Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Their savings, our problem?

by Brad Setser Tuesday, November 30, 2004

It seems like American households are now saving about a penny of every dollar they earn, and recently even less. Foreigners exporting to the US, in contrast, save roughly 35 cents of every dollar they earn.

That is why the US depends so heavily on foreign central banks — and other generous souls abroad — to finance our budget deficit, and, more generally, to let Americans spend more than Americans earn. In aggregate, foreign savings will finance somewhere between a quarter and a third of all US investment this year.

Bond king Bill Gross clearly does not think this game can be sustained for long. But he also notes that if foreign central banks snap up every extra dollar that their exporters are earning in the US and then lend these dollars back to the US by buying US Treasuries, a larger current account deficit could well be consistent with stable Treasury prices/ relatively low interest rates — at least for a while.

If Gross did not learn that lesson from personal experience, others certainly did. Shorting the 10 year Treasury bond was painful at times over the summer. If a falling dollar generates more pain than the rest of the world can bear, and some big time players start intervening again and they park the dollars they are buying in the Treasury market, that would have an impact on the Treasury market. To quote Crane and MacKenzie in today’s WSJ: “Asian central banks have been called the no. 1 distorting factor in the Treasury market for much of this year. Their stepped-up buying of Treasurys, particularly in the first quarter, helped keep yields artificially low, according to many domestic investors and analysts.”

Crane and MacKenzie, though, go on to note: “investors now believe Asia’s support can no longer be taken for granted.” The Bush Administration, unfortunately, does not seem to be in the same place as the bond market. The United States’ current creditors have reason to be scared when an economist at a think tank close to the Bush administration on economic policy, if not on foreign policy, suggests that the US can increase its fiscal deficit by $212 billion a year without any impact on interest rates. The evidence: US debt went up by a trillion in Bush’s first four years without much impact on long rates. Of course, Asian central bank buying had something to do with that — as Steve Roach has noted, Asian reserves went up by about a trillion over the same time frame too.

Gross’ commentary on the Treasury market suggests one way our creditors could make their (dis)pleasure at US policy known: shift from Treasuries to short-term bank deposits. That would put pressure on long-term interest rates. It might remind US policy makers that long-term interest rates stayed low despite a surge in supply in no small part because of an offsetting surge in demand from foreign central banks. Sell Treasuries but not dollars. Clever. The tactic would work anytime a major holder of Treasuries wanted to signal, relatively subtly, that US economic policy — or for that matter US foreign policy — is failing the global test.

To be sure, a big holder could not shift out of the Treasury market, particularly the long-end of the market, without moving the market and cutting the value of its remaining holdings. The US should not take too much comfort from this though. If Gross is right, those in Asia holding long-dated, fixed coupon Treasuries are gonna see their value fall, the only real question is when … if they start to think the US is ignoring their concerns as creditors, they might decide the time has come to send the US a signal.

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Just because one dollar currently buys something like a million and half Turkish lira …

by Brad Setser Tuesday, November 30, 2004

That does not necessarily mean the Turkish lira is cheap. Right now, given Turkey’s almost US scale current account deficit (close to 5% of GDP), the lira probably is a bit overvalued. Turkey is going to exchange a million old lira for one new lira in January. That will make working on Turkey a bit easier — no more lira quadrillions — but lopping a bunch of zeros off both the currency and off local prices is not going to make any one rich (apart from a few scam artists), nor will it change the lira’s external value.

The same is true in Iraq: One dollar currently buys 1460 Iraqi dinar, but that does not necessarily mean the dinar is cheap.

This article is not going to make me popular in some quarters. It seems that there are some folks selling dinar to the US retail market, though there not as many who are also willing to buy. The sales pitch for dinar often goes like “if each dinar were only worth one cent” … you would make a killing.

That, alas, is not going to happen. End the war, and Iraq’s economy should be bigger than the $20 or $25 billion it is now. So the dinar might (and emphasis should be placed on the might) do something like double in value if (a big if) all goes well in Iraq over some time frame. It also might fall if things go poorly.

