market value of their assets by restating balance sheets at the depressed prices at which they could be liquidated today. But this is not a practical solution, since many complex securities are no longer trading in the market. Forcing an actual sale of these securities at fire-sale prices in order to establish market values could also create unnecessary bankruptcies that would further impede credit flows.
The current situation has the elements of a Catch-22: The credit flows needed for economic expansion require confidence in the values of existing financial assets, but market participants may not have such confidence while the risk of recession hangs over us.
There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.
The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble.
The implication of this for Fed supervision policy is clear. The way out of the current crisis of confidence is not. We can only hope that those who predict nothing worse than a temporary slowdown are correct.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.
The specter of deleveraging still haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process that feeds on itself. That means that the credit crunch could easily turn into something much nastier.
Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.
While it was happening, only a few sourpusses complained. Increasing debt was seen as a natural trend. As economies get richer, they have more need for debt-financed investments and inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away. It was a bubble, which has now been popped.
In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car.
Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.
In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.
The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.
If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.
How far can this go? Historical parallels aren't terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 -- house prices dropped by 40%, after taking inflation into account, but share prices rose.
Politicians and central bankers are alarmed by the rapid shift to deleveraging. There are limits to what they can do. Sharp interest-rate cuts may not be enough to make banks abandon their newfound caution in lending, especially if loan losses are rising. Higher government deficits may not help either. In a deleveraging world, the government may borrow so much it crowds out private borrowers seeking funds.
The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.
As Wall Street firms hunger for dependable trading profits, an out-of-favor strategy is making a comeback.
Now that volatility has returned and interest rates are moving, some traders using a so-called global macro strategy are thriving. By betting on economic trends in currencies, interest rates and other instruments around the world, these traders have been scoring big gains.
![[Hedged Bet]](http://s.wsj.net/public/resources/images/MI-AP135_HOWARD_20080218193623.gif)
Last year, global macro funds rose more than 17% on average, according to Credit Suisse/Tremont Hedge Fund Index. These funds gained 1.7% on average in January, according to Hedge Fund Research, a Chicago-based research firm.
One of the funds with the biggest gains is Alan Howard's $20 billion Brevan Howard Asset Management LLP. The London-based fund racked up winnings of about 10% last month, even as many hedge funds sputtered and global stock markets tumbled. Mr. Howard's profits come on the heels of gains of 25% in 2007 for his firm's flagship hedge fund.
Other winners include GLG Partners Inc.'s macro fund, managed by Greg Coffey, which was up 51% last year, and Peter Thiel's Clarium Capital Management, which jumped more than 24% in January and more than 40% in 2007.
These kinds of funds can include a variety of styles -- and returns vary wildly. Paul Tudor Jones's Tudor Investment Corp., one of the largest and most respected macro funds, gained less than 1% in January, investors say, while Goldman Sachs Group Inc.'s Global Alpha fund has been struggling.
The bond market's volatility, falling interest rates and a steep yield curve in the U.S. -- or a difference in yields between short- and long-term debt -- is causing the "sort of environment that is very good for macro managers," says Gary Vaughan-Smith, a partner at London-based SilverStreet Capital LLP, which has about $700 million under management.
![[George Soros]](http://s.wsj.net/public/resources/images/HC-BZ289A_Soros_20051011151715.gif)
That is advantageous for someone like the 44-year-old Mr. Howard. His firm is blossoming, soaring from $12.5 billion at the beginning of 2007 to become one of the largest hedge funds in the world. Other macro-oriented hedge funds have become hot tickets, too, investors say. Popularized by billionaire investor George Soros, macro trading was widely practiced two decades ago. But its popularity waned as the global economies turned calm, rising in unison.
The macro strategy "seems to be the only thing that is performing in this current period of market upheaval," says Omar Kodmani, senior executive officer in London at Permal Group, a fund of hedge funds that is a unit of Baltimore investment company Legg Mason Inc. It is among investors that have been adding money to macro funds like Brevan Howard over the past year.
In recent years, Brevan Howard's annual gains weren't particularly extraordinary -- about 10.5% on average. But Brevin Howard specializes in short-term trades that generally profit as interest rates in developed nations fall, a stance that has helped lately. The fund also has profited from a series of currency investments. It does a bit of stock trading, too, in recent months sticking with consumer staples.
Brevan Howard steers clear of so-called credit wagers, or investments that depend on the improving or deteriorating quality of a company's credit, difficult terrain in the past year. Mr. Howard's traders work independently, judged on their performance. That strategy creates a competitive environment that rewards top performers, say people close to the firm.
