Brad Setser

Brad Setser: Follow the Money

Confronting Iran would be a lot easier if the Saudis had more spare capacity

by Brad Setser Sunday, September 26, 2004

David Sanger looks at Iran and North Korea’s nuclear ambitions in today’s New York Times. Sanger suggests it will be hard to stop Iran’s quest for nukes, no matter what the nature of Iran’s regime — the refomers in Iran argue that if a secular Pakistani government can have nukes, why not a more secular Iranian government? Nouriel has beefed up his site’s coverage of geopolitical risks, including Iran. Iran, afterall, offers the potent combination of nuclear proliferation, political islam, oil and transatantic tensions over what to do.

Energy economist Philip Verleger has emphasized that with oil markets tight, any confrontation with Iran risks triggering a sharp upward spike in oil. Iran could cut its exports to retaliate for UN sanctions, or the world could try to stop buying Iranian oil to punish Iran. Consequently, it would be a lot easier to confront Iran successfully if another producer — and that almost always means oil’s central banker and swing producer, the Saudis – was able to make up for any fall in Iranian production. The Saudis did so during the 03 Iraq war, but it now seems doubtful that the Saudis have sufficient spare capacity to make up for any shortfall in Iranian production.Two other points are worth making. First, the Saudi Arabia’s position in the oil market traditionally stems not just from the scale of Saudi production, but from the Saudi’s resevoir of unused production capacity. Spare supply gave the Saudis the ability to add supply/ remove supply to influence price. Second, the set of countries whose oil firms have invested in Iran’s oil fields includes countries like France that did not support the US in Iraq, but also countries like Italy and Japan that did. The globalmacro Iran page includes a paper by Carnegie’s Perkovich and Manzanero that tries to look at how an economic confrontation over Iran’s nuclear program might play out. It provides a useful overview of FDI in Iran, and Iran’s trading partners — though any interruption in oil would impact on the global oil price, not just those countries who currently import oil from Iran.

The currency strategist at Morgan Stanley might want to talk to the chief economist at Morgan Stanley

by Brad Setser Thursday, September 23, 2004

Steve Johnson’s market insight column in Thursday’s Financial Times keys off Morgan Stanley’s currency strategist Stephen Jen’s argument that “As long as Asia insists on staying inside this dollar area, then the current account deficit is not what people think it is.” Rather, the US current account deficit excluding the Asia dollar zone is only 2.2% …

What? Jen’s numbers are right, much of the US currrent account deficit is with Asia and it is offset by financing from Asia. But why does it make sense to net all this out and hide the real size of the US external deficit? Dollar claims on the US held in Asia are still external debts of the United States, and claims on future US exports. Stephen Roach, Morgan Stanley’s chief economist is more worried, both about the underlying 5.7% of GDP current account deficit in q2 and the assumption that the rest of the world will finance it in the face of rising disenchantment with US hegemony.In a sense, Stephen Jen’s core argument is right: to quote Johnson paraphrasing Jen: “the current account deficit run being run against Asian nations is not unduely worrying as long as Asia continue to park its capital surpluses in US assets.” Current account deficits are never a problem so long as they are financed! The real question is whether a growing deficit can continue to be financed by Asia, and when will the strains start to show.

Jen’s call may suit the relatively near-term time frame of currency strategists — though I would be reluctant to bet that the dollar will rise in the face of large expected q3/ q4 current account deficits (oil above $45 a barrel does not help the current acccount). But more importantly, the basic analytics are off. The fact that Asia is part of a de facto dollar zone does not mean that it makes sense to net out the US current account deficit with Asia, or that the US current account deficit with Asia won’t cause problems.

Argentina was a part of the dollar zone until the end of 2001, but that did not mean that its current account deficit and rising external debt did not matter … or that what really mattered was the current account deficit Argentina ran with the non-dollar zone. What mattered was the stock of external debt relative to its export capacity, and Argentina’s ability to borrow to pay interest on its existing extenral debt, and in the process to run up its debt stock. Once it could no longer borrow, it had to adjust, and since the currency board blocked rapid adjustment, it ended up defaulting.

The US is in a better position because it is borrowing its own currency, both from Asia and the rest of the world, and so its creditors are taking the risk the dollar’s real value will fall. But presumably Asia’s willingness to keep financing the US in dollars is a function of the size of the total set of external claims on the US economy relative to the United States ability to service those debts, not just the external claims on the US from outside the Asian dollar zone. If the United States’ current account deficit with Asia doubled, to 6% of GDP (pushing the overall deficit up to 8.5%), would Jen really argue that the relevant US external deficit is only 2.5% of GDP? All external debt, including debt owed to the Asian dollar zone, is claim on US exports.

