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apputtu no 1

Recycling Dollars ...

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Hi All,

I found this article below in the economic times, an indian newspaper. Please note that there is a huge stock / housing boom (or is it another bubble) going on there. Bombay stock exchange sensex is > 9000 and people say it will go beyond 10000 points. Similarly apartments in places like chennai, bangalore etc are scaling about Rs.40 lakhs (Rs.4 Million) or so. Could this article explain the reason? The writer is not clear in his thought process in some places but still good enough to stir a thought.

Here it is: Please review it:

Recycling dollars on a treadmill


[ WEDNESDAY, DECEMBER 21, 2005 12:10:24 AM]

An astonishing global recycling of dollars is occurring. Asian

countries, faced with a huge inflow of dollars, are recycling these

dollars out by buying US treasury bonds. But foreign institutional

investors (FIIs) are recycling those dollars right back into Asian

equity markets. The net result is that Asian countries are becoming

ever-bigger owners of US treasuries, while foreign portfolio investors

are becoming ever-bigger owners of Asian equities. Both trends spell


Asian ownership of US treasuries is still a tiny fraction of the total.

But foreign institutional investors (FIIs) are rapidly becoming majority

shareholders in top companies across Asia. This has the potential to

create a serious nationalist backlash. Possibly three-quarters of the

fast-rising forex reserves of Asian countries are held in dollars.

China has $769 billion of forex reserves, Taiwan $252 billion, Korea

$207 billion, India $138 billion, Hong Kong $122 billion, others have

billions more. But these add up to only a small fraction of total

outstanding US treasuries of over $8 trillion.

By contrast, FIIs own majority stakes in top companies across Asia. They

own 50-74% of Infosys, Satyam Computers, ICICI Bank, HDFC Bank and many

others. Brokers say loosely that FIIs now own the sensex, but that is

not quite true: many Indian promoters have majority stakes. But foreign

ownership is rising daily. In South Korea, an estimated 60% of the

shares of top companies are now owned by FIIs (including 64% of Samsung

and 70% of POSCO). FII ownership is rising fast in other emerging

markets too.

After being burned by the Asian financial crisis, Asian countries have

run large current account surpluses. This, combined with inflows of

foreign direct and portfolio investment, means that dollars have flooded

in unprecedented amounts into Asia. If unchecked, this would have caused

Asian currencies to appreciate, and dented their export prospects. To

prevent this, the RBI and other Asian central banks have bought billions

of dollars from the market and parked them abroad in western treasury


Central banks are non-commercial: their mandate is to minimise risk, not

maximise returns. So they invest only in the safest international

instruments (bonds of rich-country governments) regardless of low

yields. Massive Asian buying has driven down 10-year treasury yields in

the US to 4.5%, barely above the current inflation rate, and barely

above the short-term rate of 4.25%.

Asian central bank buying has driven long-term yields down to

non-commercial levels. Wall Street managers may get fired for poor

returns, but no central banker ever got fired for buying US treasuries,

no matter how low the yield. But this has had commercial consequences.

Asian central banks have crowded western investors out of western bond


Western investors have switched billions out of US treasuries into

alternatives, such as equities, derivatives and junk bonds. The switched

billions have already made US equities and corporate bonds look

overvalued. So, many western investors are heading for emerging markets,

from Latin America to Asia.

India alone looks like receiving $10 billion in 2005, on top of $8.5

million the previous year. The RBI is trying to recycle the dollar

inflow out of the country. Alas, foreign investors are recycling the

dollars right back into India. This is recycling on a treadmill.

What are the consequences? First, there is a huge deadweight loss:

recycling entails significant transactions costs. Second, the RBI aim of

a safe haven for forex reserves is jeopardised. The inexorable rise of

US foreign debt increases the risk of a dollar collapse, which in turn

will mean a collapse of Asian forex reserves held in “safe” US


If the US tries to check the dollar’s fall by raising interest rates,

that will depress treasury prices, leaving Asian central banks with huge

losses regardless. Third, I believe that recycling means huge losses for

Asian countries and huge gains for FIIs, since the return on US

treasuries will be far less than the return on Asian equities.

Some marketmen will disagree; past booms in emerging markets have ended

in tears. But I would argue that the current recycling is a new

phenomenon, and that Asian economies today are infinitely safer than

they were in the past. Certainly the actual experience in the last two

years is that FIIs have made a fortune in emerging markets, while Asian

central banks have obtained low returns on forex reserves.

Fourth, there are sterilisation losses. When the RBI buys dollars, it

releases additional rupees into the markets that could cause inflation.

To prevent this, it mops up excess rupees by selling Indian treasuries

(technically called sterilisation). But the Indian treasuries that it

sells have a higher yield than the dollar securities it later buys, so

it suffers a huge loss.

Fifth, foreign ownership of Asian companies is rising fast. I have

argued in the past that this is a favourable trend: FIIs have catalysed

major stock reforms that have greatly improved transparency and

shareholder value. But beyond a limit, foreign acquisitions will cause a

nationalist backlash.

Some of this is familiar ground to those who have debated exchange rate

policy over the years. But the debate needs to take note of a new

factor: outward recycling by the RBI is being foiled by inward recycling

by FIIs. I earlier called this recycling on a treadmill, but that is not

quite the case. A treadmill represents a status quo, but the current

recycling means that Asians own ever more US treasuries, and FIIs own

ever more Asian equities.

Had the pace of this change been modest, it would have signified healthy

global integration. But at the galloping pace we see today, there is

danger. What will happen if the recycling stops even temporarily? The

lack of Asian money will send US bonds crashing, and the lack of FII

inflows will send Asian markets crashing. Gird your loins, ladies and

gentlemen, for turbulent days ahead.

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