As chief investment officer, as well as chief executive, Mr. Howard is responsible for 20% of the flagship fund's investment portfolio, as of October 2006, according to regulatory filings. Mr. Howard, who sits in the middle of the firm's trading room surveying his traders, contributes to Israeli and other charities, such as Holocaust education. He lives near several of his firm's senior partners in Hampstead, an affluent, leafy London neighborhood.
He received a master's degree in chemical engineering in 1986 from London's Imperial College of Science and Technology. Working as a trader for Credit Suisse, Mr. Howard itched to start his own hedge fund as the firm became more conservative under then-head John Mack. But he told an acquaintance that he wouldn't quit the bank unless he could raise $500 million to $1 billion.
He did exactly that, leaving Credit Suisse in 2002 and starting Brevan Howard with $870 million, increasing it to $1.2 billion in its first month. Brevan Howard now invests money for Credit Suisse and the bank acts as a broker for the fund.
Last spring, Mr. Howard raised about €770 million ($1.13 billion) from listing a fund called BH Macro on the London Stock Exchange, falling short of the €1 billion he had hoped to raise, as some investors weren't impressed, at the time, by the firm's returns. Proceeds of the listing were invested in the flagship Master Fund, which is otherwise closed to new investors.
Brevan Howard executives are upbeat that the recent big gains will continue, anticipating that interest rates in a number of countries will head even lower. In a recent shareholder letter, they said they expect the European Central Bank to hold rates steady, that the U.S. is likely to slip into a recession and that the economy of the United Kingdom will continue to slow.
The firm also expects the problems in the banking sector to continue and the "punishing recession" in residential investment to spill into other sectors, it says in the shareholder letter. "In short, [Brevan Howard] sees anemic growth in 2008 with downside risks," the letter adds.
Think about the Americans with sketchy credit backgrounds who depended on adjustable-rate mortgages to finance home purchases. Many thought they would refinance into fixed-rate mortgages if their adjustable rates reset much higher. Instead, their rates shot up and their banks wouldn't refinance. For many it suddenly becomes impossible to finance the most essential of long-term investments -- a home. Nearly 16% of risky, subprime mortgages with adjustable rates were at least 90 days delinquent as of Sept. 30, compared with 6% for subprime mortgages with fixed rates.
![[Chart]](http://s.wsj.net/public/resources/images/MI-AP157_AOT_20080218192024.gif)
Wall Street is getting trapped by short-term borrowing in different ways. Two prime examples from last year were investments known as asset-backed commercial paper and structured investment vehicles. In both cases, banks and their clients went to the short-term commercial-paper markets to raise money. They used the money to acquire long-term investments, such as mortgage debt, or to make long-term loans. When commercial-paper markets seized up, the short-term borrowing rates soured and the strategy imploded.
An old-fashioned bank run works the same way. Depositors put their money in a bank, understanding they can pull it out at a moment's notice. Banks use the money to make long-term loans to businesses or homeowners. When depositors get skittish and demand their money back, the bank has a problem: the funds are tied up for decades with customers. That is what happened to a British mortgage lender called Northern Rock last year. Now, the bank has been nationalized.
Something with similar contours is happening in the auction-rate-securities market. Municipalities, museums, student lenders and others issue these securities, which have interest rates that reset every week to 35 days. They use the money to finance projects or make student loans with long repayment periods. Investors have fled the market, and the municipalities that issue the notes have had to digest soaring interest costs.
There is nothing new about any of this. It was an ingredient in the financial crises that plagued emerging markets in the 1990s. Countries that depended on short-term debt got squeezed when investors became skittish about the miracle stories of emerging-market growth. The savings-and-loan crisis of the 1980s had its roots in a mismatch between the maturities of thrifts' long-term assets and their short-term liabilities.
The U.S. government does the same thing. Much of its debt rolls over within a few months or years, even though its obligations to retirees look out as far as the eye can see.
Borrowing short term works most of the time. In the past 26 years, yields on three-month Treasury bills have been higher than yields on 10-year Treasury notes in only 22 months out of 313, or about 7% of the time.
The trouble is even the most sophisticated bankers have very short-term memories. Because when the strategy doesn't work, the consequences can be dire.
As we debate interest rates, fiscal stimulus and all that, I thought it might be worth backing up to think about what our macroeconomic problem is right now.