But Iraq is going to remain a relatively poor country for some time. The dinar is not going to go up by a factor of ten, let alone the factor of fifteen needed for one dinar to buy one cent. That would be like the euro appreciating so that one euro bought ten dollars, or the yen appreciating so that ten yen bought one dollar. Like Martin Wolf, I think the dollar has further to fall, but even I think that kind of change is just not going to happen.

Make no mistake, the big brokers selling dinar are making a profit no matter what. The central bank was selling dinar this morning for 1460, so a million dinar cost about $685 in Baghdad. A broker is offering a million dinar for $790 over the internet. Getting the dinar out of Iraq probably takes a bit of effort — the broker is offering a real service — but that is still a nice markup …

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Et tu, Indonesia

by Brad Setser Monday, November 29, 2004

First, Russia decides it wants to hold more Euros and fewer dollars. And now Indonesia?

“Indonesia’s Aslim Tadjuddin, deputy governor for monetary policy at the central bank, said on Nov. 26 that the country may trim its U.S. holdings should the dollar keep dropping.”

While Korea has not said — to my knowledge — that it wants to hold more Euros, its central bank clearly would prefer not to be accumulating quite so many dollars. But it seems to be having a hard time getting out of the Bretton Woods two cartel; Korea intervened again on Monday. The consequences of truly floating, at least when China is still pegged to the dollar, seem to be a bit too dire … given the state of Korea’s own economy.

An argument could be made that Japan was the first to defect from the Bretton Woods two dollar financing cartel: it stopped intervening to support the dollar back in the spring, and while it has not diversified its existing reserves, it has not been adding to them. That could be considered a form of defection. Full membership in the cartel requires two things: a) holding on to your existing stock of dollar assets, and b) buying more dollar assets to keep your currency from appreciating, and in the process provide the ongoing vendor financing the US needs to consume more than it produces.

It is hard to say that Japan is really out of the cartel, though, when there is such a strong expectation that they will step back in should the yen rise above a certain threshold …

Where is China keeping its reserves …

by Brad Setser Monday, November 29, 2004

It is not too hard to figure out what Japan is doing with its reserves.

From the beginning of 2003 to September 2004, Japan’s official reserves increased by $360 billion. Over that time frame, Japan’s holdings of treasuries increased by $342 billion. That number also includes private Japanese purchases of treasuries, but it still tracks the reserve data pretty closely. There is a bit of a lag between the purchase of dollar reserves and the purchase of treasury bills with those dollars, but the two go up together. There is a reason why treasury dealers say Japanese intervention leads to higher demand for short-term treasury bills.

China poses a bit more of a mystery. From beginning of 2003 til September 2004, the People’s Bank of China’s (PBoC) reserves increased by about $268 billion (including the roughly $45 billion used to recapitalize state banks). China’s recorded holdings of treasuries increased by $56 billion over this time, so only 20% of so of China’s increased reserves are showing up in higher recorded Chinese holdings of treasuries. This year reserves are up $106 billion while holdings of treasuries are up only $16.5 billion, so the fraction of Chinese reserves going into Treasuries seems to be declining over time.

So what is China doing with the remaining $210 billion of reserves assets that it has added over the past two years? Some of it may be going into “disguised” buying of Treasuries – through various asset management firms or foreign broker dealers. Holdings of treasuries by Caribbean banking centers are up are up $50 billion this year; UK holdings are up by a comparable amount. Some of the demand from the Caribbean represents demand from US hedge funds based there. But some may be coming from central banks working through foreign broker dealers or even investing in hedge funds (remember, the Bank of Italy invested in LTCM).

Some of China’s growing reserves are no doubt going into other US assets – agencies, asset backed securities, even corporate bonds — to try to get higher yield. Reported official buying is of these assets is small, but central bank may be buying through intermediaries.

