Brad Setser

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Cross border flows, with a bit of macroeconomics

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U.S. dependence on Asian central banks

by Brad Setser
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.

The fact that so many of the dollars that the world earns is going to buy US treasuries, not US goods, has a major impact on the structure of the US economy, as I argued in my earlier post. It favors interest-sensitive sectors like housing, and hurts manufacturing, for example. China is supporting the U.S. economy by buying US treasuries and keeping US interest rates low, not through booming demand for US exports! (Exports to china are up this year, but off such a low base that the overall impact is small — about 0.1% of GDP — and imports from China are on pace to increase by more like 0.4-0.5% of GDP)

The big question facing the global economy over the next couple of years is whether the US current account deficit and its need for financing will grow faster than the rest of the world’s (and specifically Asia’s) appetite for dollar reserves. Remember, the more dollar reserves Asian central banks hold, the bigger their prospective losses shoud the dollar depreciate against Asian currencies.


  • Posted by Clay Hampton

    Hi Brad,
    This of course is all true and the main reason why it will be not only necessary but inevitable that the new administration will take immediate action when it takes office in 2005. Fiscal policy will be reversed (with its relevant time lags)and monetary policy will be tightened more next year. Clearly the US will have to grow more slowly than its trading partners. The US’ partners will need to switch their expenditures to some degree on US exports. What is your opinion on the relative merits of predictable fiscal policy choices on the part of the two US candidates? Bush seems to want guns, butter. Kerry may pull a Clinton and cut the guns and wallow in butter. There is the remote chance that Bush exposes the emperor as having no clothes and cuts the butter “in the interest of national security”. Kerry, in a first term, would certainly not have either the inclination nor the opportunity. It would be nice to have another peace dividend perhaps with tax cuts and entitlement honesty.

  • Posted by Brad Setser

    Clay — Full disclosure is in order, I am an unabashed Bob Rubin fan, and, not suprisingly, tend to think Kerry would conduct a more responsible fiscal policy than Bush. I am not a neutral observor.

    A few other reactions:

    1) I would characterize Clinton’s fiscal policy as a) using the peace dividend to help stabilize the budget (your less guns) b)some politically difficult tax hikes and c) relative spending restraint, particularly in the first part of his administration. To me, clinton was no more butter than you can pay for with rising revenues. I don’t have the data on hand, but my sense is that Bush increased spending on butter at least as fast as Clinton, if not faster Clinton, even as revenues have fallen sharply.

    2) I doubt Kerry would go for less guns. He has called for two new army divisions and doubling the special forces. That costs money. Maybe some expansion of the army can be offset by finding some efficiencies in the air force’s budget (I think wes clark has suggested this), as the war on al-queada/ the war in iraq is ground, not air, intensive. But Kerry will spend a lot on guns.

    3) Bush’s policy has been described as guns, butter and tax cuts (financed by debt). He won’t roll back his tax cuts (you don’t have to read his lips) or cut military spending, so he either needs to cut the butter or keep rolling up the debt. So far, he has shown no inclination to cut back on the butter, and no hestitation to add to the debt. Would he act differently in a second term? I doubt it. Some restraint on the butter will be needed to keep the deficit from getting much, much bigger (particularly as interest costs start to rise), but I personally doubt Bush will do more until the markets (or more accurately, foreign central banks) stop financing the deficit at low rates. (Nouriel’s blog has more analysis of the budget).

    4) On entitlements, I would distinguish between social security (funded til 2040 or so)and medicare (a real problem, as both public and private health care costs are growing rapidly). Social security is currently running a 0.6% of GDP or so cash flow surplus, and has assets of around 10% of GDP, while the cash flow deficits of the rest of the US government, taking out social security, is north of 4% of GDP and it has quite a substantial accumulated debt,including its debt to the social security system. My first priority would be to fix the rest of the government’s finances — they are in much, much worse underlying shape than social security’s finances.

  • Posted by David Nowakowski

    Peter Peterson’s recent article in Foreign Affairs [] is also worth a look. It takes a more political view, and also highlights the demographic reasons why the rest of the world’s high savings rates will not persist: they will retire and “want their money back”. I believe it is a summary/outline of his book, ‘How the Democratic and Republican Parties Are Bankrupting Our Future’.

  • Posted by DF

    You’d better write this book : “how capitalism fell 15 years after the fall of communism.”

    Just add :
    Incoming debt crisis : debt deflation
    Incoming dollar crisis (and so doing international currency crisis)
    Incoming economic crisis (can’t have and end to asset economy without some economic trouble … and debt deflation)
    Incoming protectionism (well Bush started it … But if you add a falling dollar and bigs problems in international monetary system … for all the good will … it’s gonna be hard to avoid it)

    Well you get renewed 30’s …
    Threat of terrorism and religion fanatics replaces threat of communism

    Hard times ahead …