On Nouriel Roubini's Global EconoMonitor, Nouriel provides detailed analysis on how the weakness of the dollar along with near-zero interest rates and quantitative easing are fueling a correlated bubble across global asset classes, which is getting bigger by the day.  Nouriel provides a number of reasons for why and how these carry trades can unravel and cautions policy makers that the bigger the bubble the bigger the crash.  Please read Mother of all Carry Trades Faces an Inevitable Bust.

Don’t miss Nouriel’s CNBC Interview Discussing Carry Trades and Asset Bubbles.

On the RGE Analyst’s EconoMonitor, Arpitha Bykere and Elisa Parisi-Capone analyze the administration’s policies on regulatory reform, housing sector programs and fiscal stimulus. They also highlight the challenges for President Obama going forward, including addressing the fiscal deficit and entitlement burden and passing the healthcare legislation.   Please read One Year after Obama’s Election: Regulatory and Fiscal Challenges.

In Too-Big-To-Fail: Regulatory Reforms of Systemically Important Institutions, Elisa Parisi-Capone considers the initiatives currently on the table to deal with the too-big-to-fail problem. The options range from break-up—which is the one favored by Nouriel Roubini—to stricter regulation and setting the right incentives. While the debate goes on among regulators and academics, the European Competition authority has taken action and ordered the divestment of significant parts of ING, RBS and Lloyds since their bailout packages were deemed to have given them an unfair advantage under State Aid rules.

In Nigerian Oil: Delta Ceasefire, Political Bottlenecks, Lee Hudson Teslik examines what the Delta peace initiative and Nigeria’s push for oil industry regulatory reform will mean for Nigerian output and for international oil companies operating in the country.

On the Finance & Markets Monitor, Rick Bookstaber debates whether innovation promotes economic growth and considers the impact of financial innovation over the past 10-15 years arguing that “just because we are able to take some cash flow and turn it into an instrument doesn’t mean we should.”  Please read Does Financial Innovation Promote Economic Growth?

In Please, Listen to the Lady! Daniel Alpert notes that Sheila Bair, Chairwoman of the FDIC, continues to prove that she has the best interest of the country and the banking system at heart as she advocates for important reforms like funding the proposed resolution fund during fat times.

In How Goldman Bet on a Housing Crash, Barry Ritholtz points out the obvious conflicts of interest in the practice of financial companies that decide to market a financial product, which they consider to be a loser, to unsuspecting customers without sharing their real opinion of the product.  But is it criminal?

Also on the Finance & Markets Monitor:

The Cruel Basic Mathethematics of Losses by Barry Ritholtz

Uh-Oh: Economists Say Recovery, Market Gains Solid by Barry Ritholtz

Wood Warns of Correction, Says “Key Variable in the West is Government Policy” by Edward Harrison

The Return of Mixed Results by James Picerno

On the Peterson Institute for International Economics Monitor, Michael Mussa, a former student and professor at the University of Chicago, sits down with Steve Weisman and assesses the influence - for good and for ill – of economics as espoused at the University of Chicago.  Please read Is the “Chicago School” to Blame in the Economic Crisis?

In Latvia, Lithuania, and the IMF, Anders Aslund compares how the financial crisis has been handled by these countries, which appear to be facing very similar conundrums.

On the Global Macro EconoMonitor, Mark Thoma presents a piece by Mikhail Gorbachev who claims that the global crisis was necessary to recognize the organic defects of the present model of western development, which he believes was imposed on the rest of the world as the only one possible, and pushes for drastic democratic reform.  Thoma adds that the failure of the market-based development model as well as the success of countries with different development models like China has undermined the faith in traditional market-based development strategies.  See The Berlin Wall Had to Fall, But Today's World is No Fairer.

In Do Smart, Hard-Working People Deserve to Make More Money? James Kwak recognizes that financial success often depends on luck and chance and questions why the unlucky deserve less.

In Sustainable Growth? Tim Duy argues that while the GDP report confirms that the recession has come to an end, the drivers of the boost are potentially unsustainable, and thus he isn’t breathing easy yet.

In The Hubris of Economics, Barry Ritholtz provides a rational look at some of the problems with the field of economics.