Is much going into Euro denominated assets? To date, probably not – people in the market would know if the PBoC was moving into Euro. Moreover, China is large enough that its numbers impact on the global statistics: in 2003, the world added roughly $60 billion in euro and yen reserves, and $440 billion in dollar reserves. Since China accounted for about a quarter of the overall increase in the world’s reserve, it seems likely that its reserve acquisition did not deviate too much from the global breakdown of roughly 90% dollars/ 10% other currencies.

Let’s look at the data in slightly different way, by looking at China’s total stock of reserves rather than what China is doing with the reserves it has bought over the past two years. The Economist this week estimated that 80% of China’s $515 billion in reserves are in dollars, which works out to $412 billion. China’s recorded holdings of Treasuries are around $175 billion. That leaves around $240 billion in other dollar assets – not chump change.

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Where are the bond market vigilantes?

by Brad Setser Sunday, November 28, 2004

The typical price of irresponsible fiscal policy is higher long-term interest rates.

U.S. fiscal policy has been, in my view, somewhat irresponsible, particularly given the lack of private savings in the US. Over the past four years, the US government has shifted from a small structural surplus to a structural deficit. And the long-term deficits also has gotten worse, at least if you make reasonable assumptions about spending growth and assume existing tax cuts are made permanent.

Long-term interest rates, though, remain quite low. In part, this is because short-term interest rates remain low. But that is not the entire reason.

Let me posit one other reason: long-term interest rates have remained low because the US has not (yet) had to market many bonds to private investors.

The overall number of Treasuries in the hands of “US” market participants fell substantially between 1996 and 2000 as the supply of “marketable” Treasuries fell (as a result of budget surpluses), and then stayed constant between 2000 and 2003 despite the large increase in the overall supply of treasuries. Why? Because the Federal Reserve is holding more Treasuries as a result of its monetary policy operations and because foreigners – as we all know well – bought a lot of Treasuries. There is good reason to believe that most foreign purchases of Treasuries are coming from foreign central banks (see below). Consequently, the overall stock of Treasuries in the hands of US investors (other than the Federal Reserve Board) probably mirrors the stock of Treasuries in private hands reasonably well.


Put differently, private US investors certainly held lots fewer Treasuries in 2003 than they did in 1996 — and private investors worldwide probably did to — despite the Bush Administration’s 2002 and 2003 fiscal deficits. We don’t have full data for 2004, but the broad story likely stayed the same — at least until recently.

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Chinese yuan hits new low against euro, swiss franc, pound …

by Brad Setser Wednesday, November 24, 2004

Just a reminder of what falling dollar currently means. Dollar depreciation is clearly part of what is needed to bring the US trade deficit down to a more sustainable level. But what is the case for China — with its $50 billion or so current account surplus and $150 billion or so annual reserve increase — to depreciate against the world as well?

General glut’s weblog nicely reviews today’s events.

And let me take a moment to give Thanksgiving kudos to the Financial Times for their recent coverage of the dollar story. The oped page has run solid pieces by Wolf and Cecchetti. Phil Coggan’s column on Monday said what a lot of what I was trying to say in my post about “large players in large markets” in a lot fewer words. The Wall Street Journal ran a Monday story emphasizing that Asia was accepting dollar depreciation (to a degree). The FT had a set of stories on Monday highlighting the difficulties created by the asymmetries in the way Asia is adjusting: the won and the yen have strengthened v. the dollar and the yuan has stayed fixed (i.e. the won and yen have strengthened v. the Chinese yuan). Hence friction between Korea’s finance ministry and central bank, and Japanese talk of intervention. The WSJ story was OK, but it failed to pick up on the tensions among the Asian countries in the way that the FT’s combined coverage did.

Today’s FT had a nice story on Russia’s desire to build up its euro reserves — evidence that at least some of smaller parts of the Bretton Woods system are tiring of the dollar reserve accumulation game.

All these articles tell part of the dollar’s story — the growing desire on one hand to diversify reserve holdings to protect against a dollar fall (or in the case of the People’s Bank of China, a desire not to have to add to its already massive dollar holdings to soak up massive capital inflows) and on the other hand worries that failure to intervene will siphon away growth by undermining exports.

