Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Russia is to China as …

by Brad Setser Friday, December 31, 2004

Canada is to the United States?

Large in area, scarcely populated, cold and a major supplier of natural resources to its large southern neighbor …

Well, not yet.

Russia, I think, generally exports its energy to Europe, not to China. The pipelines flow west, not south and east.

But that may be changing.

It seems like the Yukos stake formerly held by western investors is being offered to China. Before, Khodorkovsky controlled Yukos and foreign — mostly western — investors had a minority stake; now, the Russian state seems likely to gain majority control, with China getting a minority stake.

There is one clear difference between Russia and China and Canada and the US: the state plays a much bigger — and a much less transparent — role in both the Russian and Chinese economies …

China clearly does not just want to buy the world’s surplus (production in excess of national demand) oil. It wants to own a share of the companies that are producing the oil China expects to buy. Look at Iran, Sudan and now Russia. China’s state oil companies go where the oil is …

Make no mistake, if you forecast out China’s future demand for oil, China is gonna be a big buyer. China’s government has plenty of cash. The Wall Street Journal reports China’s reserves reached $542.7 billion at the end of October, up an amazing $28.2 billion in a single month. There is a pretty natural marriage between China’s surplus cash and the world’s surplus oil: oil companies supplying a growing Chinese market are likely to earn more than US Treasuries (or Agencies) …

Billmon, in one of his comments to an earlier post, asked whether China at the turn of this century is to the US as Germany was to Britain at the turn of the last century, or as the US was to Britain at the turn of the last century.

Few questions are more important. Consequently, the (hidden) battle between private US companies (and investors) and state owned Chinese companies for control over existing oil fields (or more precisely, for minority stakes in locally owned oil firms that have control over most countries domestic oil fields) is worth watching. The really high stake game, though, is for control over new oil fields which, with foregn investment, can be brought on line to meet the world’s growing demand for energy — not for control of the world’s existing oil fields.

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Look who is supporting the mortgage market …

by Brad Setser Wednesday, December 29, 2004

No Surprise: the People’s Bank of China. The PBOC has shifted from buying treasuries (03) to buying mortgage backed securities (04).

From Reuters: “Make no bones about it, mortgages really went global in 2004,” said Arthur Frank, director of MBS research at Nomura Securities International. “Overseas investors had dollars to put to work and MBS were their vehicle of choice, offering them an attractive pick-up in yield over Treasuries …. “Foreign demand has certainly climbed over the years, but it picked up rapidly this year,” said Frank.

Net foreign purchases of MBS were $242 billion in mid-2004, up $19 billion from year-end 2003 and $35 billion more than 2002, according to Inside MBS & ABS, a publication of Inside Mortgage Finance. While data is not available yet for the second half of 2004, most analysts believe foreign investment in MBS gained even more momentum during that period.

The strong performance of the $4.5 trillion MBS market in 2004 can partly be attributed to buying from Asian portfolios and China’s central bank in particular, according to Steven Abrahams, fixed income mortgage strategist at Bear Stearns.

“U.S. dollar portfolios in Asia have made themselves felt this year in the U.S. rates markets, and perhaps in no sector more than MBS,” he said in recent research.

The Chinese central bank’s demand for mortgages is partly due to the climbing balance of dollars it has for investment. China’s reserves for the year ending in August grew by $131 billion, second only to Japan’s $272 billion increase, according to the International Monetary Fund. China’s reserves now stand at around $501 billion, while Japan’s are at $827 billion.” End Reuters.

Since the PBOC’s reserve accumulation likely surged in q4 2004, the amount of Chinese support for the mortgage market probably accelerated in the second half the year. China’s reserves are almost certainly closer to $600 billion than $500 billion now …

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If you cannot beat em, join em

by Brad Setser Wednesday, December 29, 2004

Daniel Gross’s article on the currency preferences of the world’s underworld is too good not to link to. It seems like the world’s drug lords are less willing than the People’s Bank of China to finance the US on the cheap. Indeed, some may even be joining Warren Buffet and no doubt George Soros and others in betting againt the dollar. Thanks to General Glut for the link.In 2002, I briefly worked on the balance payments of an Eastern European country. Even back then, Eastern Europeans were starting to shift from “dollars under the mattress” to “euros in the domestic banking system.” What prompted the shift? First, the dollar had stopped rising v. the Euro (and v. most Eastern European currencies), and was starting to fall. Up until that point, the dollars under the mattress had delivered a solid return: their local purchasing power rose along with the dollar. Second, euro notes were starting to circulate widely. Confidence has many sources. A virtual ecu (the euro’s antecedent, the european currency unit; also, an old french currency) is not that different from an euro denominated bank account (a few lines on the bank’s computer system). But the ability to turn virtual euros in the bank into physical euro notes mattered.

