Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

China’s Estimated Intervention in February

by Brad Setser Monday, March 27, 2017

The proxies for Chinese reserve sales show very modest sales in February. Foreign exchange settlement (which includes the state banks) shows $10 billion in sales, and only $2 billion counting forwards. The PBOC’s balance sheet shows similar changes—foreign reserves fell by $8.5 billion and foreign assets fell by $10.6 billion. No wonder the (fx) market is no longer focused on China.

The fall off in foreign exchange sales is particularly impressive given that China didn’t have its usual trade surplus in February, for seasonal reasons (China’s trade often swings into deficit during the lunar new year). Modest reserve sales alongside a monthly trade deficit imply that the pace of capital outflows fell.

The only analytical problem is that the fall in pressure on the renminbi is a bit over-determined.

Controls on outflows were tightened. For real, it seems. That likely helped.

And the yuan was stable against the dollar, broadly speaking. There continues to be a correlation between movements in the yuan and the pace of outflows.

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Just How Much Money Should the Border-Adjusted Tax Raise Be Expected To Raise?

by Brad Setser Friday, March 17, 2017

I have a new paper out with David Kamin of New York University Law School—it will be formally out in Tax Notes in a couple of weeks, but given that there is a live debate on the topic, we are posting it in draft form now—and the New York Times had a related editorial linking to it earlier this week.

So this is a joint post with David Kamin.

Our paper makes two arguments.

1) Even with fairly optimistic assumptions about long-term growth and long-term interest rates and the persistence of “excess returns” from U.S. direct investment abroad, the U.S. cannot sustain trade deficits of approaching 3 percent of GDP over the long-run. The CBO’s estimates for long-run growth and the long-run nominal interest rate on the U.S. debt stock imply a sustainable long-run trade deficit of about 1 percent of GDP. That would generate maybe 20 basis points of GDP in permanent revenue. If the excess returns (“dark matter”) on U.S. foreign direct investment go away, the U.S. would need to run a small trade surplus—and the border adjustment would lose revenue over the long-term.

As a result, realistic projections of revenue from a border adjustment should show that revenue falling considerably and, possibly, entirely disappearing over the long-term.

Remember the border adjustment acts as a tax on imports (imports are not deductible as a cost) and a subsidy for exports (a portion domestic wage and other content of exports is effectively rebated, as exports are not considered revenues while domestic wages are considered expenses, creating a tax loss). So it only generates revenue in net if the revenue collected on the border adjustment on imports exceeds the revenue lost on the export rebate.

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Capital Is No Longer Flowing Uphill

by Brad Setser Wednesday, March 15, 2017

So report Emine Boz, Luis Cubeddu, and Maurice Obstfeld of the IMF —the net financial outflow from emerging markets that characterized the pre-crisis global economy is no more. Capital isn’t exactly flowing downhill, e.g. from rich, advanced economies to poorer emerging economies. The aggregate current account of the emerging world is close to balance.

But the basic flow of funds is not from one set of advanced economies (Europe, Japan, the Asian NIEs) to another set of advanced economies (U.S., UK, Canada, Australia). It is no longer uphill.

In my view, there is both more and less than meets the eye here.

Less, because Asia’s surplus hasn’t actually changed much from the pre-crisis period. China’s surplus is a bit smaller after its 2016 stimulus. But the surplus of the NIEs is bigger than it was before the crisis (I do not quite understand how the NIEs can be considered advanced economies for discussions of the global flow of funds but be judged against the reserve adequacy standards for emerging economies—but that is a topic for another time). Japan’s surplus is back to roughly it pre-crisis level — and the rise in Japan’s surplus in 2016 has partially offset the fall in China’s surplus. The split within East Asia between “emerging” and “advanced” is a bit arbitrary. All the major east Asian economies are importers of resources and exporters of manufactures.

Emerging Asia is still in aggregate an exporter of savings to the world. Especially if India and others in South Asia are excluded, or if the NIEs are included.

More, because the relatively constant surplus in emerging Asia means there has been a giant swing in the aggregate current account balance of the commodity exporters. One proxy is the aggregate current account balance of the former Soviet Union, Latin America, the Middle East, and Africa. These regions of the world ran a surplus of $300-400 billion before the global crisis and a similar surplus in 2011 and 2012. They now run a deficit of similar size.