Basically, I'd say, the problem is twofold. First, in the mid-00s the U.S. economy got badly unbalanced — too much dependence on housing and housing-inflated consumer spending, too big a trade deficit. This figure shows "deviations" in share of GDP — it's the difference, in percentage points of GDP, between 2007 and average 1980-2000 spending on consumption (C), nonresidential investment (NR), residential investment (R), and net exports (NX). Notice that even with the housing collapse in progress, residential investment was still running a bit high — this year it will surely be well below "normal." But the main thing at this point is high consumption offset by a high trade deficit.
Second, in the process we also got a credit bubble that's now bursting, and threatening to take down spending that wasn't all that high to begin with — like business investment.
What we want, and will eventually get, is a rebalancing: smaller trade deficits, consumer spending more in line with income, more normal housing spending. The trouble is in getting there. At the moment it seems likely that consumption and housing investment will fall faster than net exports can rise — probably with additional downward pressure from at least some types of business investment, especially commercial real estate. The result will be a recession or at least something that feels like one.
The goal of monetary and fiscal policy should be to bridge the gap — to sustain spending until a falling trade deficit comes to the rescue, and to hasten the rise in net exports (remember, in the current context a weak dollar is good.)
A comparison of two house-price indices: OFHEO and Case-Shiller.
Predicting how much worse the U.S. housing market will get is tough. The future is never certain. But when it comes to home prices, getting a clear picture of the recent past turns out to be surprisingly hard as well.
That's confusing to homeowners, who fret about the value of what for many is their single largest asset. There is a huge psychological difference between a slower climb in the value of one's house and an outright decline -- and, as a result, a difference in the political reaction.
Tracking home prices is harder than tracking the price of stocks, which are traded constantly in public view on exchanges. And it's harder than tracking the price of toothpaste. That just involves sampling posted prices on grocery-store shelves and Web sites.
![[Robert Shiller]](http://s.wsj.net/public/resources/images/HC-DW830_Shille_20051025002842.gif)
The two best -- though far from perfect -- measures of housing prices are the Office of Federal Housing Enterprise Oversight's index and the gloomier Standard & Poor's Case/Shiller index. Both are based on a concept, developed in the 1980s by Karl Case of Wellesley College and Robert Shiller of Yale University, that looks at repeat sales of the same houses.
Ofheo's index says home prices rose nationally by 1.8% between the third quarters of 2006 and 2007. But the S&P/Case-Shiller national index of home prices was down 4.5% in the same period. The Ofheo index showed a 2.16% increase in house prices in Chicago; the Case-Shiller index showed a decline of 2.48%.
Those discrepancies persist even though both barometers avoid distortions that occur in other widely cited measures -- such as the National Association of Realtors' median home price -- that reflect the mix of homes actually sold in a given month as well as the change in prices. Such measures rise in months when a lot of high-end houses are sold and fall at times when a lot of low-end houses are sold.
![[Charles Calomiris]](http://s.wsj.net/public/resources/images/HC-FM401_Calomi_20051017141644.gif)
The Realtors' measure fell 6% in 2007. The group says the index was pulled down by a drop in the number of high-end home sales, which have been hurt by disruptions in the market for mortgages exceeding $417,000, the maximum mortgage giants Fannie Mae and Freddie Mac are allowed to guarantee.
The big picture here is clear: House prices rose rapidly in the early years of this decade. They have stopped rising in many places. And, in many markets, they are now falling. (Even Ofheo's index showed a quarterly decline at the end of 2007.) And prices don't appear to have touched bottom yet. But Charles Calomiris, a Columbia University economist, says, "Too much weight is being attached to the Case-Shiller index. ... Housing prices may not be falling as much as some economists say they are."
With house prices so central to the economy right now, there is intense public (as well as scholarly) interest in why these two carefully constructed measures differ.
Ofheo gets a steady stream of inquiries from ordinary homeowners trying to figure out what's happening to the price of their houses, and offers an online calculator to make estimates. Ofheo's quarterly numbers -- to be released monthly beginning in March -- go into the Federal Reserve's estimates of household wealth. Case/Shiller is increasingly prominent and is the basis for future contracts that allow investors to bet on the price of houses.
There are a couple of very big differences. The Ofheo index relies on data collected by Fannie Mae and Freddie Mac, which Ofheo regulates, so it excludes loans too big for Fannie and Freddie to guarantee (those exceeding $417,000) or too shaky (the riskiest of the subprime). Case/Shiller includes those, but its data are limited to 100 major markets because it relies on the costly process of going to local property records for data. One of Mr. Calomiris's complaints is that house prices in these markets may be doing worse than those in other places.
