Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Another month, another bad trade number

by Brad Setser Thursday, October 14, 2004

The latest monthly trade data came out today, and was worse than expected — though in my view that indicates expectations have yet to catch up with reality. Exports have been stuck in the $95-96 billion (monthly) range for several months, while higher oil imports combined with continued strong non-oil import growth means that the United States’ monthly import bill keeps on climbing.

If you extrapolate $54-55 billion monthly trade deficits out til the end of the year, the annual trade deficit would be in the $610 billion range. I think that is probably a bit optimistic if oil stays north of $50 a barrel: higher oil prices will lead to some additional widening in the deficit in q4, barring a broad slowdown. So a deficit of $615 billion seems quite likely. That translates into a current account deficit of $670-$680 billion, particularly if the q2 weakness in the income account continues (it should) — or an 04 current account deficit closer to 6% of GDP than to 5.5% of GDP. UBS has noted that the trade deficit has been 5.6% of GDP over the past three months, a level for the trade deficit that implies a 6% of GDP current account deficit.

This scares me. All other things being equal, this year’s strong global economy should be reducing our trade/ current account deficits. However, as analysts like Steve Roach have emphasized, the currrent global economy relies on the US for demand and China for supply. The widening deficit is one sign that US consumption growth continues to drive the overall global expansion. My $615 billion overall trade deficit forecast for 2004 can be broken into several components. I expect exports to continue to show strong y/y growth (13%), and to rise to $1152 billion — a reflection of a strong global economy. This is in some ways an optimistic forecast: US exports were strong in q4 of 03, so to continue to show strong y/y growth, q4 04 monthly exports in 04 would need rise from their current level of around $95 billion a month to something more like $98 billion a month. If oil prices stay high, 2004 Oil imports should reach $180 billion, up 39% y/y. 2004 non-oil imports should reach $1588 billion, up 14.5% y/y, so total imports would rise to $1768 billion. Note that the pace of growth in non-oil imports continues to exceed the pace of growth in US exports: the US trade deficit would be growing even without the oil price shock. Exports have to grow 50% faster than imports to prevent the trade deficit from widening, 13% growth in exports and 14.5% growth in imports will not cut it.

Not surprising, various bilateral deficits are also on pace to widen:

The 04 deficit with China is on pace to reach $159-160 billion, an increase of about $35 billion. But China is not the only source of the overall deficit. Other bilateral deficits are also both large and growing. The 04 deficit with NAFTA countries is on track to rise $20 billion to $115 billion — largely because of a $19 billion deterioration in the trade balance with Canada (presumably driven by higher prices on US energy imports from Canada). The deficit with the Eurozone is likely to grow by about $10 billion, to $85 billion, and the deficit with Japan may widen by $8-9 billion to close to $75 billion. A bilateral deficit per se is not a cause of concern, as a bilateral deficit with one country can be offset with surpluses elsewhere, and in some cases, modest overall deficits make sense. But large bilateral deficits with basically everyone imply an enormous global deficit and rapidly growing external debt, both of which should raise concerns, particularly if the overall external deficit is not the product of a surge in investment.

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Oil and the US current account deficit

by Brad Setser Wednesday, October 13, 2004

Oil above $50 a barrel is not good for the U.S. trade balance. Higher oil prices are a tax on US consumers, with the proceeds pocketed by oil exporters. If oil stays above $50 in November and December, the U.S. current account deficit is more likely to be $650 billion in 2004 (5.5% of GDP) than the $615 billion Nouriel and I forecast in August. Indeed, based on the Q2 current account numbers and the current oil price, $650 billion may be a bit too low. A 5.7-5.8% of GDP deficit is not out of the question, given that the quarterly q2 deficit was 5.5% of GDP. Oil is a bit more expensive now than it was then, and at least in q3, US consumption growth seems to have been strong — so it hard to see much of a fall off in non-oil imports offsetting the rising oil bill.

US imports of petroleum and petroleum products are likely to be around $180 billion in 2004, assuming oil stays at around $52 til the end of the year — up from $129-130 billion in 2003 and $100-101 billion in 2002. That mostly reflects the rise in the annual average oil price from $26 a barrel in 2002 to $31 a barrel in 2003 to $42 a barrel in 2004 (I am using sweet light crude/ WTI as a proxy for oil import prices — actual US imports include some heavier, creaper grades and thus cost less that the market price for sweet light crude, but all the price of all grades of crude tends to rise when WTI/ sweet light rises). Since oil was a lot lower at the beginnning of the year than it is now, the full impact of $52 a barrel oil — assuming that recent price spike is sustained — on the current account won’t show up til 2005. It is no wonder that analysts like Stephen Roach are starting to get worried.Let’s look at 2005 in more detail. A $10 barrel increase in the price of oil — say from an annual average of $42 a barrel in 2004 to $52 a barrel in 2005 — is likely to increase the US oil import bill by about $50 billion (around 0.4% of GDP). This forecast assumes US oil import volumes grow by 5% — their current pace — as a result of continued US demand growth and perhaps some slight falls in US production, but the volume effect is small. That implies an estimated 2005 oil import bill of $232 billion, by my calculations. Ouch. That would be an increase of $52 billion from my 2004 forecast, $103 billion from 03 levels, and $131 billion from 02 levels. Of the $131 billion increase from 02 levels, $113 billion comes from the doubling in oil prices (from roughly $26 to $52 billion), and $18 billion from growing import volumes.