Stephen Jen leaves out two points that I suspect will cause tensions within the US/ Asian dollar zone in the near future — though my definition of the near future (next two-three years) may be a bit different than his (next two-three months?).

1: The imbalances created inside the U.S. economy by a large and growing current account deficit with Asia, financed by Asian inflows into the US fixed income market. That favors interest sensitive sectors, and hurts manufactures and other producers of tradables. It encourages a housing bubble, and the shift of resources out of goods production. That risks protectionist pressure, but in this case, the pressure reflects not just the tensions created when one sector is falling and another rising, but rather the broader macroeconomic imbalances created when a country imports close to 16% of GDP and exports a bit less than 11% and makes up the difference by borrowing from abroad. The US is taking on external debt, but not building up it s future export capacity. China’s export growth to date has come in part by taking market share from other Asian exporters (total US imports from the Pacific Rim were roughly constant between 2000 and 2003), but China can only sustain its current pace of export growth by moving into markets now served by US producers. That is happening in 2004 — overall US Pacific Rim exports are rising, suggesting China is no longer just taking market share from other Asian producers, and that trend is only going to continue looking forward. If it is not offset enormous growth in US goods exports to china/ asia (enough to shrink the overall deficit), not just the export of US treasuries to China’s central bank, there is almost sure to be friction. Think about Republican congressmen running for election in ohio in 2006 …

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US Treasury was for a global growth deficit before it was against it

by Brad Setser Thursday, September 23, 2004

The U.S. Treasury needs to get its talking points straight. It is hard for the Treasury to argue that the world economy is doing very, very well (the IMF forecasts global growth to be at a 30 year high) in one context (don’t worry about oil prices, global growth is strong) and to argue the US trade deficit is largely the result of a global growth deficit in another context.

The reality is global growth this year is strong, that US export growth this year is strong, and the trade deficit is widening because import growth is also strong. With a big gap between the United States’ $1.5 trillion import base and its $1 trillion export base, exports have to grow substantially faster than imports to keep the deficit constant. Exports are growing fast this year, but not anywhere near fast enough to offset 13-14% import growth.

The real problem is that the parts of the global economy that are growing strongly are also intervening heavily to keep their currencies from appreciating against the dollar, and so long as the US budget deficit is large, the US needs the cheap financing from their growing reserves to keep interest rates down, so it is not in a strong position to complain!It is true that growth in parts of Europe, notably Germany, is disappointing. But the U.S. also only exports $28.8 billion (2003 good exports) to Germany. If US exports to Germany were on track to double in 2004, that still would not have been enough to offset rising US imports and keep the trade deficit from widening. Stronger growth in Germany alone is not going to end the global imbalances associated with the US current account deficit. The deficit reflects the fact that the US consumption is rising faster than US income, along with growing US dependence on foreign savings to fund the budget deficit without crowding out domestic investment.

The IMF has refused to bailout bond holders before Argentina!

by Brad Setser Tuesday, September 21, 2004

Adam Thomson of the FT has an interesting article arguing that Argentina’s bond restructuring could succeed if Argentina is willing to offer bondholders 30 cents on the dollar, only a bit more than the 23-25 cents it already has said it will offer. Since Argentina has about $100 billion in outstanding bonds (and other, similar debt), Thomson is arguing that Argentina could pull off its restructuring by pleding another $5 billion in cash and discounted future cash flow.

That feels about right. The chances of a sucessful restructuring would go way up if Argentina’s offer turns out to be a bit above the current market price of its debt. Bondholders have not gotten much out of Argentina’s recovery, and a succesful restructuring would increase their upside should Argentina’s strong recent economic performance continue. Alas, it is not yet clear that Argentina will sweeten its offer, and even if it does sweeten its offer, it is likely to have a lower participation rate and face more holdout litigation than has been typical of other recent restructurings.Thomson, though, includes an assertion in his article that is false, though it reflects a common (mis)perception:

“Argentina’s tactics have shown that when investors buy sovereign bonds they are in effect lending without security or collateral, without the ability to enforce their contract and without the ability to seize assets. Until now this did not matter much because investors knew that IMF bail-outs would always provide the money to pay bondholders back. Argentina’s approach changed all that, and the market is struggling.”