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On the Cost of Holding Reserves. Sometimes It Is Not That High

by Brad Setser Monday, March 13, 2017

A few quick reactions to Tony Fratto’s argument that the cost of holding foreign exchange reserves acts as a natural limit on exchange rate manipulation. The cost of holding reserves is the cost of so-called sterilization—issuing short-term domestic currency debt to offset (in technical monetary policy sense) or to fund (in a financial sense) the purchase of a typical reserve portfolio of say 3 to 5 year Treasuries and similar euro-denominated assets.

1) The cost of holding reserves is often the highest in the countries that need reserves the most. They tend to have high domestic interest rates, so the “negative carry” on reserves is significant. Turkey for example. Or Brazil (though Brazil’s central bank has made money on the appreciation of the dollar against the real from 2014 on, with the capital gain on its dollar reserves offsetting some of the negative carry). The high apparent cost of reserves in countries with high nominal rates is one reason some countries—like Turkey—have found creative ways to limit the fiscal cost of reserves. Turkey allows its banks to borrow from abroad and place the borrowed foreign currency on deposit at the central to meet the banks domestic reserve requirement (the Reserve Option Mechanism).

2) The cost of holding reserves conversely isn’t much of a constraint in “savings glut” countries with low domestic interest rates. Taiwan for example. That is one reason why reserves are a ridiculously high level relative to GDP (about 80 percent of GDP). Or Switzerland. The Swiss National Bank is taking tremendous amounts of foreign exchange risk (so there would be large capital gains or losses from moves in the franc-euro exchange rate, or given the composition of its reserves, in the dollar-euro exchange rate), but its actual interest bill isn’t a constraint. Negative rates on sterilization instruments and positive rates on Treasuries should result in positive carry. The fiscal cost of holding reserves also isn’t a constraint in Japan, though Japan hasn’t been intervening recently. The Ministry of Finance funds its reserves with essentially zero rate notes. The “carry” on reserves is one reason why Japan’s government is actually, according to the IMF, receiving more in interest income than it pays out of interest on its debt.*

3) The cost of holdings reserves did not prove to be a constraint on China either, back in the pre-global crisis days when China really was intervening at a rapid clip to block appreciation of the yuan. China’s reserve to GDP ratio rose from around 15 percent of GDP (2000) to around 50 percent of GDP in 2007 (if you counted all of China’s shadow reserves in 2007 and 2008).

China’s fiscal cost though was limited by China’s relatively large stock of base money. Base money is a zero interest rate loan to the central bank, it is very cheap funding. And it was further limited by China’s ability to shift the costs onto the backing system: China stopped selling expensive sterilization bills, and instead sterilized by raising the required reserve ratio in the banks. And the rate of remuneration on the reserves was kept low. Other countries no doubt have used the same trick.

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Getting Puerto Rico’s Fiscal Baseline Right

by Brad Setser Friday, March 10, 2017

Developments in Puerto Rico are accelerating. The long-run fiscal plan is really a critical component of PROMESA—as it is intended to be a guide both for Puerto Rico’s annual budget and for any debt restructuring. I want to offer a few quick comments on the Ernst & Young report, and the most recent letter Puerto Rico’s oversight board sent the governor:

1) Puerto Rico probably isn’t going into (over?) its pension cliff and the health care cliff with a $1 billion primary fiscal surplus (the primary fiscal balance is the revenues minus non-debt expenditures). The Ernst and Young report suggests that spending is likely understated (unlike in past years, when the standard problem was that tax revenues were typically overstated). The oversight board seems to agree: “the Board has concluded that the Government’s FY17 expenditures could be understated by an amount ranging from $60 to $510 million, with a cumulative impact much greater over the next ten years. The Government’s liquidity projection is further understated by $300 million in FY17.” The implication alas, is that when Puerto Rico loses $1 billion in pension financing (as its pension assets will soon be depleted) and $1.5 billion in health care financing (as the Affordable Care Act grant will soon run out), it will face substantial fiscal deficits even in the absence of any debt service. The fiscal math I walked through on Monday still I hope works, but the likely starting point is worse.*

2) The oversight board recommends lowering the nominal growth forecast for the next few years, and being more cautious in the medium-term. The implied real economic contraction is now over 3 percent in both 2018 and 2019. That I fear is the unfortunate reality: one clear lesson from Greece is not to imagine away near-term pain. I would though be interested in seeing more explicit treatment of how the magnitude of the proposed near-term fiscal adjustment is contributing to the fall in growth.