That also puts the 2005 current account deficit — again, assuming US growth remains strong — in the 6.5% of GDP range or more range, since the impact of oil will be combined with, in all probability, a growing non-oil trade deficit and a rising interest bill on the growing stock of US external debt. See Stephen Jen’s piece in the Morgan Stanley global forecast. Jen is not worried about deficits of this magnitude. I am. But even Jen is worried that others will start to get worried, undermining his dollar forecast.

The next president can duck Social Security reform

by Brad Setser Wednesday, October 13, 2004

Schlesinger and Murray have a pre-debate overview of economic issues in today’s Wall Street Journal. All in all, it is not bad.

But I do object to their characterization of Social Security. They note that the first of the baby boomers will reach Social Security’s early retirement age of 62 in 2008 (true) and b) there is not enough money in the Social Security system to pay full benefits for those who will retire over the coming decades ( true only if the 2040s count as a coming decade). The unstated implication is that Social Security won’t be able to cover the benefits of those just about to retire. That is false. Social Security is projected to cover all benefits til 2042 — or until the 62 year old retiring early in 2008 is 96. After that it is forecast to have revenues sufficient to cover around 75% of forecast benefits without any reforms.

People my age should be a bit more worried — I’ll hit 67 in 2037, and after 2042, identified revenues are only expected to be sufficient to cover 75% of expected benefits. Still, I would argue that the next President should focus on lots of things other than a forecast 1% of GDP deficit in the Social Security system after 2042, for example, the roughly 4% of GDP deficit in the rest of the government’s CURRENT budget — a deficit that would be closer to 5% of GDP but for the funds the rest of the government is currently borrowing from social security. We will run out of money to do all the things the federal government currently does well before Social Security faces trouble.

I don’t want to imply that financing future retirement benefits is not a problem. The share of federal spending going to Social Security is sure to go up over time, as Pete Peterson and others like to emphasize. But that, in a sense, is fair. Social Security has been financing the rest of the goverment since the mid-80s reform. The rest of the government will have to pay Social Security back. Interest on the Social Security system’s government bonds will be paid out of other federal revenue sources, allowing Social Security to pay benefits in excess of Social Security taxes for a while. Nothing surprising there. Borrowed money has to be repaid with interest. My problem with the emphasis usually placed on Social Security reform is that it detracts attention from the much bigger (4% of GDP v. 1% of GDP) and much more immediate (2005 v. 2042) problem with the rest of the federal goverment’s finances. The Social Security system is taking in more money that it pays out in benefits, and will do so for several more years. The same most certainly can not be said for the rest of the government.

No jobs, No WMD, No Osama

by Brad Setser Friday, October 8, 2004

By the criteria the Bush Administration set for itself in 2002 (and perhaps early 2003), the past two years can hardly be judged a success. Osama is still wanted, dead or alive. It turns out that Saddam had disarmed, so we did not need to disarm him. And job growth has lagged far behind the Bush administration’s own forecasts, forecasts made when the Bush Administration decided to sell cutting taxes on investment income as a short-term jobs program. Check out the charts produced by Kash at the Angry Bear.

Incidentally, the private sector jobs deficit (and particularly the dearth of manufacturing jobs) is not divorced from the way we have been financing our fiscal deficits — the trade deficits associated with borrowing from abroad to finance fiscal deficits hurt manufacturing intensive states like Ohio. Of course, the large purchases of government bonds and other fixed income assets by Asian central banks are also helping to keep property values up, at least in coastal cities that don’t depend on manufacturing. After all, borrowing from China keeps interest rates below what they otherwise would have been. More on the sectoral implications of current macroeconomic imbalances later.