On the U.S. EconoMonitor, Robert Reich points out that if the goal is to help the most Americans in a time of need, perhaps our priorities need to be refocused.  Read Health Care Reform is Critically Important, But Getting Americans Back to Work is More So.

In Another Crack in Republic’s Foundations: Not the Size of the Debt, But When it’s Due,  Fabius Maximus shrewdly explains the different scenarios that are possible with regards to short-term and long-term bonds, and how the former makes the solvency of the government that much more vulnerable.

In Roubini Predicts “Mother of All Carry Trade Unwinds”, Yves Smith pushes the conversation on how the weak dollar is the funding currency for risky carry trades that are blowing asset bubbles.

Also on the U.S. EconoMonitor:

Bullish Data, Recoveries, Crashes and the Psychology of Forecasting Redux by Edward Harrison

Five Myths About Our Land of Opportunity by Mark Thoma

On Revisions and on Conditioning by Menzie Chinn

Tax Cuts and Recoveries by Mark Thoma

How Obama Can Convince Congress to Enact a Larger Stimulus, and Why He Must by Robert Reich

On the Emerging Markets Monitor, Michael Pettis is still negative about global imbalances despite positive GDP numbers coming out of the U.S. because he sees the drivers of growth to be unsustainable.  He argues that rebalancing is going to happen one way or another, but pushes for less Chinese investment in infrastructure and more distribution of wealth to Chinese households, because it is consumption growth that powers economies over the long term.  Please read What Rebalancing of Chinese and American Consumption?

On the Asia EconoMonitor, Anoop Singh examines how it is that Asia has rebounded sooner and more strongly than the rest of the globe from the economic slump when the region is so heavily dependent on exports for its growth.  See The Puzzle of Asia’s Rapid Rebound.

In Looking back at Indira Gandhi, Ajay Shah presents a piece that takes a look at recent history and provides 5 lessons for today’s Congress in India.

On the Europe EconoMonitor, Simon Johnson reports that pressure from the EU and voices within the Bank of England have pushed the government to begin a process to restructure the banking system.  See Britain To Break Up Biggest Banks.

In Trouble in Ireland as Fitch Cuts Debt Two Notches to AA- and Deficits Soar, as the news gets progressively worse out of Ireland, Edward Harrison asks again whether Ireland is the next Iceland.

CNBC -- The mother of all carry trades faces an inevitable bust, Nouriel Roubini, chairman of RGEMonitor.com, told CNBC.

_______________________________________

CNBC --  'Mother of Carry Trades' Leading to 'Asset Bust': Roubini

By: Jeff Cox

The "mother of all carry trades" that Nouriel Roubini warned of recently is growing and threatening to cause a global implosion, the economist warned in a CNBC interview.

For the second time in as many weeks, Roubini cautioned that investors using cheap US dollars to embrace risk will quickly reverse course once the greenback strengthens.

But he intensified his prediction, saying that the likelihood of the Fed keeping interest rates low and thus weakening the dollar will prolong the carry trade and make it all the more painful when it starts to unwind. Roubini is an economist at New York University and chairman of RGE Monitor.

"Eventually there's going to be an end to this carry trade," he said in an interview. "When that snapback of the dollar is going occur it's not going to be 2 percent or 3 percent, it's going to be more like 25 or 20 percent. And then everybody will have to close their shorts on the dollar, they'll have to sell these risky assets across the world and you could have this huge asset bubble going into an asset bust."

With the Fed unlikely to change its monetary stance following the close of its Open Market Committee meeting today, the dollar carry trade will grow through next year and continue to boost the prices of commodities and global equities, he said.

"It's going to eventually occur but it's going to be six months from now, a year from now," Roubini said. "In the meanwhile the bubble's going to become bigger globally and the bigger the bubble the bigger is going to be the crash."

Another problem he cited was the market's pricing in of a V-shaped recovery, which would see the economy improve sharply without a significant additional decline.

Instead, Roubini predicted the bounceback will look more like a U-shaped move, with the expiration of the dollar carry trade and the subsequent popping of the asset bubble exacerbating the slowness.

"It's like a rush to the exits. When everybody tries to go at the same time there will be a stampede," he said. "Risky assets are going to collapse, the dollar's going to snap back. So the risk is that there's not an orderly way of doing it unless you more aggressively signal (a change in monetary policy). That's not what the Fed is telling us, that's not what the other central banks are telling us."

