Brad Setser

Brad Setser: Follow the Money

Large Players in Large Markets

by Brad Setser Saturday, November 20, 2004

One of the world’s ironies is that even as John Snow putters on about how currency values should be set by market forces, the market — or at least the private market — is now playing a comparatively small role in defining the dollar’s value (and in providing the capital flows the US needs). True, the dollar’s value v. the Euro is set in the private market, to the current chagrin of Germany’s finance minister. But the dollar’s value v. the Chinese renminbi (yuan) surely is not set in private markets — and the US is likely to import as much from China as the Eurozone this year. The dollar’s value v. the ruble is not really set entirely in the market, given the Bank of Russia’s reserve accumulation. Its value v. the yen? Certainly not set by the private market this spring, when the Japanese government spent $140 billion defending the dollar, and expectations of MOF (Ministry of Finance) intervention still cast a shadow over the market.

The US has not intervened to support a strong dollar during the Bush Administration (intervention requires selling the US government’s stock of yens or euros to buy dollars), but other countries sure as hell have intervened to keep their currencies weak against the dollar (buying dollars with their yen, renminbi or rubles). John Berry is right: the US may not have a strong dollar policy, at least not in the sense of using policy tools to keep the dollar strong. But lots of other countries clearly do have a strong dollar policy: they are spending real money to keep their currencies weak. Intervention is intervention: the dollar’s value is being managed, just not by the United States.

The interesting question is whether some countries currently intervening to keep their currencies weak (and the dollar strong) are tiring of that game — as it implies both the risk of importing inflation and growing holdings of risky dollar assets. Russia, for example, seems to be interested in holding more euros and fewer dollars. Korea intervened last week, but it may be having second thoughts. The other interesting question is whether some countries (or economic regions) not currently intervening to keep their currencies weak are tiring of watching their currencies strengthen against the dollar, and their economies slow — afterall, a stronger euro means weaker European exports and a weaker Eurozone economy. Eurozone finance ministers –if not the ECB — seem to be at least contemplating getting into the currency management game …

Intervention clearly played a big role supporting the dollar in 2003 and 2004. I increasingly suspect it will play a big role going forward as well. It is hard to go from borrowing $400 billion plus from the world’s central banks annually to zero. The key question may be whether central bank intervention is done to support the current overvalued dollar (as China is doing now), or whether it is done to support an “orderly” depreciation of the dollar — effectively providing the US with the financing it needs (at the rates the US needs to avoid a sharp slowdown) as it starts to adjust.

More details follow, but a warning first: the following dicussion is rather long, even by Nouriel Roubini/ Brad Setser blog standards.Roubini and some of his non-Setser coauthors developed an interesting model to explain the impact of large player — which they took to be the IMF — on financial markets in emerging economies. Their model is based on two observations. First, the IMF does not provide all the financing an emerging market needs in a crisis. The IMF can be overwhelmed if all external creditors and investors — or if all domestic creditors and investors — decide to leave. Second, the presence of IMF financing can change the perceptions of other actors in the markets, and thus still have an impact. The US Treasury/ IMF bailout of Mexico worked. Roubini, Corsetti and Guimaraes drew on the global games literature to develop a more sophisticated — you might even say nuanced — view of the impact of a large player like the IMF on the market for emerging market debt.

Take the following example. Suppose a country needs to raise $50 billion annually to roll over its domestic and external debt. Suppose its domestic and external private creditors think the private markets will only make $40 billion — max — available. That could generate a panic which leads everyone to get out before the financing shortfall leads to big asset price falls/ sharp falls in the currency/ other nasty things. The country might not even by able to get anything close to $40 billion, at least not until after its financial markets have tanked. No one wants to buy high and then sell low. Now suppose the IMF makes $20 billion available. Creditors now think, hey, the country has all the financing it needs, the IMF is putting up $20 and we think the markets will be good for at least $30 billion, so let’s stay in. That oversimplifies a bit — I am leaving out the role of improved policies in the debtor country, for example. But the basic idea is simple: the presence of a large player willing to put money on the table can influence the behavior of other players in the market.