The first sentence is accurate: it is hard to seize a sovereign’s assets. The second sentence is wrong. Remember Russia? OK, Russia did not restructure its eurobonds, but it certainly restructured soveriegn debt held by foreign investors — both its ruble denominated GKOs and its dollar denominated London Club syndicated loans, which had been repackaged and sold into the markets. Plus, Pakistan, Ukraine and Ecuador all restructured their Eurobonds before Argentina defaulted.

Indeed, one the biggest myths around is that IMF bailouts largely go to pay bondholders. Bonds are long-term obligations, and in most case, shorter-term creditors, not long-term creditors, are the ones who get bailed out. Take Argentina: a run by domestic bank deposits overwhelmed the $10 billion or so net financing that the IMF provided in 2001, and accounted for most of Argentina’s reserve losses. That is why so many bonds are around that need to be restructured: only $7 billion or so of Argentina’s large — initially above $90 billion — stock of international bonds came due in 01, and had a chance to get out! The IMF never has provided enough funds to a crisis country to let everyone with a financial claim get out.

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Who is in more financial trouble: social security or the rest of the government?

by Brad Setser Monday, September 20, 2004

There is a common sense that social security is bankrupt and people now in their 20s and 30s won’t get anything from it. That is false. Social security can fund all projected benefits until sometime around 2042, though the forecast is subject to a substantial margin of error. After that, projected revenues of about 5% of GDP will cover about 75% projected expenditures. That is a problem, but a manageable one.

The real problem is with the rest of the government, including the other big entitlement program — Medicare. Just compare social security’s finances to those of the rest of the government. Right now social security is running a surplus and has substantial assets, while the rest of the government is running a huge deficit and has substantial debts (including debts to the social security system). In 2003, social security took in $469 billion in tax revenue, and spent only $406 billion. It lent the surplus — $63 billion, or 0.6% of GDP – to the right of the government and also got credited $75 billion in interest on its existing assets. During the course of the year, its assets rose from $1217 billion to $1355 billion, 12.3% of GDP). Social security is expected to continue to add to its assets until around 2015.

The rest of the government, shorn of social security, took in $1382 billion in 2003,12.6% of GDP, and spent $1864 billion, 17.0% of GDP — my numbers come from the data on the federal governnment in the flow of funds, adjusted to take out social security taxes and benefits. The rest of the government had a cash flow deficit of $482 billion (4.4% of GDP) while social security has a cash flow surplus of $63 billion (0.6% of GDP). It seems that interest paid to the social security trust fund is not included in the reported total annual deficit. Add that in and the deficit would have been $557 billion. The federal government ended 2003 with debts of $6998 billion (64% of GDP), and ended August, 2004 with debts of $7351 billion. The debt to revenue ratio of the government shorn of social security is around 500%, not a good number.

We don’t need to fix social security half as much as we need to fix the rest of the government! Social security has a projected cash flow deficit of about 1% of GDP only after 2042. The rest of the government had a cash flow deficit of around 4.4% of GDP in 2003 (and more in 04). Social security taxes cover about 75% of projected future benefits even after the system runs out of assets in 2042. The rest of the government is only taking in about 75% of what it needs to cover its current spending, and already has substantial debts. By every measure, the federal government today is in worse shape than social security is expected to be in 2050 (assuming the government keeps its promise to the social security system).

The basic bargain behind the social security reform was that the relatively regressive social security payroll tax would take in more than it needed to pay current benefits until roughly 2015, and lend the proceeds to the rest of the government. That in turn has let the more progressive income tax be lower than it otherwise would need to be to pay for the other operations of the government. In return, as the baby boom starts to retire and the social security system’s costs increase, the regressive payroll tax will be lower than it otherwise would need to be as some of the burden of paying social security benefits would be shifted to the income tax. But that only works if the rest of the government can pay back the money that is now borrowing from social security: the bonds held in the trust fund, like the Treasury’s marketable debt, are claims on the rest of the federal government’s future tax revenues.

Nouriel is right about the U.S. fiscal train wreck. You cannot run a 17-18% of GDP federal government with a 12-13% of GDP revenue base (taking social security out of both the revenue and the spending numbers). We can only do it know because the central banks of China, Japan, India, Taiwan, Korea and Russia are generously willing to join the social security trust fund in financing the rest of the federal government. Get rid of the social security trust fund, and one of the following has to happen: the rest of the government has to cut back, other taxes have to go up, the government has to run a larger cash deficit (squeezing private investment), or the government has to borrow even more from the rest of the world.