Yet Roubini conceded that at least part of the seven-month stocks rally has been based on fundamentals, but they're not strong enough to justify all of the growth.

"Part of that increase in price is fundamentals, but it's become so rapid and so perfectly correlated around the world," he said. "Price (to) earnings ratios are out of hand. So there's a signal of a bubble and that's what many policy makers in this country are worried out."

Central banks will be looking at the issue of asset bubbles more closely in the months to come, Roubini predicted.

"It's not just Roubini's worried about it," he said. "Globally, people are starting to worry about it because it's getting out of control. That's the reality of it."

If the government creates a new firewall between deposit-taking institutions and investment banks, as was the case before the repeal of the 1935 Glass-Steagall Act in 1999, only the former group would receive access to lender of last resort facilities and deposit insurance. The latter should be subject to receivership should they get in trouble. Advocates of this solution include Paul Volcker (who chaired the Group of 30 report), Mervyn King (Governor of the Bank of England), and even Alan Greenspan favors a breakup, according to recent statements (although he supported the repeal of Glass-Steagall). Among policymakers, King has made a particularly forceful case, noting that "it is important that banks in receipt of public support are not encouraged to try to earn their way out of that support by resuming the very activities that got them into trouble in the first place.”

Arnab is an exceptional strategist and he has a proven track record of success for building strategy teams.  I hope you will find the attached analysis useful and thought-provoking. It is the first of many such insights to come from RGE’s Strategy Team. Future Strategy Team reports will be available exclusively to RGE clients. To subscribe or upgrade your current account, please contact sales at 212.645.0010 or email info@roubini.com  

Sincerely,

Dean Daniels

Chief Executive Officer

Roubini Global Economics

On Nouriel Roubini's Global EconoMonitor, Nouriel discusses the seriousness of global imbalances, which raise the risks considerably of future financial crises and asset bubbles.  While this financial crisis has temporarily reduced the magnitude of the global imbalances, it would be a mistake to assume that rebalancing is taking place naturally.  Please read A Balanced Global Diet.

In U.S. Real GDP Growth: Should We Really Get Excited? Nouriel Roubini and Christian Menegatti react to the Q3 U.S. GDP report and analyze the shape of the recovery and the outlook for the U.S. consumer.

As Investors worldwide are borrowing dollars to buy assets including equities and commodities, Nouriel warns that we have “the mother of all carry trades.”  See Bloomberg's Reporting of my Remarks...

Nouriel also discusses the state of the economy, the dollar’s weakness, the prospect of gold, and fixing the banks at My Morning Interviews/Videos with CNBC's Squawk Box.

Also see Bloomberg Reports Roubini in Good Company as Investor with Most Wisdom.

On the RGE Analyst’s EconoMonitor, RGE Analysts take a closer look at which countries are most likely to implement capital controls following Brazil’s actions on October 20.  The article points out that capital controls and other forms of intervention are ineffective at reverting appreciative forces on the currencies, but they can ease the pace.  Please read Are Capital Controls in Fashion Again?

In Pakistan’s Surging Violence: How Big a Risk?  Kavitha Cherian and Arpitha Bykere throw light on the political and security vulnerabilities Pakistan faces in the wake of recent terrorist attacks. Instability in Pakistan has broad ramifications on regional security given Pakistan’s nuclear arsenal and has increased pressure on the fragile civilian government. Additionally the sustained military operations have weighed on Pakistan's economic growth during 2008-09 and slowed policy implementation putting Pakistan’s balance of payments at risk.

In If Infrastructure Investment is Hot, Why Can’t Funds Raise Money? Monika Brown notes that business boomed over the past decade for unlisted infrastructure funds as private investment, mostly by pension funds, in infrastructure projects grew.  However, fund raising by unlisted infrastructure funds slowed to a relative trickle in 2009, despite no change in allocation to these investments by pension funds. What's the reason for the sudden change of interest in the infrastructure funds?

On the Finance & Markets Monitor, Joseph Mason sheds light on the complexities of the corporate governance industry, which was believed to be related to firm performance.  The depths of this recession has elicited a call for financial regulation and a restructuring of financial instruments, but the risks of “getting it wrong” are serious and could affect U.S. economic performance and competitiveness.  Don’t miss What if Regulating Executive Pay Doesn’t Work? A Brief Primer on the Limits to Knowledge in Corporate Governance Research.