This process — reverse currency substitution — was generating substantial capital inflows into Eastern Europe. A dollar (cash) is an external financial asset, a domestic euro denominated bank account is a domestic financial asset. In effect, Eastern Europeans were running down their external savings (their hoards of dollars), and in the process financing either current account deficits or central bank reserve accumulation.

A similar process has been an important source of financing for Turkey this year. Why hold dollars cash, of even dollar denominated bank accounts, when you can earn much higher rates on a Turkish lira bank account? The dollar’s purchasing power in Turkey has been falling since Turkey started to recover from its 2001 crisis. So long as long as the new Turkish lira tracks the euro, not the dollar, Turkish citizens will earn far more lending a(new) lira to the Turkish government than holding a stack of 100 dollar bills.

Alas, this is not necessarily the most stable way to finance a current account deficit — and Turkey is one of the few countries other than the US running a large current account deficit.

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How Europe finances the US

by Brad Setser Wednesday, December 29, 2004

Europeans invest in emerging Asia. That capital inflow would naturally tend to drive up emerging Asian currencies v. the euro. But emerging Asian currencies are generally stable v. the euro. In many cases, emerging Asian currencies are actually falling v. the euro. China, for example, is tracking the dollar down. To avoid appreciating v. the euro — or v. the dollar — Emerging Asian central banks intervene in the foreign currency market. Rather than financing a current account deficit in emerging Asia, the capital inflow from Europe finances reserve accumulation in emerging Asia. Most of those reserves are invested in US dollars.

The net effect: Europe lends some of its current account surplus to emerging Asia, and emerging Asian central banks onlend some of Europe’s surplus to the US. Asia provides the cheap financing that fuels US consumption, but the central banks of Asia — not Europe’s private investors — get stuck with the risk that the dollar will fall v. emerging Asian currencies.

Funny how the world works. Sustaining the current pattern of global growth requires that Asian central banks subsidize both European private investors and Asian exporters.

With consumer confidence soaring and housing strong, this weeks’ indicators point to continued strong growth in US demand. That likely will translate into continued strong import growth (right now, non-oil imports are growing at 15% y/y). If China is not going to buy new Boeings for a while,

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Beware of a 12 division budget and a 10 division tax base …

by Brad Setser Monday, December 27, 2004

General Sinseki famously — and it seems accurately — warned of the risks of a “12 division strategy and a 10 division army.” To paraphase the US Defense Secretary: You fight a war with the army you have, not the army you want. But if you don’t plan realistically for your future commitments, your means are likely to lag your commitments. The US would be in better shape right now if it had started training and equipping a couple new army divisions back in early 2002.

The same is true of the federal budget. Ends (spending) have to match means (tax revenue) over time — though the federal government’s ability to borrow means that “over time” can be “over a very long time.” Right now we have a 10 division revenue base — federal taxation as a percent of GDP is at its lowest level since the 1950s: 16.2% of GDP in 2004. Alas we have a 12 division spending strategy: spending was just a bit under 20% of GDP in 2004, for a deficit of between 3.6 and 3.7% of GDP.

Take out social security, which takes in more revenue than it spends, and the budget math is even worse: revenues of 11.4% v. spending of 16.3%, or a deficit of nearly 5% of GDP. Non social security revenues only cover 70% of non social security expenditures — that is the federal government’s real financial problem, not the smaller predicted gap between social security’s revenues and its expenditures that will only emerge after the trust fund is exhausted in 2055.

The Bush Administration’s public line is no longer “deficits don’t matter.” That is a bit too in your creditors’ face, even for a Texan. The new line is: “We won’t raise taxes. But we will control spending … ”

The commitment to cut the deficit in half is not a commitment to go from a $400 bilion deficit to a $200 billion deficit. Nor is it a commitment to cut the observed 3.65% of GDP FY 04 deficit in half — to around 1.8% of GDP in FY 09. Rather, it is commitment to reduce the deficit to 2.25% of GDP, or 1/2 of the peak forecast of the 04 deficit (4.5% of GDP). No doubt the Administration will exclude any borrowing for social security privatization from its accounting of how Bush is meeting his commitment to cut the deficit in half.