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Optimist or Ostrich?

by Brad Setser Saturday, November 20, 2004

For those who want dispassionate economic analysis devoid of politics, read no further. Wait for my next dollar post. This is a center-left response to the Lexington column in this week’s Economist. It claimed the Republicans generally, and W specifically, won not by playing to people’s fears but by capturing their optimistic dreams. W was the optimist both demographically, capturing the votes of fast growing exurbia in the sunbelt (Houston, Atlanta, Phoenix, central valley of CA), and with his policy proposals, notably his call for partial privatization of social security.

I have three problems with this argument 1: While partial privatization and a policy that gives tax advantages to individual health care savings accounts while taking away the tax advantages now given to group health insurance plans arguably reflect an “optimistic” assessment of the ability of individuals to manage risk, they reflect a deeply pessimistic view about our capacity to do things together. They dismiss the values that spring from Bill Clinton’s observation that “we are all in this together.” Don’t count on the government to insure you against the worst risks that come with old age. Don’t count on any company to insure you against massive medical expenses. Etc. That is not necessarily an optimistic vision.

2: It now it is an article of faith for many that Social Security is bankrupt, and is an act of courage to try to fix social security. The substance behind this assertion is a cash flow deficit in the social security system of @ 1.5% of GDP after 2042, which translates into an actuarial deficit on a 75 year basis. But until 2017, social security is projected to run a cash flow SURPLUS, unlike the rest of the government, and to be building up assets, unlike the rest of the government, which is running up debt. Social security is adding to its assets to the tune of $180 billion plus a year right now. Moreover, many proposed reforms would accelerate the onset of a cash flow deficit in social security and increase the overall fiscal deficit to fund transition costs. I would argue that focusing on relatively small cash flow deficits in social securty after 2042, while largely ignoring the 3.5% of GDP fiscal deficit (@ 5% of GDP without social security’s cash flow surplus) and the now more than 5% of GDP trade deficit — is the work of an ostrich — not the work of an optimist. We cannot obviously afford to run up the deficit and our debt to fund the transition costs of partial privatization right now.

3: The argument that Bush got the vote of the “optimist” demographic in the 2004 election is interesting. But the fast growing, “optimistic” sectors of the economy recently have often been those sectors that benefit most from unusually low interest rates — the blue city in a blue state hedge fund industry as well as the red suburbs and exurbs in red states house building industry (not to mention the consumer credit industry). But if you think — as I do — that the US won’t be able to export debt to the tune of $700 billion plus annually to fund a consumer and housing driven economy and will have to start exporting more goods and less debt to pay for its imports, then a new set of sectors are likely to expand in the future. Today’s optimistic sectors may be tomorrow’s Ohio, and vice versa. Basing your electoral future on an exurbia now prospering on the back of cheap credit might not be the best forward looking bet …

Greenspan, part II

by Brad Setser Friday, November 19, 2004

Federal Reserve Board Chairman Alan Greenspan was careful to frame the risk created by rising US external debt for foreigners investing in the US (and in the process financing the US current account deficit) as one of “concentration” risk. Too much of their international portfolio would be invested in the US, they would not be sufficiently diversified, and the lack of diversification itself would lead them to limit their future financing of the US (or demand higher rates).

To quote the maestro:

“Given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point … International investors will eventually adjust their accumulation of dollar assets or, alternatively, seek higher dollar returns to offset concentration risk, elevating the cost of financing the U.S. current account deficit and rendering it increasingly less tenable.”

Greenspan almost has to frame his (and one assumes, the Fed’s) concerns in terms of excessive concentration. He cannot very well come out and say that the US is not an attractive place to invest. But is Greenspan right? Is the risk one of too heavy a concentration in US assets, or is the risk that US assets themselves could simply be unattractive to foreign investors at current prices/ interest rates?