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U.S. dependence on Asian central banks

by Brad Setser Thursday, September 16, 2004

One country’s external debt is another country’s asset. The U.S. capital account data leaves little doubt that foreign central banks have been a huge source of financing for the U.S. current account deficit. This really got started in 2002, when the U.S. first started to run large budget deficits, and the pace of reserve accumulation by foreign central banks picked up. It accelerated in 2003, and shows no real sign of slowing in 2004. This is the heart of the new Bretton Woods two system of managed exchange rates – though that is a bit of a misnomer: the original Bretton Woods did not finance enormous current account deficits.

The Bank of International Settlements (the BIS, the central banks’ bank) provides the key numbers in its annual reports. A couple of things stand out.

First, the increase in dollar reserves exceeds the inflows from foreign central banks reported by the BEA in the capital account data. In 2002, the BIS reported a $234 billion increase in dollar reserves. That compares with $139 billion in reported inflows from the Bureau of Economic Analysis (BEA). Not all dollar reserves are invested in the US, but most probably are (dollar denominated assets issued by non-US borrowers tend be riskier than US debt). So it is likely that the build up of dollar reserves provides a better measure of central bank financing than the BEA data. In 2003, the BIS reported a $341 billion increase in dollar reserves, v. $274 billion in the BEA data.

Second, Asia has a ton of reserves. Asia also has a ton of people. But it is hard to see why Taiwan needs more reserves than all of Latin America. Between the end of 2001 and the end of 2003, the combined reserves of Asia and Japan increased from $1158 billion to $1860 billion. That financed a large chunk of the US current account.

Third, China and Japan are not the only countries financing the United States, just the biggest. Between the end of 2001 and 2003, Japan’s reserves increased by $265 billion, and China’s by $191 billion (they just about doubled, rising from $212 to $403 billion). India’s reserves rose from $46 billion to $98 billion (a $52 billion increase). The combined reserves of the Asian NICs increased by $163 billion, whie Eastern Europe and Russia’s reserves increased by $87 billion.

Fourth, growing reserves are continuing to finance the US current account deficit. In 2003, Japan, China, India, Russia and the Asian NICs increased their reserves by $477 billion. In the first half of 2004, Japan increased its reserves by $145 billion, and China, Russia, India and the NICs increased their reserves by $125 billion (IMF data). Japan has stopped its massive intervention. But if we assume that the others are continuing to add to their reserves at a similar pace (China just reported a solid monthly trade surplus despite higher oil prices, and it is continuing to attract large FDI inflows) for the rest of the year, their total reserve accumulation would be about $395 billion – a bit below their 2003 pace, but still substantial. Of course, the U.S. financing need is even bigger ($800 billion, taking into account the US need to finance FDI outflows). But it is far easier to get $400 billion in private inflows (at current rates) than to get $800 billion in private inflows.

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Growing out of the trade deficit

by Brad Setser Thursday, September 16, 2004

The U.S. government’s spin on the widening trade deficit is that it reflects a growth deficit in the rest of the world. This spin does not hold up well. All parts of the world other than Europe are doing quite well this year. Global growth is strong. In any case, the US does not trade all that much with Europe: US firms tend to produce in Europe for the European market, and European firms tend to produce in the US for the US market. The big trade flows are across the Pacific. Strong world growth is producing strong export growth: year over year U.S. export growth is 12.7%.Exports are growing faster than GDP, so exports as share of GDP are rising (good news — they were falling as a share of GDP from 00-02). The problem: imports are rising even faster — 14.2% overall (y/y). Even if you take out oil (up 22% y/y), goods imports up 13.4%.

The real problem is that the US already imports (1.5 trillion at the end of 03, 15% of GDP) so much more than it exports (1 trillion at the end of 03, 10% of GDP), that exports have to grow 50% faster than imports just to keep the trade deficit constant. So if imports are growing at 13%, exports need to grow at around 18% to keep the trade deficit from rising. Extrapolating based on monthly trade data suggests the 04 trade deficit (goods and services) will widen by $85 billion, to around $580 billion. A realistic estimate would add in another $10 billion to this estimate to reflect expected high oil prices, putting the overall deficit at around $590 billion for 04.

In the long-term, US exports need to rise as a share of GDP, so the US say exports 16% of GDP and imports 16% of GDP. But if imports keep rising substantially faster than GDP, exports are chasing a moving target.