That is an awful lot of nuance for a plain talking Texan who says what he means and means what he says.Suppose the administration is serious about cutting the deficit to 2.25% of GDP by FY 09, and wants to hold revenue constant at 16.2% of GDP. The CBO forecasts a rise in revenue in 05, but that assumes some of the tax cuts that expire at the end of this year are not renewed … Spending as a percentage of GDP has to fall to around 18.4% of GDP, or by around 1.5%. Let’s assume that “mandatory spending” — social security, medicare, etc — stays constant at around 10.8% of GDP (the CBO baseline has mandatory spending falling a bit in 2005 as a share of GDP, rising back to 04 levels by 08 and then rising by about 1% of GDP between 09 and 14 as the baby boomers retire).

Interest spending as a percent of GDP is expected to rise by around 0.5% of GDP by FY 09. That implies meeting W’s commitment requires other spending to fall by about 2% of GDP. Suppose defense and homeland security spending stay constant as a share of GDP at FY 05 levels, or around 4.25% of GDP. Then non-defense discretionary spending needs to fall from 3.6% of GDP to about 1.6% of GDP.

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Argentina in the boxing day New York Times

by Brad Setser Sunday, December 26, 2004

The IMF’s typical diagnosis of an emerging economies problem is “its mostly fiscal”, or so the wonky saying goes. Larry Rohter of the New York Times makes the argument that Argentina’s post 2001 success hinges on its heterorthodox economics: I am not convinced.

The number one reason for Argentina’s financial and economic stabilization is its belated conversion to fiscal discipline — or what in the old days might have been called a conservative fiscal policy. Why no hyper-inflation after Argentina’s default? The government matched revenues and expenditures, avoiding the need to print money. Hardly radical.

Rohter writes:

“Rather than moving to immediately satisfy bondholders, private banks and the I.M.F., as other developing countries have done in less severe crises, the Peronist-led government chose to stimulate internal consumption first and told creditors to get in line with everyone else.”

The first part is no doubt true. The second half, though, is a bit off: the government has not ran an expansionary fiscal policy after its default. The initial impetus for Argentina’s recovery came from the devaluation, which led to a surge in export revenues (measured in local curency terms), not government policies to spur consumption. Government spending initially had to fall to match falling revenue.

The strongest indictment of the IMF is that an Argentine government that explicitly defines its policy in opposition to the IMF has adopted a far more conservative fiscal stance than any Argentina government that embraced the IMF in the 1990s.

The world works in mysterious ways: in order to prove that it did not need the IMF, Argentina ended up adopting a more conservative fiscal policy stance in 2004 than the IMF demanded. Argentina’s primary surplus is likely to exceed 4.5% of its GDP (a primary surplus is revenues minus non-interest spending) this year …

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Euro continues to soar, renminbi hits new lows …

by Brad Setser Friday, December 24, 2004

If anyone thinks that what the world really needs right now is a weaker Chinese renminbi, do let me know. Yet that is exactly what the markets have delivered this week …

It seems pretty clear that Bush economic policy is not passing the global test. But the tumbling dollar (it has tracked the renminbi down … ) has yet to hit the Bush Administration where it would hurt: the price for the ten-year treasury bond needs to start to tumble as well. That just might prompt a much needed reevaluation of the Administration’s second term economic priorities.

My guess is that Europeans were not buying many Treasuries to begin with, so the fall in the euro-dollar is not (directly) hurting the folks who are lending support to the Treasury market. Despite the rise in the Korean won and some other less-than-fixed-but-not-freely-floating Asian currencies, key emerging Asian economies are still providing substantial support to the Treasury market, and probably to other US fixed income markets as well. Let’s see what happened to China’s reserves in q4. Korea’s too.

Speaking of Europe: French Finance Minister Gaymard suggests that the time has come for international policy coordination. I agree. Alas, support from France probably just assures that it won’t happen, at least in the current political environment.

And speaking of coordination, shouldn’t Europe start by coordinating its own message? If France and Germany are worried about the Euro’s strength, why is the Dutch Finance Minister, Gerrit Zalm,( the Dutch currently hold the rotating presidency of the EU) going around saying the ECB should raise rates. Wouldn’t that just increase demand for euros? Eurozone policy coordination is still very much a work in progress. Lower ECB policy rates to support Eurozone demand would be a core component of any sensible plan for international macroeconomic coordination.

European policy makers minds are no doubt focused on oysters and champagne, not international macro, on the day before Christmas. Markets are thin. So I’ll try to keep this post thin too —

Happy Holidays/ Merry Christmas to all.

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One more point on Martin Wolf

by Brad Setser Wednesday, December 22, 2004

It is a simple point, but an important one. Wolf says the United States would be fine if it reduced its current account deficit from 6% of GDP to 3% of GDP. External debt to GDP then stabilizes at 50% of GDP. All true.