I suspect it is a bit of both. If the US current account deficit is absorbing 75-80% of global surplus savings (i.e. savings not invested at home, or the the rest of the world’s current account surplus), the share of US assets in foreign portfolios (notably foreign central bank portfolios) is rising. So yes, they are over time taking more and more dollar risk, and having a more and more unbalanced portfolio. Greenspan is onto something. A rapidly rising US external debt — barring a surge in the amount of global savings that is invested in foreign assets/ a fall in so-called home bias — implies an ever increasing share of foreign savings will be invested in the US.

That said, you don’t need a theory of optimal global portfolio allocation to highlight the risks of investing in the dollar. Nouriel and I argue that over time, the US trade deficit needs to fall from a bit over 5% of GDP today to no more than 1% of GDP to stabilize the United States external debt to GDP ratio. That could happen today and happen fast, stabilizing the US external debt to GDP ratio at around 30%. But that kind of adjustment would be jarring, as Steve Roach emphasized today. The adjustment could happen gradually and over time, stabilizing the US debt to GDP ratio at 50%. That just might work out OK, a slow fall in the real dollar would lead to a gradual increase in real interest rates and a tendency for US income to grow faster than US consumption. Or the US could continue running large deficits for some time, which almost assures that the subsequent adjustment will happen fast and that the US debt to GDP ratio will stabilize at a high level. But it is hard to see how even the modest adjustment scenario happens without some additional dollar depreciation — even from today’s levels.

So continued investment in the US to fund deficits on the current scale means foreigners are taking on the risk of having an ever increasing share of their assets in one country, and moreover, the risks intrinsic in having even a small share of your assets in a country with a large external trade deficit. The combination of the two is scary. Does that mean investing in dollar assets is a bad idea? I guess that depends. If your home currency has already fallen substantially against the dollar (i.e. the euro), and you think you have identified the next google, investing in the US is probably a good idea. If Stephen Jen is right, the euro has already overshot and should appreciate against the dollar over time, and you might even want to buy a plain old treasury bond (I would personally not recommend it, I have trouble calling the dollar undervalued when the US trade deficit is so large in relation to US exports, and so much higher than what is consistent with a stable external debt to GDP ratio – call me old fashioned. Plus, the euro started life at 1.17-1.18, so even 1.3 is only a 10% appreciation from pre dollar bubble days). If your home currency has not adjusted against the dollar and you are buying low yielding treasury, agency or corporate bonds, it is hard for me to see how current US interest rates compensate for the risk of future dollar depreciation, given the gap between the current US trade deficit and the trade deficit consistent with a stable debt to GDP ratio.

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Greenspan in the news

by Brad Setser Friday, November 19, 2004

Alan Greenspan’s comments on the US twin deficits are getting lots of play. Just saying that at some point foreign appetite for US assets is likely to diminish and won’t stay at its current strong pace is hardly news — it is nothing other than a statement that US external debt cannot rise without bounds over time, and right now, US trade deficits far exceed those consistent with a stable debt to GDP ratio. But it is no doubt significant that Greenspan emphasized that “there are limits” on foreign appetite for US assets, not his standard argument that the “attractiveness of US assets” and “global portfolio diversification” could well support continued foreign demand for US assets for some time.

An aside — the portfolio diversification has to be one-sided to fund the US current account deficit. If US demand for foreign assets goes up by more than foreign demand for US assets, “diversification” would lead to net outflows. To get net inflows, foreigners have to want to put more of their portfolio in the US and US residents have to (broadly) want to keep their portfolio in the US.

While I am glad Greenspan is lending his powerful voice to those calling for fiscal restraint to contribute to orderly adjustment of the current account deficit, the Wall Street Journal article this morning on Greenspan left me in a cranky mood.

I took his comment that government officials making “80,000-100,000″ would be less likely to spot risky hedge fund activity (and, one assumes, risks of all kinds) than Wall Street experts earning millions rather personally — afterall, at one time I worked for the US Treasury looking at emerging market risk. I would hope that the size of your salary is not always indicative of the quality of your analysis. Some people may be motivated by a sense of public service, not just a desire for private reward.