In The Next Step in the Bank Explosion Cycle??? Reggie Middleton expounds on the currency risk of the “mother of all carry trades” as some of the largest and most respected banks in the world are heavily leveraged into this trade in one way or another.

In trying to answer Why Do Bankers Make So Much Money? Rick Bookstaber considers whether banks operate in a competitive market and whether workers get paid commensurately with their talent.

Also on the Finance & Markets Monitor:

Why Wall Street Reform is Stuck in Reverse by Robert Reich

Richard Berstein: Once a Huge Market Bear, Now a Bull by Edward Harrison

Too Big to Fail: Why The Big Banks Should Be Broken Up, But Why The White House and Congress Don't Want To by Robert Reich

The Private-Sector Solution to the Bonus Problem by Models & Agents

What a Tangled Web Mortgage Securitizers Weave… by Barry Ritholtz

Gold Market – Accident Waiting to Happen or Crime Scene? by Prieur du Plessis

Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors by Simon Johnson

Jeremy Grantham: The Market is 25% Overvalued; 15% Correction Coming by Edward Harrison

On the Peterson Institute for International Economics Monitor, Gary Clyde Hufbauer and Jisun Kim examine the nexus of the WTO and climate change.  Please read The World Trade Organization and Climate Change: Challenges and Options

On the Global Macro EconoMonitor, Yves Smith presents a piece by Richard Alford that speaks to the fact that the G20 and Bernanke do not appear to have established anything in the current or promised policy mix that will actually address the global imbalance issue, and therefore a return to unstable global imbalances seems inevitable.  See Guest Post: Global Rebalancing: The G20 and Bernanke Versions,

In Reserve Accumulation and Easy Money Helped to Cause the Subprime Crisis, Mark Thoma presents interesting analysis from Guillermo Calvo who sketches an outline of a theoretical framework to explain the crisis and presents the real sector impact as well as policy implications.

On the U.S. EconoMonitor, James Hamilton argues that regardless of your interpretation of how this financial crisis arose, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds, and asserts that such unconventional operations should not be part of the central bank’s arsenal of tools in the future.  Please read Evaluating the New Tool of Monetary Policy.

In Tax Credits, Screwdrivers, and Supply and Demand Curves, James Kwak uncovers who the homebuyer tax credit is really helping.

David E. Altig makes a compelling argument for The Growing Case for a Jobless Recovery.

Also on the U.S. EconoMonitor:

Why State and Local Governments Need More Stimulus Funds by Mark Thoma

Breakdown of Single Family Homes by Price by Barry Ritholtz

Case Shiller: Home Prices Fall More Slowly by Barry Ritholtz

Searching for the Ghost of Tom Joad Amidst the Financial Crisis by J Clinton Hill

Has the US Financial System been Nationalized? by Fabius Maximus

On the Emerging Markets Monitor, Heiko Hesse and Tigran Poghosyan provide the first empirical evidence linking oil prices to bank performance in oil-exporting economies, which suggests that easily observed oil prices could inform macro-prudential regulation in these countries and mitigate pro-cyclical bank lending.  See Oil Prices and Bank Profitability: Evidence from Major Oil-Exporting Countries in the Middle East and North Africa.

On the Asia EconoMonitor, Rumi Malott Morales discusses the turf war on the field of ASEAN between Japan and Australia about the role of the U.S. in the region, while China is focusing its energy on winning friends through investment and infrastructure development in Asia and is prepared to assume the regional leadership mantle currently abandoned by the U.S.  Please read The Dragon in the Alphabet Soup.

In Chinese Railways and Speculating Pig Farmers, despite last week’s excellent economic numbers and the subsequent cheerleading by many, Michael Pettis continues to stress his concerns over investment that doesn’t make economic sense, unemployment for college grads, currency intervention between trade surplus countries, and the potential for asset bubbles.

On the Latin America EconoMonitor, Nicolas Eyzaguirre discusses the benefits of having “fiscal space” and highlights the value of strengthening fiscal policy frameworks in the future, so that all countries can be better prepared for future episodes of unfavorable conditions.  Read Latin America and the Caribbean: Finding Space for Countercyclical Fiscal Policy.