![[chart]](http://s.wsj.net/public/resources/images/NA-AP420_Capita_20080213200415.gif)
But puzzles remain. It turns out, for instance, that prices of low- and moderate-priced homes with mortgages that aren't guaranteed by Fannie and Freddie are falling particularly sharply, buoying the Ofheo index -- even though that index includes plenty of other of low- and moderately priced homes in the same neighborhoods.
Of course, by the time the experts get the measures perfected, we'll be onto a bubble in some other asset market.
Corrections & Amplifications:
In addition to its widely followed 20-city survey of home prices, S&P/Case-Shiller publishes a national home price index based on data from more than 100 metropolitan areas. The original version of this column incorrectly said the data is limited to 20 major markets.
Shares of Chinese property companies are coming down to earth a lot faster than the prices of the apartments they are selling. Somewhere in there may be a buying opportunity.
The Chinese government's measures to rein in the overheating sector are starting to work. Big cities across China have begun to see declines in sales volumes and even prices for residential properties, after a four-year run of steady, mostly uniform price increases. Many Chinese property developers have seen their Hong Kong-listed shares fall more than 40% since the start of November, outstripping declines of 26% on the broader Hang Seng Index.
![[Real Estate Stocks]](http://s.wsj.net/public/resources/images/MI-AP096_WSTOX_20080213193634.gif)
Analysts say the sharp declines have brought these companies' valuations back down to reasonable levels, making the sector ripe for cautious bargain-hunting. Brokers and analysts in the physical-property market remain optimistic about the overall China property story, pointing to rising wages and waves of mass migration to the country's booming cities, trends unlikely to abate for years.
Those who watch these stocks, like Clifford Lam at Credit Suisse in Hong Kong, are also keeping a positive "overweight" rating on the sector -- though he bluntly titled a recent report "Don't Get Too Excited."
One reason for the cautious optimism: The recent success of Beijing's aggressive tightening measures may mean central authorities will hold off on initiatives to curb lending or hold back developers. "We see a very small probability of overtightening in 2008," Tony Tsang, an analyst at Citi Investment Research in Hong Kong, wrote on Jan. 31.
Another positive may be rising inflation, a major concern of authorities and consumers. Current levels could drive more people to buy property as a hedge.
Developers active in the Shanghai area are particularly attractive to analysts, given the robust demand fundamentals there. So are developers with strong balance sheets and access to alternative sources of financing, as equity markets are likely to keep facing head winds this year. Many developers issued shares and debt in recent years to fund aggressive land acquisition, which in turn propped up share prices.
"Much of the rise has been fueled by a virtuous circle of rising residential prices, land prices and equity prices," Robert Fong, an analyst with Merrill Lynch in Hong Kong, wrote late last month. "For a while, it seemed all that developers needed to do was to keep buying more land to fuel a seemingly endless surge in equity prices."
Now, it is a question of which developers will be able to sell their flats and keep cash flowing in. Those with fat wallets will gain even more of an edge in a year that many expect will see a wave of mergers and acquisitions. Conversely, weaker developers could become takeover targets as big players scour for sources of land to develop at low costs.
Two Hong Kong-listed developers that are well capitalized are China Overseas Land & Investment and China Resources Land. Analysts say both are light on debt and should have good sales in 2008. And Shanghai Forte Land is seen as well positioned in its home city. For the three developers, share prices dropped about 40% or more between Nov. 1 and Jan. 22, though all the stocks except Shanghai Forte have since regained some ground.
Analysts say it is generally best to avoid problem areas in southern China, where the Shenzhen and Guangzhou property markets have shown the most serious signs of cooling, even as nearby Hong Kong enjoys high growth. In recent years, prices rose dramatically in the two mainland cities, which depend on retaining big industrial bases.
"The growth there is not very sustainable, and going forward, demand growth for property won't be as aggressive," says Yi Chen, a property analyst for ABN Amro in Hong Kong, who notes that new-home sales in Shenzhen have slowed to fewer than 20 units a day from 200 units not long ago. Home prices dropped about 8% in Shenzhen between September and the end of 2007, while prices in Guangzhou in November fell 9.9% from a month earlier, government figures show.
That is one reason Mr. Chen, who lists China Overseas Land and Shanghai Forte as his strongest recommendations, has a "sell" rating on Guangzhou R&F Properties, a developer with a big presence in both cities. From a Nov. 1 peak of HK$43.40 (US$5.56), its stock tumbled 55% by Jan. 22, to HK$19.22, before recovering a bit. Yesterday, it closed at HK$22.80.
Mr. Tsang of Citi doesn't share the pessimism, arguing that Guangzhou R&F could soon reach its goal of listing on Shanghai's exchange, a move that should boost investor interest in the company.