No one would argue that a green beret who leaves the US military and joins a private security contractor for five times the salary is suddenly five times more effective as a soldier. One of my colleagues left the Treasury to join the risk management team at a major investment bank. Did the quality of his work go up simply because he started to get paid more? Should the quality of something like the analysis of US external sustainability that Nouriel and I did be judged by our salaries (less, one assumes, that those on Wall Street doing similar work), or by our actual arguments? Indeed, I would argue that highly paid Wall Street risk assessment sometimes suffers from three problems:

1) The profit motive may hinder judgement of risks, especially if the profits are booked today and the risks are likely to show up later. Hence addmissions by bankers that their peers are “low-balling” credit standards to “gain lucrative trading income and gain market share” in today’s FT article on hedge funds.

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Is it the currency of John Snow and the problem of everyone else?

by Brad Setser Thursday, November 18, 2004

That headline draws on a nice quote from Steve Barrow of Bear Stearns. It paraphrases the famous saying about the dollar — I think from Nixon’s Treasury Secretary John Connally — “it is our currency but your problem”

That is partially true. Falls in the dollar’s value stimulate the US economy — more exports, fewer imports, etc. A rising Euro punishes some of W’s favorite countries — France, Germany and the like. Our currency, your problem.

Alas, though, it is not entirely true that a falling dollar is just everyone else’s problem. If foreign investors start to expect further falls and to demand higher interest rates on their lending to the US, the overall impact on the US is mixed at best. Small falls in the dollar won’t change the fact that the US needs continued access to foreign savings to support its economy. Indeed, foreign savings now finances about 1/4 of the roughly 20% of GDP invested in the US every year. A country that is running a 4.5% of GDP current account deficit is in better shape than one that is running a 6% of GDP current account deficit, but it still needs to attract big net capital inflows from abroad.

So if the US has to pay more to borrow the foreign savings it needs because of expected further falls in the dollar, a falling dollar becomes very much “our problem” — and something John Snow won’t be able to brush off. The real question the US faces today is whether foreigners will continue to want to buy $40 billion of US corporate bonds every month at current, relatively low, interest rates … and if not corporate bonds, then low yielding treasury bonds or something else.Expect more from me on the capital inflow data and reserve data soon. It is always nice when data collected by debtors (in this case, the US) and data collected from creditors (in this case, foreign central banks)match. I have a sneaky feeling the September US capital inflow data doesn’t match with the creditor side data.

In the Wednesday Lex column in the FT, I saw that Asia added $29 billion to its reserves in September. That is impressive, for two reasons. First, Japan was not intervening so the entire reserve accumulation came from emerging Asia (mostly China). Second, Asia imports a ton of oil — more in relation to GDP than the USA — and oil was not low in September. So oil importing Asia was adding to its reserves in September, and no doubt oil exporters were too — I just saw in an I-bank report that Nigeria added almost a $1 billion to its reserves. All in all, it is not unreasonably to think total reserve accumulation was $40 billion or more in September.

Recorded inflows to the US from official sources(i.e. central banks) in the TIC data were only $13 billion. That means one of two things: central banks are buying US assets indirectly (and perhaps moving into higher yielding assets like corporate bonds) through foreign intermediaries that the US reporting system does not catch — remember that Higgins and Klitgaard found that central bank data on dollar reserve accumulation in 2003 far exceeded the inflows the US reporting system caught. Or central banks are buying euro or yen reserves, not dollar reserves. Probably a bit of both …

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Taking away the punch bowl when the party is really getting going?

by Brad Setser Thursday, November 18, 2004

That is the classic view of the role of the central bank. It extends beyond using monetary policy to prevent “overheating” and price inflation. Most central bank regulate the banking system, and since banks supply credit to much of the rest of the financial system — both to investment banks and to hedge funds, the central bank therefore indirectly regulates many “unregulated” institutions and markets.

I am glad the banks are feeling a bit of regulatory heat right now. New York Federal Reserve President Tim Geithner seems to be trying to make sure that banks are not extenting too much credit to hedge funds in good times, setting themselves up for trouble should conditions change.