3) In standard macroeconomics, a fiscal consolidation only depresses short-term growth. The economy eventually bounces back to potential. I worry though that in Puerto Rico near-term consolidation will reduce long-run potential (hysteresis) for one simple reason: lots of Puerto Ricans will respond to the ongoing contraction by migrating off-island, permanently weakening Puerto Rico’s economy.

4) The enormous uncertainty around Puerto Rico’s future fiscal bargain with the federal government (Medical funding is the most significant aspect of this, but in my view the interaction between Puerto Rico’s system of tax and the federal corporate income tax is also part of the bargain) impedes any quick restructuring agreement. Any deal that Puerto Rico strikes with its creditors before its future Medicaid funding and corporate income tax treatment is settled leaves the downside risk with the residents of Puerto Rico.

One last point: The oversight board’s web site has become an essential source of information on Puerto Rico remarkably fast.

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The January U.S. Trade Data

by Brad Setser Wednesday, March 8, 2017

Over the last year, U.S. import growth stalled. Capital goods imports did nothing—in part because of weakness in non-residential investment. And consumer goods imports were flat.

That appears to have changed. Real consumer goods imports were up 9 percent year over year in January. Real capital goods imports were up 7 percent (table 10 in the trade data release).

To be sure, the January trade data can be a bit funky. As Bill McBride of Calculated Risk notes, the timing of China’s lunar new year plays havoc on the United States’ own seasonal adjustment. But the ISM import index suggests February won’t be much different.

Of course, there are different ways to interpret the recent strength in imports.

Import growth can reflect an acceleration in demand growth that is also supporting strong growth in domestic activity (China right now?).

Or it can mean that more of a given amount of demand growth is bleeding out to the benefit of the rest of the world, leaving the “home” economy short demand — slowing the economy (U.S. from 2001 to 2004?).

In practice it is often a bit of both. See Neil Irwin.

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Puerto Rico’s Daunting Fiscal Math (My View)

by Brad Setser Monday, March 6, 2017

An applied economics question:

A country with no independent monetary policy, undergoing a ten-year slump that has reduced its real GDP on average by over a percentage point a year, needs to do a fiscal consolidation of roughly 10 percentage points of its GDP. How much does output fall?

The example is not entirely hypothetical.

Puerto Rico isn’t a country, but rather a territory of the United States. It is a part of the U.S. monetary and currency union—though it isn’t completely a part of the U.S. fiscal union (Puerto Ricans—and firms based in Puerto Rico—generally do not pay federal income tax). Puerto Rico’s gross national product (GNP) is down more than 14 percent since 2006 (the last data point is 2015, and the Government Development Banks’s high frequency indicator shows a further decline in 2016). GNP is the relevant measure—GDP is clearly inflated by the tax games played by firms operating in Puerto Rico. And the oversight board has asked Puerto Rico to show the impact of closing a $7 billion (just over 10 percent of GNP) fiscal gap through austerity. More on that later.

The answer—fairly obviously, I think—depends on your view of the fiscal multiplier. The Fed is raising rates: directionally it will be hurting, not helping. There is no monetary offset. If you use a multiplier of around 1.5 (well justified on the basis of recent analysis*) GNP should fall by roughly 15 percent.

That is huge, and it seems unreasonably large. But it is a function of asking for an unreasonably large fiscal adjustment in an economy that lacks the capacity to offset fiscal consolidation through monetary easing. Greece’s experience though shows that a massive fiscal consolidation can produce a massive fall in output. There is plenty of empirical cause to worry.

The Fiscal Gap

So why is the financing gap—$7 billion on average over ten years—so big?

That to me is the interesting bit.

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U.S. Manufacturing Exports—Excluding NAFTA—Are Surprisingly Small

by Brad Setser Wednesday, February 22, 2017

Take out U.S. exports of manufactures to Canada and Mexico, and the United States manufacturing exports to the world are about 3 percent of U.S. GDP.*

Non-NAFTA manufacturing imports are over 7 percent of U.S. GDP.