On the Europe EconoMonitor, Edward Harrison puts forward an answer for why London housing prices can be on the rise while the rest of the economy is surprisingly contracting.  See If the UK Economy is Still in Recession, why are London House Prices Hitting New Records?

Don’t miss Edward Hugh’s in-depth analysis of the economic data out of France, Germany, and Spain in the following:

The French Rebound Continues In October While Germany Moves Sideways

Beyond the Consensus on European Bank Credit

As reported in our latest RGE Global Economic Outlook (Q4 and Beyond – available here for paid clients), RGE expects a strong second half of the year in 2009. We forecasted real U.S. economic growth to come in at 3% in Q3 2009.  We expect growth to be a bit weaker in the fourth quarter, at 2.5%.

Today’s GDP report surprised on the upside, revealing a 3.5% growth rate after consensus forecasted a 3.2% rate; yesterday, Goldman Sachs cut their estimates ahead of the report from 3.0% to 2.7% in wake of a lower-than-expected durable goods report.

Even if the report displayed growth just slightly above expectations, markets rallied. Both the DJIA and S&P 500 closed the day up over 200 points.  It is a bit puzzling why markets went up when the report was almost in line with what was expected by consensus. Market psychology is complicated, but could this be more of a sign of high uncertainty? It almost feels like the markets took a deep breath.

Some Details of the Report

Inventories contributed to 1% of this strong performance. This is smaller than anticipated and might slow down significantly when private demand shrugs off the support coming from policy measures. The only real quasi-surprise came from residential investments, which snapped back and displayed a 23% annualized growth rate in the quarter (after contracting at an average annual rate of 20% since 2006). This rebound accounts for the 0.5% difference between our prediction and the actual reported growth. This is not entirely a surprise. The policy incentives set in place to revive the housing sector have produced positive effects; homebuilding activity, as a consequence, has stabilized. Yet housing starts are still moving sideways, shy of the 600,000 per year mark (but above the 480,000 bottom of April 2009), and completions are still falling. This implies that a portion of the residential investment improvement was due to spending related to home improvement, which is perhaps the only surprise here. So, we are back to the U.S. consumer.

The full piece is available only to RGE paid subscribers and is available here. It includes an analysis on the outlook for the U.S. consumer and overall economic performance.

Oct. 29 (Bloomberg) -- The Oracle of Omaha retains his pre-eminence as a market visionary, outshining a new wave of financial strategists and the best-known central bankers.

Billionaire investor Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., is regarded as the best assessor of financial markets by a plurality of almost one-fourth of respondents to the quarterly poll of investors, traders and analysts who subscribe to the Bloomberg terminal.

The closest runner-up, Bill Gross, the founder and co- chief investment officer of Pacific Investment Management Co., is chosen by 16 percent. Billionaire investor George Soros gets 10 percent, followed by Nouriel Roubini, the New York University professor who in 2006 predicted the financial crisis, and Marc Faber, publisher of the Gloom, Boom & Doom Report.

Fewer than 1 in 10 cited Federal Reserve Chairman Ben Bernanke, despite high marks for his performance as a central banker. Only 3 percent pick Alan Greenspan, the former Fed chairman.

“The other people in the list have their merit, but I think consistency -- which does not mean total absence of mistakes -- is the key to rating Buffett,” says poll respondent Frédéric Bach, 46, a partner and head of fixed- income investments at London-based Falcon Money Management LLP, which manages $4 billion. “I would add a non-financial element: there is some humility in the man, as when he opted out of tech stocks because he didn’t understand them. Who in finance nowadays will admit they are wrong, or they don’t understand something?”

Obama Rating

Investors’ confidence in President Barack Obama and his economic team dropped sharply during the past three months, even as the Standard & Poor’s 500 Index rose about 7 percent and Obama was awarded the Nobel Peace Prize. Among global investors, 57 percent say they hold a favorable opinion, down from 73 percent in a July poll.

Among U.S. investors, two-thirds hold an unfavorable opinion of Obama. Treasury Secretary Timothy Geithner and Lawrence Summers, head of the National Economic Council, also get negative grades from U.S. respondents.