The FT has long paid more attention to international economic issues than the WSJ, in part because of London’s currency markets. And in a world where at least half the financing for the US current account deficit is likely coming from official sources (i.e. central bank intervention), its greater emphasis on the “policy world” also is likely to pay real market dividends.

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The budget deficit before all the bad stuff

by Brad Setser Tuesday, November 23, 2004

Isn’t that what leaving any increase in deficit associated with partial privatization of social security off the books implies?

Bush’s formula on the dollar in Santiago emphasized the need to control both short-term and long-term deficits. I suspected he was laying the groundwork for arguing that his valiant efforts to reduce the relatively small (1.5% of GDP) deficit in the social security account after 2042 should offset the say 1.5% increase in the current budget deficit associated with many partial privatization schemes. But even I did not think they would float the idea of excluding any increase in the deficit associated with the transition off the books.

W has long spoke against the “soft bigotry of low expectations” — the idea that you are doing a student who does not meet educational standards a favor by promoting the student to the next grade, irregardless. But isn’t that kind of like what the Bush economic team is proposing here? If you cannot meet the 2% of GDP fiscal deficit target in 2008, conventionally defined, shift the goal post/ make the test easier/ change the way the deficit is measured so a 4% of GDP deficit is now called a 2% of GDP deficit. Judging from the currency markets today, I suspect cooking the books won’t pass the global test.

That is why the market should discount the administration’s new talk of fiscal discipline — they show no signs of being willing to make hard choices. A serious proposal for partially privatizing social security would raise taxes to fund the transition costs — not change the way the deficit is measured so that the transition costs are kept off the official books.

Incidentally, Steve Friedman is leaving the White House. He clearly was no Robert Rubin. But I suspect he did exert some moderating influence on W’s economic policy — Friedman and Rubin worked extremely closely together at Goldman Sachs, so I suspect he shared at least some of Rubin’s economic policy instincts. The names floating around for the NEC job right now are not encouraging.Incidentally, I am not at all sure W is doing himself any favors by emphasizing the long-term deficit:

1) Medicare is in much worse shape than social security. It has a much larger long-term deficit than social security. W made its long-term deficit worse with the Karl Rove “I want to win Florida” prescription drug benefit.

2) It is easy to see how partial privatization could increase, not decrease Social security’s long-term deficit. Roubini wrote about this recently in his blog. To cut the long-term deficit in the social security system, you need to increase revenues/ decrease benefits. Partial privatization reduces the systems’ revenues, which means the needed cut in benefits is much deeper. If you partially privatize and don’t cut benefits enough to eliminate the existing (after 2042) deficit AND the additional deficit created by diverting funds into private accounts, you make the system’s long-term deficits worse.

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Maybe Airbus will make the A350 in America?

by Brad Setser Tuesday, November 23, 2004

Airbus seems to be planning to update the A330 to compete with the Boeing 7E7. Civilian aircraft are (or perhaps were, Airbus is certainly gaining) the United States’ leading export. Maybe Airbus should consider following the advice of the Deputy Governor of the People’s Bank of China, who seems to think the US will remain a competitve base for glocal aircraft production.

“They [the US] should concentrate on sectors like aerospace and then sell those things to us [China] and we would spend billions on this. We could easily balance the trade.”

One of my concerns about the trade deficit is that the US is borrowing tons of money from abroard, but not to invest in US export industries. Rather, we are selling Treasury bills to fund the government, securitized credit card debt (and other asset banked securities) to fund consumption, and agency debt (securitized mortgages) to fund investment in residential housing. If European capital wants to use US labor to produce for a global market, I am all for it …

After all, producing the A350 in the US would be one way for Airbus to hedge v. the Euro/$.

US economic policy does not pass the Chinese test

by Brad Setser Monday, November 22, 2004

You could sort of see this headline coming: China tells the US to put its house in order.

Lenders never like receiving lectures on sound economic policy from their borrowers.