Still, in general, southern China's weakness reinforces the appeal of the Yangtze River delta, home to Shanghai and second-tier cities Nanjing, Hangzhou and Suzhou. Demand and price growth have been relatively restrained there for several years and only started to take off last year. Property broker Jones Lang LaSalle, suggesting fundamentals in Nanjing are still healthy, notes that land auctions in the provincial capital set records four times in 2007.
Joe Zhang, chief operating officer of Shenzhen Investment, a Hong Kong-listed developer with a major presence in Shenzhen, said recently he remains bullish on that city despite what he estimates is a 20% correction there since September.
Still, his company is hedging its bets, receiving HK$1.2 billion from sales of land and property in Shenzhen and adding exposure in the eastern Yangtze River delta provinces of Jiangsu and Anhui. That could help Shenzhen Investment shore up its battered shares, which fell 55% between Nov. 1 and Jan. 22. The stock closed yesterday at HK$4.19, or 45% below its Nov. 1 level of HK$7.66.
It hasn't, but the 25-year-old marketing assistant recently bought the place anyway. That's because two weeks ago and half a world away, the U.S. Federal Reserve cut interest rates again, hoping to stimulate an economy dragged down by a housing sector in disarray. Since Hong Kong pegs its dollar to the U.S. currency, it followed the Fed's lead, knocking the city's base rate down twice in less than two weeks for a total of 1.25 percentage points.
![[Hong Kongs central district]](http://s.wsj.net/public/resources/images/AI-AN182_HKPROP_20080212135602.jpg) |
| A picture taken from the roof of Two International Finance Centre, Hong Kong's tallest building, shows the city's Central district. |
The unintended result: home-loan rates so cheap that they are throwing more fuel on an already scalding property market.
A typical mortgage here -- which is pegged to the prime rate which, in turn, is tied to the base rate -- now carries interest of about 3.1%. But compared with Hong Kong's inflation rate of about 3.8%, which is hovering at a more-than-nine-year high, that looks especially inviting, creating a so-called negative real interest rate.
For many potential home buyers in Hong Kong, mortgage payments are now effectively cheaper than rents, which are slower to adjust to rate changes. Indeed, within hours of the Fed's latest rate cut, Ms. Lau was on the phone with the owner of the apartment in the Kowloon district of Hong Kong and signed the contract to buy it that night. She says she plans to rent the flat out to tenants for two years to make money on the mortgage/rent spread and then may move in herself.
Real interest rates have been in negative territory before here in China's international-finance hub. During the early 1990s, cheap home loans helped inflate a property bubble that hit records before bursting, with devastating effect, during the Asian financial crisis of 1997-1998. Prices have only now begun to touch those levels again, and further gains could be in the cards.
Andrew Fung, head of investment and insurance for Hang Seng Bank in Hong Kong, calls the property market here one of two "certain investments" -- along with the appreciation of China's currency, the yuan -- in an uncertain economic environment. Underlying the property-buying enthusiasm: fast-rising wage increases, unemployment near its record low and bank deposits growing at about 20% a year.
Then there's the weakness of Hong Kong's dollar, which is tracking the U.S. dollar's decline. Mr. Fung credits the cheap currency with making properties even more attractive to foreign private-equity funds.
![[Hong Kong property charts]](http://s.wsj.net/public/resources/images/AI-AN177_HKPROP_20080212130012.gif)
"A couple of years ago, lots of funds were pouring their money into Singapore's residential market, and now we're seeing them buying in Hong Kong," says Keith Yeung, a senior director and head of greater China property for Merrill Lynch in Hong Kong. Also pushing up the market, Mr. Yeung says, are speculators from mainland China looking for new places to put their money.
Finally, new supply is tighter than ever before. According to property broker CB Richard Ellis, home prices in 2008 will rise another 20% or so in both the luxury and mass markets. The number of new units in the luxury residential market fell to 70 in 2007 from 1,055 units in 2005. In the mass residential market, new supply fell 44% in 2007 from the year before to more than 8,700 units.
That tight supply has helped push prices for luxury properties up 38% in the past year alone, with fresh reports of eye-popping transactions grabbing headlines every few months last year. In November, one 7,000-square-foot penthouse apartment fetched $36 million, or about $5,140 a square foot. A few months earlier, a luxury house on Hong Kong's Victoria Peak sold for $27 million, or about $5,270 a square foot. Prices in the mass market, which is comprised of the nonluxury properties, grew quickly as well in 2007, though at a more modest rate of 14% -- a sign, analysts say, that even more growth lies ahead.