It is easy to say, after a crisis, that “what is really important is better crisis prevention.” But effective crisis prevention is hard, because it means voluntaryily refraining from the last, often rather enjoyable drink, even when the bar is still open. For the US, it means taking steps to cut our current account deficit before the market forces us too. For the financial system, it means reigning in lending to hedge funds before some hedge fund — or a set of hedge funds making the same fundamental bet — gets in trouble.

The key quote — to my mind — in Geithner’s recent speech on hedge funds comes at the end. The note of concern is rather clear, even if it is cached in Fedspeak.

“Further progress in strengthening risk management practices is an investment worth making “

My translation: A little market discipline please — not every 28 year old trader deserves their own hedge fund.

“particularly when the markets appear to be pricing in a relatively benign view of risk in the financial system and in the economy overall”

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Where are George Soros and the other macro hedge funds?

by Brad Setser Monday, November 15, 2004

With apologies to Philip Coggan, I plagarized his FT headline from a few days ago — he asked the same question as Brad DeLong, namely, why aren’t big bets from big macro hedge funds driving the dollar down, and thus forcing the global economy to correct its biggest imbalance? DeLong went one step further, and suggested that the hedge funds could — collectively — overwhelm Asian central banks with leveraged bets against the dollar, if they decided to make those bets.

Coggan (his columns are available here, but they are behind the FT’s firewall) supplies part of the answer to DeLong’s question. He argues that there is no upward limit on the amount a central bank can intervene to fight appreciation. If the People’s Bank of China wants to add $200 billion rather than $150 billion to its reserves, nothing stops it. To put it differently, to avoid appreciation, you sell your own currency and buy dollars, and you have an (almost) infinite supply of your own currency (there is that pesky sterilization problem, but let’s set that aside). To avoid depreciation, you sell dollars (or euros) and buy your own currency, and you only have so many dollars (unless you can borrow them from the Fed, the US Treasury or the IMF, or someone else with lots of dollars — the central banks of China and Japan both now have far more “dollar denominated” financial firepower than the IMF).

That is no doubt right, but I also suspect there is more to story. The notion that the hedge funds can overwhelm markets may need to be revised after Japan’s Ministry of Finance (MOF) redefined the possible by selling some insane amount yen debt to fund an intervention war chest — a war chest that has financed $100 billion of intervention earlier this year and is far from being empty.

The MOF, and the Chinese central bank, are effectively becoming the biggest macro hedge funds of them all. Both are making enormous leveraged bets on the dollar: selling local currency debt and using the proceeds to buy long-term dollar debt on a scale sufficient to fund a very large portion of the US current account deficit. Soros famously made $1 billion betting against the pound, and I would be shocked if Soros had not joined Warren Buffet in betting against the dollar right now. But the BOJ now has made something like a $500 billion bet on the dollar(assuming the ratio between Japan’s holdings of Treasuries and the BOJ’s holdings of Treasuries approximates the global ratio between foreign holdings and central bank holdings, which is a bit of an assumption).

Since the interest rate on the yen debt is less than the interest rate on the dollar debt the MOF is buying, there is no negative “carry” or fiscal cost associated with this bet. Of course, the real risk is that the dollar will (note correction from original post, per fatbear’s comments — I typed the original too quickly!) depreciate/ the yen will appreciate eventually, leaving the MOF with a capital loss. But the current account deficit can be sustained (and the dollar does not need to fall) so long as the MOF (and others) intervene on a scale large enough to provide the bulk of the needed financing (and to overwhelm any outflows associated with private hedge funds betting against the dollar).

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Will partial privatization of social security pass the global test?

by Brad Setser Saturday, November 13, 2004

This post is primarily about the implications of partial privatization of social security on the budget, not about its overall merits.

For what it is worth, I personally think good old pay-as-you-go social security has an important role to play in a world where old fashioned welfare capitalism and defined benefit pension plans are giving way to 401 (k) type accounts, and more and more people’s retirement income already depends on what happens in the markets. There is something to be said for not putting all retirement eggs in the same 401(k) basket. The “insurance” aspect of social security is important — insurance against bad financial investments, insurance against living longer than your savings, insurance against just earning less over a lifetime than you expected.