John Snow might have been well served if had asked the Europeans to leave the G-20 meeting (temporarily) and then started his comments with “my creditors, thanks for $400 billion plus in 2003, and, I hope, something similar this year.” As Steve Roach noted today, we need China to keep lending to us at low rates to keep our current credit fueled expansion going —

Still, it seems the Chinese are getting a bit cocky. We knew China was going after the Carolina (textiles) and even Ohio (autoparts). But Kansas and the rest of the agricultural Midwest? The logic behind the statement that “The appreciation of the RMB will not solve the problems of unemployment in the US because the cost of labour in China is only 3 per cent that of US labour they should give up textiles, shoe-making and even agriculture probably” is, I suspect, a bit off as well. Some agricultural production is labor intensive, and China may have an advantage — apple picking and apple packaging, for example. But never underestimate the power (the efficiency) of a tractor, a combine and a big expanse of flat land …

China is right to note that the US — and US policy makers — bear primary responsibility for the US trade deficit. But China also needs to recognize that the US cannot import more than it exports indefinitely. The explosive growth in China’s exports to the US will have to slow unless US exports to China really, really take off — and it won’t happen unless the US exports a few things other than planes.

For the past ten years the US has consumed more than it produced. In one or another, the US and the world will have to adjust, now or later. Adjustment will likely require more than just a smaller US budget deficit; the real exchange rate also will need to adjust. Chinese wages won’t continue to be 3% of US wages forever. If the exchange rate stays constant, the adjustment will come through some combination of Chinese inflation and US deflation. Far better, in my view, to let the exchange rate move.

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The Times is overselling the impact of the Iraq debt deal

by Brad Setser Sunday, November 21, 2004

Getting agreement from the Paris Club creditors to write off 80% (in stages) of the $40 billion or so that Iraq owes them is no doubt a good thing — not the least because it lets the US (and Iraq) press the gulf states and private creditors who are owed another $85 billion or so to do a comparable deal. 80% debt relief across the board would cut Iraq’s debt to about $25 billion, or around 100% of its current — depressed — GDP. Iraq also still owes about $30 billion in war reparations.

I even accept the Bush Administration’s spin that this is a sign of the health of the Atlantic alliance — the Bush Administration wisely sought to work through the existing institutions for granting debt relief (the Paris Club), not to work around them. It based its case for debt relief on the grounds that Iraq has more debt than it can pay, not on the harder to win argument that all of Iraq’s debt is illegitimate (If Saddam’s debt is illegimate, why was Russia stuck with the Soviet Union’s debt? Not an irrelevant question since Russia is an important creditor of Iraq). The Evian communique last year even laid the groundwork for a deal by calling for developing new Paris Club rules allowing greater flexibility for middle-income countries.

Good job, all around. You might even say the Bush administration decided to frame its calls for debt relief in a way that passed the global test.

What I have trouble swallowing is the hyperbole in Craig Smith’s article, namely the idea that writing off a bunch of debt that was never going to be paid somehow is a crucial milestone in Iraq’s reconstruction. Writing a large chunk of the debt off is a necessary thing to do at some stage, but it is not going to change anything on the ground right now. Statements like “Clearing the liabilities from Iraq’s books is considered almost as important to its future as defeating the insurgency because the country cannot hope to attract investors while carrying the current amount of debt” are just ridiculous overstatements. US aid flows to Iraq have not been blocked by a debt overhang. Private investors won’t suddenly flood Iraq, even into the oil industry: they don’t want to invest long-term in a country whose future political structure is still so undefined. Any private long-term investment in the current climate would come with an extraordinarily high risk premium, and effectively require Iraq to sell its politically sensitive future oil production on the cheap.

Indeed, in a sense, nothing has changed with the debt deal. Before the debt deal, Iraq was paying nothing on its debt of $125 billion (using the IMF’s estimate, not the estimate in the NYT article). After the deal, Iraq won’t be paying anything for the first three years on a smaller debt load (interest on Iraq’s debt is being deferred, as is principal). Most new aid to Iraq still should be in the form of grants, not new loans.

The real reason for the debt deal is laid out later in the article. It was something that everyone could do to help Iraq on the cheap.

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