Now, with inflation eating away at bank-deposit returns and volatility hitting the stock market, interest rates are giving Hong Kong residents another incentive for putting their cash into real estate, a classic hedge against inflation.
"With so many favorable factors in place, the housing sector is likely to heat up further," says Gordon Tse, corporate-development director at Midland Realty in Hong Kong, a big local brokerage firm. But, he adds, "exactly how hot it will get is difficult to predict."
Does that mean a bubble is in the offing?
![[Hong Kong home prices chart]](http://s.wsj.net/public/resources/images/AI-AN180_HKPROP_20080212135614.gif)
Analysts are urging home buyers to be cautious since interest rates could continue to fall. A bubble is "absolutely possible," says Nicholas Kwan, regional head of research for Standard Chartered Bank here. If rates drop even more sharply in 2008, which Mr. Kwan says is possible, the market could at some point begin to overheat. "But it's so hard to say where that point is," he says.
The average price of mass-residential apartments in Hong Kong rose 10.3% to roughly $593 a square foot in December from about $537 a square foot in June, according to CBRE Research in Hong Kong.
Much also will depend on where inflation and interest rates are in relation to each other. While most analysts see inflation staying high in China for some time, pushed up by more expensive commodities, interest-rate movements are going to be decided, for the most part, in the U.S. That, in turn, will depend on the condition of the U.S. economy, a broader and more important variable than interest rates alone.
"Negative real interest rates is a plus, but it's not everything," says Steve Chow, a corporate credit analyst at ING Wholesale Banking who covers the property sector. The "economic outlook is equally important for potential buyers, since buying an apartment is a major decision in many people's lives." And lately, the global economic outlook is looking wobbly, he adds.
Some Hong Kong market watchers point out that interest-rate cuts had long been expected here and that the lessons of the 1990s bubble are still seared in the city's collective memory, serving to temper further excesses.
Also, property owners are generally far less leveraged than they were a decade ago, with mortgage payments currently accounting for an average of 35% of disposable income, compared with an average of 92% in the 1990s, according to Oscar Leung, a senior investment manager at ING Investment Management in Hong Kong. Back then, cheap home loans were also accompanied by ample new supply in the market, a far cry from today's slow trickle of newly constructed apartments.
"This is a healthier market," Mr. Leung says.
The current weakening of the labor market reflects a slowdown in hiring -- not the mass layoffs that have characterized past economic downturns.
The Labor Department said there were 1.8 million layoffs in December, about the same number as in December 2006 -- despite the mounting turmoil in the meantime in the housing, mortgage and finance markets.
Andrew Tilton, senior economist at Goldman Sachs Group, said the absence of large-scale layoffs partly reflects companies' uncertainty about the economic environment and their determination, at least for now, to hang on to their skilled workers.
![[chart]](http://s.wsj.net/public/resources/images/NA-AP410_ECONOM_20080212183651.gif)
"It's really in finance and housing -- and to some extent retail -- where the pain is being felt most clearly," he said. "Many other sectors aren't feeling pressure [yet] to lay off workers [and] are hesitant to let them go if they'll need them back soon," should the economy recover, Mr. Tilton said.
Still, job creation is lagging. Most economists say 100,000 to 150,000 jobs need to be created each month to sustain economic growth. Since July, just 68,000 jobs on average have been created each month. In January, the economy lost 18,000 jobs, the first employment drop in 4½ years.
Still, that didn't come close to the job losses of past recessions -- which typically have run 100,000 to 200,000 a month. And that has some economists scratching their heads.
"It would be odd to have a recession in an environment where there's not a lot of layoffs," said J.P. Morgan Chase economist Michael Feroli. "We're hanging in this no-man's land between recession and growth."
In the meantime, companies have hit the brakes on hiring new workers. The new government figures show there were 4.6 million new non-farm hires in December, after seasonal adjustment, down from a recent peak of 5.1 million in July 2006. There were just over four million job openings in December, down from 4.4 million the year before.
Goldman's Mr. Tilton said "underemployment" may be part of the puzzle. Workers like contractors and real-estate agents may still be employed but earning much less money now than they were at the height of the housing boom. That dynamic isn't captured in the statistics, but could help explain why consumer confidence is sinking and spending is slowing.
By Kenneth Rogoff
Given the highly vulnerable state of the US and European economies, what would happen to global growth if the Chinese juggernaut also started sputtering? Few investors or policymakers seem to be seriously contemplating this scenario.
China's remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging.