But remember that cutting the current deficit in half likely requires cutting the trade deficit by much, much more. Right now, net interest payments on US external debt are close to zero. That is largely due to a combination of good investments (The US accumulated a lot of European assets when it was running current account surpluses in the 50s and 60s, and these assets generally provide the US with a decent return) and good luck: foreigners hold lots of US debt, and US interest rates are very low.

But over time, as debt levels rise and US interest rates rise, the income balance will turn negative. If the US pays just 4% interest on a (net) external debt to GDP ratio of 50%, interest payments would be 2% of GDP. A 3% of GDP current account deficit therefore is consistent with a trade deficit of 1% of GDP — compared to about 6% of GDP now.

This oversimplifies. If the US continues to earn a higher rate of return more on its offshore assets than it pay on its external liabilities, its “income” from borrowing abroad to invest abroad (what I call financial intermediation) will offset some of the interest payments on its net debt. A net external debt of 50% of GDP might imply external assets of 50% of GDP and external debts of 100% of GDP. Suppose the US pays 4% on all its liablities, and earns 5% on its assets. US net interest payments would be 1.5% of GDP in this scenario. Then a trade deficit of 1.5% of GDP is consistent with a current account deficit of 3% of GDP.

My point is simple: cutting the current account deficit in half over time will require cutting the trade deficit by more than half. Realistically, the trade deficit (technically, the balance on trade and transfers) will need to fall by between 4.5 and 5% of GDP …

There is no guarantee that the US will be able to bring its current deficit down to 3% in an orderly way. Emerging markets typically do not adjust smoothly. Rather, once capital inflows dry up, they swing from current account deficits to current account surpluses. They rarely end up in the sweet spot — that is, they typically are not able to run the small ongoing current account deficits that can be consistent with a stable debt to GDP ratio.

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A modest proposal of my own

by Brad Setser Wednesday, December 22, 2004

My modest proposal: anyone writing about Social Security should have to pass a test demonstrating that they have read the Social Securities trustees report, and understand the basic dynamics of a system with a Trust Fund holding government bonds.

There is a certain “obvious” logic which suggests social security should face problems over the next few years — America is aging, the baby boom will soon retire, the number of workers per retiree will fall. That seems to suggest that social security should face troubles — that was what I thought, before, like Kevin Drum, I actually looked at the trustees report.

The funny thing is that social security can pay full benefits to baby boomers, even with conservative (in the sense of not unduely optimstic) assumptions. The coming retirement of the baby boomers is not a problem for social security; it is a problem for the rest of the government (the “general fund”). Remember, social security is running a cash surplus, taking in more in taxes than it pays in benefits, and will do so far at least ten more years (the tipping point is 2018). As more and more baby boomer retire, that cash surplus will slowly shrink and then disappear, meaning social security has less to lend to the rest of the government. The first problem the retirement of the baby boom creates come not with social security, but with the rest of the government. Then from 2018 to 2042 (or longer if you believe the CBO), social security has to draw on the accumulated assets of the trust fund. This too is a problem not for social security — it can draw on the trust funds’ assets and ongoing payroll taxes to pay all benefits — but for the general fund. Right now, interest paid to the social security trust fund is reinvested back in treasuries — i.e. lent back to the government. Compound interest leads the assets in the trust fund to build up over time. But they have to drawn down to fund the baby boom’s retirement — the social security will start using interest payments not to lend back to the government, but to pay benefits, and then it will start to redeem its stock of bonds to pay benefits (not a problem if the general fund is solvent — it can just sell bonds to private actors to pay off the trust fund). Again, the problems created by the baby boom show up first in the general fund, not in social security.

That’s why comments like ” ” in Monday’s Wall Street Journal are misleading.

Hard as it is to believe, the government — in a bipartisan way — acted responsibly back in the 1980s. It raised payroll taxes and cut benefits to build up a trust fund and in effect “pre-fund” the baby boom — making it possible to finance the baby-booms retirement without raising the social security payroll taxes. It all works if the rest of the government can pay back all the money it has borrowed from social security. But to do so, the “general fund” — the rest of the government — has to be in good financial shape. We were heading that way in 2000. We are not heading that way now.

Social security taxes are now something like 4.5% of GDP, and benefits are around 4% of GDP (ball park). Social security is therefore lending about a half percent of GDP ($70 billion) to the rest of the government every year, reducing the reported deficit by that much, and building up trust fund assets. Overtime, as the baby boom retires, benefits will rise to 6, may 6.25% of GDP (eyeballing the trustees report). The “gap” can be made up between 2018-2042 by the trust funds assets. that means rather than borrowing 0.5% of GDP from the payroll tax surplus and another 0.5% of GDP from the trust fund (interest payments are lend back to the government), as it does now, the rest of the government will have to pay the social security system back, to the tune of 1.5% of GDP.