These calculations are based on the North American Industry Classification System (NAICS) data for manufacturing trade, but exclude refined petrol. I cannot bring myself to count “product” as a manufacture. The division between the petrol and the non-petrol balance has long been central to my understanding of trade.

Within NAFTA manufacturing exports and imports are roughly balanced—about 2.5 percent of GDP in both directions.**

This supports Greg Ip’s view that China’s entry into the WTO—viewing WTO entry as short-hand for China’s increased integration into the global economy—in the 2000s had a materially different impact on the U.S. economy than NAFTA. By all measures, U.S. trade within NAFTA is much more balanced than U.S. trade with the world.*

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China’s Estimated Intervention in January

by Brad Setser Wednesday, February 22, 2017

It should go almost without saying that China’s ability to maintain its current exchange rate regime matters.

The yuan has been more less stable against the CFETS basket since last July. If the current peg breaks, China will struggle to avoid a major overshoot of its exchange rate.

Christopher Balding recently has argued that the fall in the dollar (on say the Fed’s dollar index) in 2017 is more or less the same as the yuan’s depreciation against the basket—which would make China’s exchange rate regime now more a pure peg against the dollar rather than a true basket peg. Hence the lack of movement against the dollar in past few weeks. Maybe. I though am inclined to think that the yuan’s depreciation against the basket this year just undid the upward drift against the basket that came when the dollar appreciated last year, and China is still aiming to keep the currency more or less stable against the basket, not stable against the dollar. Time will tell.

Right now, the exact nature of China’s peg now matters less than China’s ability to maintain some kind of peg, and thus to avoid a sharp depreciation. If there is a depreciation, either the world will absorb a new wave of Chinese exports—a 10 percent real effective exchange rate depreciation should raise China’s real trade balance by about 1.5 percent of China’s GDP, or by roughly $180 billion (using this IMF study as a baseline for the estimate, it is summarized here)—or a wave of protectionist action will limit China’s export response, and in the process threaten the global trading rules.* Neither is a good outcome.

The data for the next few months will be critical. China does seem to have tightened its outflow controls—despite the official denials. FDI outflows certainly have slowed. Hopefully the screws will be placed on a few other categories of outflows—there are plenty of categories in the balance of payments that show a buildup of foreign assets that, in my view, should be controllable. The rise in Chinese bank loans to the world, for example.

I also still think the yuan’s movement against the dollar is an important driver of outflows, so a sustained period of stability in the yuan’s exchange rate versus dollar—whether because the broad dollar is falling and that means the yuan needs to rise to maintain a basket peg, or simply because China starts to prioritize stability versus the dollar—should lead to a reduction in pressure.** Finally China does seem to be tightening its domestic policy, at least a bit. Higher money market rates should also help support the yuan.

The proxies for intervention for January do suggest some reduction in pressure in January—though pressure by no means entirely went away.

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Why Did China’s 2016 Current Account Surplus Fall?

by Brad Setser Friday, February 17, 2017

Few policies are less liked than China’s 2015/2016 credit-driven stimulus. Even people like me who worried that slamming the brakes on credit, in the absence of more fundamental reforms to lower China’s savings rate, risked creating a shortfall in demand were not exactly enthusiastic supporters. China would be far better off if had used a rise in central government social expenditure to support demand, not yet another wave of off-balance sheet borrowing by local governments and state firms.

But the current pick-up in growth suggests that arguments that (yet another) expansion of credit wouldn’t work were a bit overdone. There are no doubt better ways to support growth than more credit. But growth did responded to the stimulus, even if there is a real debate over just how strong the response was.*

Tilton, Song, Tang, Li, and Wei of Goldman Sachs (in a report summarized here):

“Chinese policy makers wrestled with challenges throughout 2016, but large and sustained policy stimulus eventually fostered recovery. … Our China Current Activity indicator bottomed out at 4.3% in early 2015, recovered to the mid-5 percent range last year, and is now running at 6.9%. Heavy industry … has seen an even more pronounced re-acceleration”

And there is growing evidence, I think, that the pickup in Chinese demand also had positive spillovers for the rest of the world.

China’s current account surplus for 2016 fell more than I expected. To be sure, China’s reported current account is prone to significant revisions, and I wouldn’t be surprised if the (very low) q4 surplus is revised up.

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