True, reality has consistently flattened China forecasters who are anything less than ebullient. With 11.4 per cent growth in 2007 and the Olympics coming up this summer, why should 2008 be different? With all due respect to the extraordinary recent performance of China's managers, the country faces economic, financial, social and political landmines just like any other emerging market, with epic environmental problems to boot. And, throughout history, no emerging market has escaped bouts of crisis indefinitely.
Inflation of more than 6 per cent is the immediate problem. Those who think inflation is caused by too little pork rather than too much money are wrong. China's relatively pegged exchange rate system has led the authorities to flood the economy with renminbi. Rampant money supply growth is the flipside of the country's $1,400bn accumulation of foreign currency reserves. The real surprise is that inflation did not sprout earlier.
The authorities must stuff the inflation genie back in the bottle. It is not going to be easy in an economy where highly controlled financial markets render normal instruments of monetary control relatively ineffective.
Until now, China has avoided this problem, as millions of idle farm workers moved to the cities, keeping wages in check. But as many of the most able workers have already migrated, the challenge of filling China's burgeoning factories is intensifying.
Protectionism is another growing risk. With income and wealth inequality rising throughout the developed world, politicians may start lashing out at China with trade sanctions on automobile parts, steel, paper products and, of course, textiles. China's explosive export growth has made it far more vulnerable to a fall in exports than it was during the 2001 global recession.
Perhaps the greatest threat to China's expansion, however, comes from pressures created by its own exploding inequality levels. According to World Bank statistics, income inequality in China has leapfrogged that of the US and Russia, which is no small feat. Rising inequality is placing enormous strains on the political system, as is evident from a recent sequence of ill-considered policies that have been aimed at mitigating the problem. The government's recent attempt to fight food inflation by using price controls is a highly conspicuous example.
But so, too, is the dubious new labour law which, at least on paper, prevents companies from firing workers with 10 years or more experience. It is as if China hopes to transform itself into France. Indeed, the greatest danger to China's economy is that, after years of market-oriented reform, the country's leadership seems to be losing faith in markets and adopting policies such as rationing that turn back the clock to old-style communist days. With rising inflation, bloated investment and a soft global economy, now is hardly the time for China to make its system more inflexible. Historically, emerging markets get into trouble when policy reform is moving backwards at the same time as an economic or financial crisis is starting to unfold. Rather than try to deal with inequality by labour market fiat, the government would do better to improve the social safety net through provision of more and better healthcare and pensions.
Rather than deal with inflation through price caps, China should accelerate exchange-rate appreciation, thereby reining in money growth. If China were to slow dramatically, while growth in Europe and the US was still weak, recent low global interest rates, high commodity prices and strong global growth would be history. Global policymakers and investors who are losing sleep over US growth ought to pay more attention to rising risks coming from the other side of the globe.
China's state-owned investment fund is in advanced discussions to invest $3 billion to $4 billion in a new fund being started by J.C. Flowers & Co., the private-equity firm that has made a name for itself investing in distressed financial institutions, according to a person familiar with the matter.
A potential investment by China Investment Corp., which has $200 billion in assets, would be the latest sign that the newly formed government investment fund hasn't been deterred by the criticism it faced from investing in another buyout firm, Blackstone Group LP. CIC took a $3 billion stake in Blackstone last year right before the U.S. company's initial public offering, only to see its investment decline sharply in value when Blackstone's stock dropped as the buyout business fizzled. Then in December, CIC invested $5 billion in Morgan Stanley for a nearly 10% stake in the New York investment bank.
In an interview with The Wall Street Journal last week, Lou Jiwei, chairman of CIC and former vice minister of finance for China, said the state investment fund was looking to invest in "portfolios" of companies, rather than individual firms.
An investment in a fund managed by J.C. Flowers would fit that criteria. The U.S. firm, run by former Goldman Sachs banker J. Christopher Flowers, specializes in buying financial companies. His firm made headlines recently for backing out of buying student-loan provider SLM Corp., better known as Sallie Mae, for $25 billion. By investing in a new fund being formed by Flowers, CIC would be able to indirectly invest in different companies and also inoculate itself from any political backlash that could arise from investing directly in iconic American companies.
A spokeswoman for CIC said she was unaware of any discussions. J.C. Flowers couldn't be reached for comment.
The discussions between J.C. Flowers and CIC were earlier reported by the Financial Times on its Web site.
CIC was formally established in September to earn better returns on China's huge pile of foreign exchange reserves, which now total more than $1.5 trillion. That money had traditionally been invested in low-yield investments like U.S. Treasurys. Two thirds of CIC's initial $200 billion in capital has already been committed to investments in China's own financial sector.