Incidentally, this is one problem I have with Sebastian Mallaby’s analysis. He likes to emphasis that manufacturing is declining as a share of GDP (because productivity in manufacturing is growing faster than in services), and that it wrong to blame trade for manufacturing’s decline. That is partially right. But at the same time, if the rest of the world started spending the dollars it earns exporting to the US, i.e. the world started buying more US goods and fewer US financial assets (right now the world saves roughly 1/3 of what it earns exporting to the US as reserves), the US would sell $500-$600 billion more of goods and services abroad. Taking the current ratio of goods exports to services exports, that translates into at least $330 billion in additional goods exports — or an increase in goods production of around 3% of GDP. Trading treasury bills for imported goods on the current scale has to have an impact on the composition of US output and employment, and it must be reducing US manufacturing output below what is otherwise would be even in the context of a long-term shift out of manufacturing. This is not an argument against trade; it is an argument that the US needs to pay for its imports with current exports rather than with promises of future exports (external debt is a claim on future export revenue just as government debt is a claim on future tax revenue), and that the rest of the world needs to be spending more of its current earnings buying US goods and less buying US financial assets.

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The US current account

by Brad Setser Tuesday, September 14, 2004

Q2 current and capital account data came out today. At 166 billion, the Q2 current account deficit was $10 billion or so more than expected. Since the goods and service trade deficit for q2 was already known, the “surprise” came from the balance on investment income (payments on US external debt and receipts on US external assets). The amount the US paid on the existing stock of FDI in the US jumped, reducing the US overall balance on income. The only surprise here is that this happened now: the cost of relying on foreign savings to finance investment is that foreigners get some of the upside, and as Nouriel and I argued in our recent paper, payments on US debt (with debt uesd to denote the stock of all external claims on the U.S, i.e. actual debt as well as foreign direct investment and investment in US stocks) have been unusually low, and should be expected to rise going forward. All in all, it looks like the U.S. could be headed for a current account deficit of 635-645 billion for the year, or 5.4-5.5% of GDP

The capital account data is also of interest. It underscores how dependent we have become on foreign central banks to fund our deficits.A little known fact: U.S. firms now are investing more abroad than foreign firms are investing in the U.S.. Consequently, the U.S. needs to borrow from abroad both to finance external FDI by US firms and to finance the US current account. That overall financing need is now immense. In the first half of 2004, the U.S. has a net FDI outflow of $65 billion, a $130 billion pace for the entire year. That implies that the U.S. needs to borrow $770 billion ($640 + $130 billion) for the year.

In the first half of the year, net inflows of $200 billion from foreign central banks (a bit more than $100 billion in q1, a bit less in q2), and $175 billion from foreign private investors provided the $375 billion in financing the US needed. If this pattern of flows continues, the U.S. will be getting about $400 billion in net financing from foreign central banks for 2004. That is insane — and smart observors think it probably underestimates the extent that foreign central banks are financing the U.S., since the inflow numbers in the BEA data set are less than the global buildup of dollar reserves reported by the BIS. Put differently, the BEA data indicate that the U.S. sold $265 billion in treasuries to foreign central banks and foreign private investors in the first half of 04, so the U.S. is on track to sell $530 billion in treasury bills to foreigners this year (along with $350 billion or so in corporate bonds, agency securities and the like — foreigners have not been big investors in US stocks this year). Foreign purchases of Treausuries are on a pace to more than finance the 04 fiscal deficit. At the end of the year, it looks like foreigners will hold more than $2 trillion in US government bonds, up from $1.5 trillion at the end of 2003. The U.S. truely has become every bit as dependent on foreign central banks to fund our deficits as it is on Saudi Arabia for oil! I would be a lot more comfortable if the US was exporting more goods and services and fewer treasury bills.

Welcome to My Blog…

by Brad Setser Tuesday, September 14, 2004

Welcome. I am Nouriel’s co-conspirator on several of his recent articles, and I’ll be adding my voice to this site as well.

Obviously, Nouriel and I do not disagree on much. But we do have different ways of thinking and writing. I am probably a bit more interested in finding the sound bite that explains the complexities of macro policy than nouriel, though neither of us is known for true brevity. I am also perhaps a bit more empirical. Rather than talking of trade in the abstract, I like to know what a country is buying from the world, and what it is selling. Right now I am particularly interested in the consequences of trading U.S. T-bills for Asian (and other) consumer goods — the topic of my most recent paper with Nouriel. Since I am as interested in geopolitics as in economics, I’ll problably also post on topics like Iraq’s debt restructuring.

Brad Setser