The quarterly Bloomberg Global Poll of investors and analysts in six continents was conducted Oct. 23-27. It is based on interviews with a random sample of 1,452 Bloomberg subscribers, representing decision makers in markets, finance and economics. The poll has a margin of error of plus or minus 2.6 percentage points.

The Bloomberg Global Poll is conducted by Selzer & Co., a Des Moines, Iowa-based public-opinion research company.

Buffett Missteps

Buffett’s lofty standing follows some recent high-profile setbacks, among them an investment in Houston-based ConocoPhillips, the third-largest U.S. oil company, which the billionaire called a “major mistake,” and the purchase of shares in two Irish banks that soon afterward plummeted in value as the financial crisis struck.

Berkshire Hathaway showed a 9.6 percent decline in book value last year, only the second time the measure has fallen since Buffett took over in 1965, and the company’s stock price underperformed the S&P 500 during the year ended Sept. 30.

Still, Buffett also seized advantage of the financial panic last fall to make big purchases in well-known companies at depressed prices, extending $8 billion in financing to New York- based Goldman Sachs Group Inc. and Fairfield, Connecticut-based General Electric Co. at 10 percent yields after the Lehman Brothers Holdings Inc. failure froze credit markets.

Jeff Matthews, author of “Pilgrimage to Warren Buffett’s Omaha” and founder of the hedge fund Ram Partners LP in Greenwich, Connecticut, says the long arc of Buffett’s investing career makes him stand out.

‘One-Hit Wonders’

“There have been a lot of one-hit wonders over the last 40 years,” Matthews says. “Warren Buffett has outlasted them all.”

Among U.S. investors, Pimco’s Gross rated as highly as Buffett. Newport Beach, California-based Pimco, the world’s biggest manager of bond funds with $840 billion in assets, has called for a “new normal” in the global economy that will include heightened government regulation, lower consumption, slower growth and a shrinking global role for the U.S. economy. Pimco is a unit of Munich-based insurer Allianz SE.

“While not always on-point, he brings a rigorously analyzed yet pragmatic perspective that yields some value at any point in time,” says poll respondent Michael Martin, senior vice president and general counsel of MDAdvantage Insurance Co. of New Jersey. “The facts, as Gross and his team have determined, appear to indicate a long and perhaps very difficult path for this country and others like it.”

International Luster

While Obama has lost some of his international luster, he continues to be viewed positively outside the U.S. In interviews, poll respondents cited the turnaround of the U.S. economy under his leadership.

“The world is facing the worst economic period of its recent history,” says Francesco Scotto, 36, head of treasury products for BNP Paribas Fortis in Milan. “Acting on both the real and the financial economy, the U.S. government helped in the best possible way the American economy to exit from the crisis.”

U.S. investors’ highly critical view of the Obama administration is at odds with the views not only of investors elsewhere but also the general public at home. Most polls of Americans have shown only small erosion in Obama’s popularity over the past three months and the president is viewed favorably by comfortable margins of the U.S. public.

The Obama policy agenda has a more direct impact on U.S. investors’ bank balances, says Ann Selzer, president of Selzer & Co., which conducted the poll.

‘Skin in the Game’

“They have a different kind of skin in the game,” Selzer says. “They worry about potential government interference in their ability to make money for themselves and their employers and their clients. They see higher taxes and controls on executive pay on the horizon and it can’t possibly make them happy.”

Bernanke’s leadership of the Fed is held in high esteem across every region, with a favorable view from 69 percent of investors worldwide, down slightly from 74 percent in July.

Geithner is viewed positively by 48 percent against 43 percent with a negative opinion.

The worldwide verdict on Summers is negative, with 42 percent rating him unfavorably versus 34 percent favorably.

Click here for additional information on methodology and a full list of survey questions.

To contact the reporter on this story: Mike Dorning in Washington at mdorning@bloomberg.net.

Global imbalances — roughly defined, the different emphasis the world’s leading economies place on savings, spending and debt — is a phrase much used and little acted upon.

Well before the current financial crisis began, world leaders pledged to address this disconnect. At an International Monetary Fund meeting in 2007, for instance, representatives of the United States and the European Union agreed they should change economic incentives to encourage more savings and less spending; officials speaking for China, Japan and Germany, meanwhile, pledged to take steps to encourage spending. At the end of the day, nothing much happened, and these imbalances helped grease the skids for the global descent toward the economic abyss.