That is a swing of around 2.5% of GDP — from 1% of GDP net financing from the social security system now to 1.5% of GDP net payments to social security. The retirement of baby boom is not a problem for the social security system: it is well prepared. The retirement of the baby boom is a problem for the general fund — which currently lacks revenues to pay anything close to all its expenses, and will have switch from borrowing from social security to making payments to social security. Unfortunately, the rest of the government is no longer well prepared to handle this challenge. That is the problem.

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Martin Wolf explains the fall in the renminbi-dollar

by Brad Setser Wednesday, December 22, 2004

Martin Wolf did the math: it turns out the renminbi-dollar zone has a current account deficit (projected) of $260 billion with the world this year. The United States’ current account deficit of $650 billion must be offset by a roughly $400 billion surplus in Japan and emerging Asia. A fall in the renminbi-dollar helps in two ways — it at least slows (one hopes, the evidence is still rather lacking) the expansion of the US trade and current account deficit, and it increases emerging Asia’s surplus with the world. Bigger surpluses in Asia = a smaller overall deficit between the renminbi-dollar zone and the rest of the world. So long as Asia is willing to save all of its surplus (actually, all of its current account surplus and then some — China also lends its capital account surplus to the US) in reserves and then lends those reserves to the US, the US can keep on running large deficits.

No surprise: I agree with Martin Wolf’s proposed solution to the US current account deficit. The global adjustment that will lead to a fall in the US deficit will require emerging Asia — basically Asia minus Japan — to shift from a significant current account surplus with the world to a current account deficit to the world. That process will support global demand — and US growth — during the shift, since US demand growth has to slow.

And Wolf is right in another way: if emerging Asia’s deficit is financed by ongoing inflows from foreign direct investment, it does not need to give rise to the same financial imbalances (too much short-term debt relative to reserves) that gave rise to the 1997 Asian crisis. The pattern of global capital flows before Asia’s 97 meltdown was not all wrong. Aging Japan should be running a current account surplus and using that surplus to finance emerging Asia: Japan’s investments in emerging Asia today will let let aging Japan finance a future trade deficit off the profits from its overseas investments. If you invest abroad, in principle, you don’t need to import labor to sustain your living standards as your population ages (and shrinks). Conversely, emerging Asia should be running a current account deficit during the “boom” phase of rapid development, as it did before the 1997 crisis. I have long argued that booming China should be running a current account deficit of $50 billion (financed by FDI inflows) right now, not a current account surplus of $50 billion. China currently saves its $50 billion or so current account surplus in reserves, saves $50 billion plus in FDI in reserves and saves $50 billion or so in “hot money” inflows in reserves as well — accumulating so many dollar denominated reserve assets make no long term sense, as Wolf rightly notes. And all the evidence suggests the pace of China’s reserve accumulation is growing, not falling.

Four other notes:

1) It would be nice to look at global capital flows to the “renminbi-dollar” area, not just the current account numbers. That, alas, is a bit more difficult. We know China is attracting large capital inflows, but don’t know how much of those inflows are coming from outside the “dollar” zone. We know that large amounts of capital — probably around $200 billion — are flowing out of the US (both for FDI abroad and for portfolio investment), but we don’t know what fraction of those flows are going to countries (like China) inside the dollar zone. If the renminbi-dollar zone has a net capital outflow (driven by outflows from the US) as well as a current account deficit (driven the the US current account deficit), its total financing need from the rest of the world would be quite large.

2) It is pretty clear that the “emerging Asia” portion of the dollar zone is attracting net capital inflows from the rest of the world. Emerging Asia then uses those flows to build up its reserves, and thus to lend to the US. China is attracting at least $100 billion in net inflows this year (the final number will likely be substantially higher), though not all from outside the renminbi-dollar zone. Add that $100 billion to the $400 billion Asian current account surplus, and the Asian portion of the dollar zone is financing $500 billion of the $650 billion US current account deficit. My numbers are a rough guess, but it seems likely that in addition to running current account surpluses to offset the United States’s deficit, Asia is attracting some of the external financing the renminbi-dollar zone needs to avoid falling against the rest of the world. For the renminbi-dollar zone to work internally, emerging Asia has to turn capital inflows into Asia into capital inflows into the US — i.e. act as a financial intermediary.

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