The most talked about partial privatization proposal apparently would divert 2% of taxable payroll (about 16% of social security tax revenue) into private accounts. That reform would get rid of social security’s cash flow surplus and would increase the consolidated budget deficit. Right now we depend on foreigners — notably foreign central banks — to finance our budget deficits, so it is worth asking if such a reform could pass the global test … any debtor that is contemplating increasing its debt generally is well advised to ask its creditors first.

Indeed, one of the ironies of the current debate is that many on the American right now have an institutional position that a 1.5% of GDP cash flow deficit in social security after 2042 is a presssing national problem that needs to be solved, pronto, while the roughly 4% of GDP current fiscal deficit (a deficit that woudl be bigger if not for social security’s cash flow surplus) “doesn’t matter” and a 6% of GDP current account deficit TODAY is just a sign of America’s economic success.

So every time I see social security’s $10 trillion hole — a hole that the Social Security trustees incidently have at only $3.7 trillion in present value terms over the next 75 years mentioned to support the argument that Social Security needs to be reformed now, I want to scream — “the entire hole comes from cash flow deficits after 2042.” 2042. The trade deficit will cause problems a lot faster. If current trends continue, the United States’ external debt will reach $10 trillion in 2010. 2010.

I suspect the United States’ foreign creditors will be less than impressed if we make our current fiscal problems worse in order to address a burning fiscal gap in 2042. The details of my argument follow:1) The key fact about social security today is that it is running a significant cash flow surplus — $180 billion in 2005 according to the Trustees Report. About 1/2 the $180 billion comes from taking in more in taxes than it pays out in benefits, about 1/2 from interest on its bonds (sidenote — social security is getting about 6% on its government bond portfolio, and got a bit more in 2001 and 2002 — not a bad investment given what has happened to stocks over the past four years).

2) On a cash flow basis, the Social Security system looks pretty darn healthy for the next ten years. The trustees forecast a cash flow SURPLUS of $280 billion and assets of $3.6 trillion in 2012. Nouriel and I forecast — on current trends — a US trade deficit of $1,300 billion (7.5% of GDP) and US external debt of $14.6 trillion (84% of GDP). Interest on that external debt will cost the US $800 billion, and that interest plus some tranfer payments will produce a current account deficit of 2,200 billion. That sounds extreme, but the reasonable and meticulous Catherine Mann has trajectories that show even bigger deficits sooner if nothing changes. Again, tell me which is the bigger short-run problem, the growing trade deficit or the social security system’s growing cash flow surplus?

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Geopolitics of a new G-7

by Brad Setser Friday, November 12, 2004

There is a growing sense that the G-7 no longer is the right grouping for discussing today’s major international macroeconomic issues. It is hard to see, for example, how you can discuss “global rebalancing” if one major part of the global economic and financial balance — China — is not at the table.

So — as the comments section on my previous post brought to light — proposals for new groups abound, whether to supplement the G-7 (which is the G-8 when Russia is included, but on many economic issues, Russia is currently excluded, to its irritation) or to replace the G-7. Some, like Larry Summers, suggest that the G-20 provides the right forum — it was created after the Asian crisis, but sort of fell by the way side in the first George W. Bush Administration. Others are calling for a G-4 (Japan, China, US, Europe). Some would add China to the G-7 and consolidate Eurozone representation. And others are calling to add the BRICs (Brazil, Russia, India and China) to the G-7, creating a G-11 … (the current G-10 has 11 members — the US, Canada, Japan and eight, yes eight, Europeans … it is a bit of an anachronism)

The logic behind all these proposals is right — the big emerging economies, above all China — are too big not to play a bigger role in global macroeconomic governance. Of course, that assumes that the G-countries should do more than get around and do a show and tell on their domestic policy choices, namely on occasion they really ought to coordinate policy.

But G-diplomacy also has its pitfalls.Pitfall 1:

Is the G-X a forum for global economic management, or a forum of the world’s largest democracies? This obviously is an issue for China. An economic G-4 is easier than a political G-4.