This might not be readily apparent from current numbers; in fact, the financial crisis has contributed to a significant narrowing of global economic imbalances. Consumers in so-called “deficit countries” — states like the U.S., Britain, Spain and the countries of Eastern Europe that have huge trade deficits — are saving more as the crisis has exposed the dangerous extent of their indebtedness. Meanwhile, in China and other large export-driven economies, fiscal stimulus spending and some other policy moves have encouraged more domestic consumption.

The reduction in the U.S. current account deficit — the broadest measure of trade in goods and services — is particularly striking and serves as an example. This reduction holds true across other, less robust economies, too. Many of the emerging economies of Eastern Europe had easily financed wide deficits during the boom years. Now they find they are reducing private consumption in light of the lack of credit.

In more desperate cases like Ukraine and Kazakhstan, this has necessitated currency devaluation that boosts the costs of imports. Others, especially Eastern European countries in line for E.U. membership, have clung to their currency pegs. This leaves room for adjustment only via a sharp reduction in domestic demand.

Changing ingrained habits — whether the tendency is to be too thrifty, or too loose with money — is never easy. There is a powerful temptation to point at current trends and argue that rebalancing is taking place naturally. That would be a big mistake.

All evidence suggests that this rebalancing is temporary — the result of reactive policy measures among exporters and retrenchment among the profligate.

China, the world’s sovereign wealth machine over the past decade, is a case in point. My colleague, Rachel Ziemba, projects China’s current account surplus will likely narrow to $350-370 billion depending on the import trajectory, down from a record $420 billion in 2008. China’s trade surplus was just under $100 billion in the first half of 2009. A trade surplus of about $30 billion in the third quarter of this year is expected, which is well below 2008 levels. Increased spending at home rather than savings could further reduce the surplus. Yet with China reluctant to allow currency appreciation, reserve accumulation has resumed at a strong pace.

Although the export-oriented growth model has been shaken by the crisis, many countries seem reluctant to recalibrate. The beginning of inventory restocking has buoyed Asia significantly, as companies that cut back sharply have now increased output. Avoiding currency appreciation will exacerbate this trend, adding to reserve accumulation and distortions.

The most recent I.M.F. estimates — released in the October 2009 World Economic Outlook — suggest that imbalances could widen again but remain lower (as a share of G.D.P.) than their 2006 peak. Yet the dollar values of these imbalances could be very large.

In the I.M.F.’s forecast, China’s surplus will widen again in 2010, even as a retrenched U.S. consumer remains weak.

So who offsets the U.S. deficit? The I.M.F. suggests a diffusion of imbalances, where surpluses of Germany and Japan will remain in shrinking mode even in 2010, while the deficits of Canada and Australia, as well as emerging economies like Brazil, will offset the growth of China’s surplus.

However, the I.M.F. five-year projections also show a widening current account surplus for the entire world. This could suggest that some of the underlying export assumptions are too optimistic given the growth estimates.

Global imbalances are back on the policy agenda with the G-20 agreeing to create a peer review of macroeconomic policies including imbalances to avoid another crisis. The details are limited so far, but focus once again on an agreement that the U.S. will consume less and save more; Japan, Germany and China will spend more and will reallocate investment away from the export sector.

These are the right goals, to be sure. But a joint communiqué from a nascent international organization isn’t much to hang the world’s hat upon. The I.M.F. needs teeth, perhaps along the lines of the W.T.O.’s authority to prod member states toward “out of court” settlements, in order to enforce these difficult political and economic goals.

These imbalances represent serious misallocations of capital in domestic economies that, projected globally, raise the risks considerably of future financial crises and asset bubbles.

While imbalances did not cause the current financial crisis — I believe lax regulation bears a far greater onus — these imbalances certainly helped create the conditions for this crisis. Easy money and low long-term interest rates created an incentive to invest in seemingly-safe high-yield assets. An orderly unwinding of imbalances might put a lid on global growth during the adjustment, but is fundamental to achieve sustainable global growth.

Nouriel Roubini is a professor of economics at the Stern School of Business, New York University. 

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.

Nordics:

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.”