Find a way to spend the $18 billion in Iraq!

by Brad Setser Friday, October 8, 2004

I have a certain interest in the topic, since in my first and so far only foray into oped writing, I supported the Bush Administration’s call for $20 billion in US grant aid for Iraq (in the end, congress authorized $18.4 billion). It made sense to me to mobilize the US’s financial power to try to win the peace in Iraq with dollars and dinar, not bullets. I say financial power consciously — right now, the US is borrowing from Japan and China to provide grant aid to Iraq. Or it would be if the U.S. were actually spending any of the aid package in Iraq. Not only has the US spent a tiny fraction of the total, only $1.2 billion, but — as Kevin Drum noted using this CSIS report –only a tiny fraction of that, $270 millon, actually has actually been spent in Iraq. $270 of $18.4 billion, after more than a year. That is pathetic. $18 billion is a lot of money for a country like Iraq; its annual GDP is probably somewhere between $20 and $30 billion. Given, Iraq’s population of roughly 25 million, $18 billion works out to be something like $750 per Iraqi. If we had simply used the existing food ration cards as the basis for a distribution system to provide a one off $100 payment for every Iraqi (marketed as an advance on their future oil revenues), it would have put $2.5 billion of purchasing power directly in Iraqi hands. Admittedly, that just supports consumption and does nothing to rebuild/ rehabilitate Iraq’s infrastructure. But it does suggest that it would not have been hard to put more than $270 million into Iraqi hands. I can see why Hagel and Lugar are not happy.

Why is China running a current account surplus in the middle of an investment boom?

by Brad Setser Wednesday, October 6, 2004

I spent most of the past week in Washington for the IMF’s annual meetings, trying to sell a few books. The focus of the meetings though, was not on emerging markets, but rather on oil, China and the United States. The most interesting presentation I saw came from Nick Lardy, who laid out the case that China’s rapid economic growth was the product of an unsustainable boom in domestic credit.

One thought occurred to me — it is rather unusual for a country to run a 2.4% of GDP current account surplus (the IMF WEO estimate for 2004) in the midst of an investment boom. The US current account deficit widened in the late 90s during the IT driven investment boom (and internet stock bubble). Countries like Thailand had massive current accounts in the mid-90s during their investment boom (and property market bubble). A surge in investment usually leads a country to import capital from abroad to finance that investment.Lardy argued that massive domestic credit expansion is fueling China’s investment boom, and that investment has risen to levels that are unsustainable even in a high savings/ fast-growing Asian economy. Moreover, Lardy argued that investment will fall as a share of China’s GDP, and, if past patterns hold, that consumption will fall as well. This is what happened from 93-97 — after another investment mini bubble burst in the early 90s. Falling investment/ rising savings (relative to GDP) is a recipe for a growing current account surplus. Remember, when Thailand’s bubble burst in 97, it went from a current account deficit to a current account surplus. Lardy expects China to cool, not crash — but his prediction that Chinese current account surplus will rise as China’s investment-driven economy cools is still sobering to those of us who are worried about the US external deficit. Lardy’s forecast implies that China is unlikely to facilitate smooth global adjustment through strong domestic demand growth, as it needs to retrench to address its own domestic imbalances.

Two further points:

1) Lardy’s argument suggests that a growing China’s current account surplus may provide additional financing for the US current account deficit. I doubt that this will provide enough additional financing to significantly delay the need for adjustment in the US, given that the US is so much bigger than China. An increase in China’s current account surplus from say 2.5% of GDP (assuming GDP is around $1.5 trillion) to 5% of GDP provides an additional $35-40 billion in financing — not really enough for the US (it is only 0.3-0.4% of US GDP). But the prospect of a growing Chinese current account surplus is a slight qualification to the argument Nouriel and I made that the US is likely to exhaust available Asian financing for its current account deficit relatively quickly — though it also raises concerns that the US might be forced to adjust at a time when China is no longer booming, and thus not helping to soften the blow to the world economy.

2) Those who emphasize that China’s overall trade is relatively balanced despite its large bilateral surplus with China probably should qualify their argument by noting that China is running a significant (2.5% of GDP counts as significant in my book) global current account surplus despite surging commodity prices (an unfavorable change in China’s terms of trade) and an unsustainable investment boom — both of which would be expected to typically generate a current account deficit. China’s exports to the US look set to grow so strongly this year that they will prevent China’s current account surplus from falling much, even with China’s rapidly growing bill for oil, iron ore and soybean imports! (China’s bilateral trade surplus with the US could be close to $150 billion in 2004, around 10% of China’s dollar GDP — enough to offset bilateral deficits elsewhere). Lardy’s argument implies that China’s cyclically adjusted current account surplus would be larger than 2.5% of GDP — more evidence that the renminbi is undervalued!