Pitfall 2:

Is the goal to bring Asia in, or to punish “old” Europe? Some in the American right are selling a G-11 with Russia, India, Brazil and China as a means of diluting French and German influence in the G-7. Implicitly, they hope the G-11 will be more sympathetic to W’s foreign policy/ the war in Iraq. To be honest, though, the dilution is more obvious than the support for W/ the war in Iraq. Lula of Brazil has won the heart of New York’s financial community, but he is not exactly on W’s side in Iraq. His global agenda (hunger) a bit different than the American president’s. India and China have their own oil/ natural gas/ energy interests, like the major Europeans. They might not be less than interested in joining a global effort to sanction Iran right after making big investments of their own in Iran. Ken Pollack says the European policy on Iran is carrots and more carrots. China just gave Iran some really big carrots.

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China

by Brad Setser Thursday, November 11, 2004

That alone ought to catch your attention. Whether talking about the US (needs Chinese financing), Latin America (needs Chinese demand for its commodities) or Europe (needs China to lets its exchange rate adjsut so it does not bear the burden of dollar adjustment alone), few countries matter more now.

China let the IMF publish its Article IV (fancy word for annual) report on China, I think for the first time. Chalk one up for IMF transparency. If only Brazil would follow suit.

IMF reports are often interesting for what is not said as well as what is said — and above all for their numbers. China probably let the IMF publish this Article IV in part because the IMF wimped out on China’s exchange rate: IMF staff highlighted the need for exchange rate flexibilty, but also “reinterated its view that it is difficult to find persuasive evidence that the renminbi is is substantially undervalued.” Flexibility potentially means relatively little; China’s likely interpretation flexibility would not change much. Substantially is a weasel word, but come on.

If the IMF thinks — and it almost certainly does — that the US current account deficit is unsustainable and it if takes its global oversight role seriously, then it has to worry about how to bring about global current account adjustment. I really would like to see how the IMF thinks global rebalancing or whatever other word you want to use for a smaller current account deficit in the US and smaller surpluses elsewhere can happen without exchange rate adjustment in China

Setting the exchange rate debate aside, the IMF report tells us a lot.1. China is not financing the US current account deficit out of its current account surplus alone. It is running a surplus, and that surplus in dollar terms rose from @ $20 billion between 99-01 to around $40 billion in 02-04. But reserve accumulation went from $10 billion in 99-00 to $50 billion in 01, $75 billion in 02, $160 billion in 03 ($40 billion of which was used to recapitalize two state banks) and estimated $150 billion in 04. Clearly, not all the reserve increase is being financed by the current account surplus. Part of the reserve increase if financing by FDI inflows, which rose from around $40 billion a year to around $50 billion a year. But the big surge in reserves in 2003 came from massive “other” capital inflows ($70 billion) — hot money flows, one assumes. That is a change: from 98-00 funds were leaking out of China, not pouring in. Today’s Wall Street Journal reported China attracted $75 billion of these hot money flows in the first half of the year — so the money is still flowing in. Ironically, the biggest loser if hot money stopped flowing to China could be the US, since the People’s Bank of China is using those speculative inflows to finance its lending to the US (reserve accumulation in dollars = lending to the US).

(I’ll try to paste in the graph soon, it tells the story better than words — UPDATE — I admit defeat. It is on p. 6 of the IMF report)

2) Between 2001 and 2004, investment rose from 38% of GDP to 46% of GDP (it boomed). If savings had remained constant at their 2001 rate of 40% of GDP (not exactly a small number), China would have had a current account deficit of 6% of GDP ($95 billion) in 2004, rather than a forecast surplus of a bit under 3% of GDP ($40 billion). Remember, as I suggested in an earlier post, both Southeast Asia and the US saw substantial deficits in their current accounts amid their investment booms. Not China. If China had still attracted $50 billion in FDI and $100 billion in other inflows, it could have financed that $95 billion deficit and still saw its reserves rise by $55 billion. Now I am not advocating that — financing current account deficits with hot money inflows is risk, as Southeast asia learned. But the financing is clearly there for a smaller current account deficit — say $50 billion or 3% of GDP.

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