Although the fund made waves with its investments in Blackstone and Morgan Stanley, its managers have said that they intend to allot the bulk of the money it has for international investments to professional fund managers. CIC said last month it had received more than 130 applications from money managers to help it with equity investors. It has set a deadline of next week for applications from managers to handle international fixed-income investments.
TOKYO -- Japan's economy is so dependent on exports that the whole nation traditionally frets when anything threatens its overseas markets. Now, though, with the world economy under threat from a U.S. slowdown, Japan is less worried. That is because of the exceptional speed with which Japanese manufacturers have tapped into China.
If Japan does go into recession soon, many economists say, it will be because of serious domestic weaknesses rather than export dependency.
![[Safety Net]](http://s.wsj.net/public/resources/images/NA-AP328_JEXPOR_20080204193215.gif)
For a long time, the U.S. was Japan's biggest export market, and Japanese businesses are concerned about the possibility of a recession in the U.S. A one-percentage-point decline in U.S. personal consumption would, according to Goldman Sachs, lower Japan's GDP growth by 0.27 percentage point.
But the share of Japan's exports going to the U.S. fell to 20% in 2007, from 30% in 2001. Last year, China (including Hong Kong) overtook the U.S. as Japan's biggest export market.
Japan is the only G-7 nation to run a trade surplus with China, as it supplies industrial equipment and parts. China imports more from Japan than anywhere else, more than from the European Union and nearly twice as much as from the U.S. That means if China and other major export markets for Japan can avoid a major impact from a possible U.S. recession, Japan would be less vulnerable to a U.S. slowdown than would be the EU and developing economies, which tend to be far more exposed to the U.S.
"Japan's economy has developed some resistance to weaker economic conditions in the U.S.," Merrill Lynch economist Takuji Okubo said.
Japan still has big economic problems of its own making, from an uncompetitive service sector to a declining work force. Wages are stagnant because of long-term job shedding by major corporations and a shift toward lower-cost, part-time workers. Last year, after the government suddenly tightened regulations on buildings' earthquake resistance, house building declined sharply.
That cut into growth in the July-September quarter, when annualized growth was 1.5%, and it could have done so again last quarter, which economists expect to have been not much better. Goldman Sachs, in one of the more pessimistic assessments so far, has said that Japan might already have entered a recession.
However, it was referring to the Japanese government definition, which is based merely on a downturn in certain indicators, and does not require two quarters of contraction, the most commonly used definition in the U.S. The consensus view is for meager growth of some 1.5% in 2008.
The question now is just how vulnerable Japan's exports are to a U.S. slowdown.
Some of the components and materials Japan sends to the rest of Asia go into products that are later exported to the U.S., and some Japanese machinery and building equipment goes into factories that make these products. Manufacturers' output is expected to fall 0.4% in January and 2.2% in February, the government announced last week. Partly because of such "triangular trade," exporters have been hit particularly hard on the Tokyo stock market, whose key index is down 9% this year.
"A lot of Japanese exports to Asia are indirect exports to America," said Takashi Omori, economist at UBS Securities Japan. "The impact of the U.S. economy hasn't declined....Recession in the U.S. would lead to a lower forecast in Japan." Mr. Omori doesn't think Japan will go into recession.
But many of Japan's exports stay in China to be used in products such as auto parts and building materials, where the final demand is from the Chinese consumer or government infrastructure projects. Such exports, however, could be ultimately dependent on Chinese exports to the U.S. Even though most Japanese auto parts that go to China tend to stay there, some of the people who buy cars in China might be able to afford them just because they are earning money from exports to the U.S.
This kind of effect means economists find it impossible to figure out exactly how much of Japan's exports rely indirectly on American consumers.
Some economists point to evidence that such impact is far less than in the past. Macquarie Securities economist Richard Jerram says U.S. world-wide import growth has slowed sharply over the past half year but Japan's total exports still have been growing strongly. Exports to China and other destinations will likely continue to contribute to Japanese growth, Mr. Jerram said, "giving hope that the slowdown over the next six months might not be too severe."
China's economy has expanded by more than 11% for the past two years. Any hiccup in Chinese growth would affect Japan. So, too, could exchange rates. The Chinese yuan is pegged to the dollar, and the Japanese yen's recent rise (to 14.86 yen to the yuan from last year's low of 16.28 on June 23) makes Japanese products less competitive and diminishes the value of Japanese export revenue when it is repatriated to Japan. However, if China lets the yuan rise, that would make Japanese exports more competitive and lucrative.