Cheney is wrong: $80 billion in debt relief if not equal to $80 billion in cash

by Brad Setser Wednesday, October 6, 2004

Last night, Vice President Cheney claimed that US allies were contributing $80 billion to the war in Iraq by providing Iraq with debt relief. He compared this $80 billion in debt relief to the cash the US is laying out to keep a large army in Iraq, and to pay for Iraq’s reconstruction/ training Iraq’s army/ training Iraq’s police. To me, this does not pass the smell test. THe debt deal has yet to be done. Plus, forgiving debts that won’t ever be paid provides Iraq with no new resources, and contributes little to meeting Iraq’s immediate need for financing. Debt relief is not the same as cash aid, or even new loans. Using U.S. budget numbers, $80 billion in debt forgiveness is worth more like $8 billion, not $80 billion.Cheney’s argument is misleading on several levels.

1: There is not yet agreement on the amount of debt relief that Iraq will receive. Iraq just got an IMF program, the first step toward getting debt relief, but there are still tons of obstacles to a deal. First, the Paris Club (the group of major creditor countries) has to agree on terms with Iraqis — something that has not yet happened. Then Iraq has to get a deal with its non Paris Club creditors, both other Arab states and private creditors. The debts Iraq owes to other Arab states are important — the $45 billion Iraq is esimated to owe the Gulf states exceeds the $42-43 billion Iraq owes the Paris Club creditors (Iraq also owes roughly $12 billion to private creditors, and another $15 billion to countries in Eastern europe and elsewhere that are not in the Paris Club — Richard Segal of Exotix provides the best estimates). There are also still differences to sort out inside the Paris Club. Iraq has roughly $120 billion in debt . The US is pushing for 90-95% debt reduction. France and Germany are saying 50%. The UK is saying 80%, I think. Russia and Japan are probably closer to France and Germany than the US. France and Germany are wrong on this: 50% debt reduction is not enough, it would leave Iraq with $60 billion in debt, too much for a $30 billion economy. And in addition to debt, Iraq also owes war reparations from the first Gulf war. To get $80 billion, Cheney is assuming that the roughly $108 billion ($120-$12 owed to private creditors) will be reduced to $28 billion — and that deal has not been done.

2: Forgiving $80 billion is worth a lot less than $80 billion. The US already has put a price tag on forgiving the 95% of the $4 billion or so that Iraq owes the US (roughly $2 billion in pricipal and $2 billion in interest arrears). It will cost cost $360 million, not close to $4 billion, because the US never expected to be paid in full. In other words, it costs the US about $100 million for every $1 billion in Iraqi debt it forgives, so forgiving $3.8 billion (95% of 4 billion) costs around $360 million. Applying a similar methodology to estimate the costs other countries would incur from reducing their claims on Iraq suggests that forgiving $80 billion in debt is roughly equal to providing $8 billion in cash. Of course, the budget cost of forgiving debt is not the same across countries, but $8 billion is a better estimate of the price tag of forgiving $80 billion in non-performing Iraqi debt than $80 billion. $8 billion is something, but it is also a lot less than the $18 billion US economic aid package, let alone the military costs the US is incurring. 3: Debt relief won’t improve Iraq’s current cash flow, or provide funds for new investments in Iraq’s infrastructure/ funds to accelerate the training of a new army. Remember, Iraq is not paying anything on its debt right now, so a deal that cut Iraq’s debt from $120 billion to $40 billion and then had Iraq make even tiny interest payments on its debt would INCREASE, the current burden of Iraq’s debt. Paying something is more than paying nothing. Iraq would gain far more from cutting the pace at which is paying its gulf war reparations, as such payments are currently eating up 5% of its oil revenues.

4: Debt relief won’t suddenly let Iraq start borrowing again. Even if Iraq’s debt was reduced by 2/3s to $40 billion, it would still not be in a position to take on new debt — its debt to GDP ratio would be more than 100%, and it would still owe reparations. In the near term, no matter what, Iraq needs grants, not new loans. I disagree with those — not just Dick Cheney — who argue that debt is major obstacle to Iraq’s reconstruction in the short-run. Debt relief is important in due time, but it is far from a pressing need. The lack of security, and the fact that is not clear who will be governing Iraq (or for that matter, if Iraq will remain a country) in a year, let alone two or three years, is a far bigger barrier to investment/ new borrowing than Iraq’s debt overhang. Debt is being addressed now because it is something that does not hinge on improving the security situation. A debt deal can be done without ever going to Baghdad. In sum, forgiving debt that is currently not being paid, and that never will be paid, is in no way comparable to providing new money, money that can be used to build infrastructure, pay the salaries of the police, pay for training an army, etc. It is easy to see why Cheney wants to get a big number out of debt relief, but it is still misleading. He is counting chickens before they hatch, and comparing apples (debt relief) and oranges (cash aid).