Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Stephen Jen might want to rejigger his model

by Brad Setser Sunday, January 30, 2005

Apparently, Mr. Jen thinks the dollar — despite the United States’ 6.2% of GDP current account deficit — is significantly undervalued against all major currencies, and fairly valued against most Asian currencies.

Call me old-fashioned, but in my book, a large current account deficit is a sign that a country’s currency is overvalued, not undervalued. Another sign of overvaluation: heavy central bank intervention to support the currency. The US just happens to have outsourced currency intervention to a group of largely Asian central banks, who spent close to $200 billion in the fourth quarter to keep the dollar from falling against their currencies.

However, Jen argues that the dollar today is like the dollar after in 1988, after the Louvre agreement (Plaza = G-7 signal the dollar had to fall, Louvre = G-7 signal the dollar had fallen far enough), of the dollar in 1995, after it has slumped v. the yen. It is poised for a large rally.

Hey, why worry if a dollar rally would push the US current account deficit toward 7% of even 8% of GDP — or somewhere between 70 and 80% of US export revenues?

I recommend that Mr. Jen add the current account deficit to his model of fair currency valuation. Adding the current account deficit would highlight the difference between 2005 and 1995, and 2005 and 1998. In 1988, the current account deficit was 2.3% of US GDP, down from 3.4% in 87 and on track to fall toward 1.4% in 1990. In 1995, the US current account deficit was only 1.5% of GDP. The US net external debt position was a lot better back in 1988 and 1995 than it is now too …

Of course, Morgan Stanley has Stephen Roach as as well Stephen Jen. And a market requires buyers as well as sellers. But I do wonder if Morgan Stanley is willing to put its money behind Mr. Jen’s model. After all, doesn’t the model say the dollar is 20% overvalued v. the euro, and should trade at 1.09?

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The Rhetoric to Results Ratio

by Brad Setser Friday, January 28, 2005

I leave it to others to assess how well the Bush Administration’s rhetoric on expanding freedom stacks up against the results it has achieved.

I am confident the Bush Administration’s rhetoric to results ratio is not great on the budget deficit. Plenty of rhetoric (at least since 2004); not great results.

And I will second the New York Times oped highlighting the gap between the Administration’s rhetoric extolling the its new approach to development aid, the Millenium Challenge Account, and the results that have been achieved to date.

The Millenium Challenge Account (MCA) is based on worthwhile idea, namely developing creative ways of measuring how well very poor countries are doing and then offering a reward to the best performers. It is one way of making sure a tiny bit of US development aid goes to countries based on their economic performance, not on their geostrategic importance.

But the Bush Administration does itself no favors by talking up the program so relentless, even though the program has yet to give out any money. The MCA was launched before the Iraq war, and we have to date, spent something like $200 billion to cover US expenses in Iraq, and have yet to disburse any thing from the MCA.

A bit less rhetoric, and few more results please.

By the way, asking for $3 billion is not the same as getting $3 billion. Since the MCCA has yet to start to disburse the original FY 04 $1 billion appropriation or the $1.5 billion FY 05 appropriation, I would be shocked if the Congress approves more than say $1.5 billion. $1.5 billion is not chump change in the development aid world, but it is also not an enormous sum either — it is almost what the Swedes give away every year, and is about half what the Dutch, for example, give away every year. Unless the Bush administration ups the budget significantly, so it say matches the French aid budget, I suspect its impact on incentives will be rather more modest that the Administration’s rhetoric suggests. Some countries close to qualifying will work hard to raise their score (or lobby for an exemption), others may decide to cultivate the big European donors a bit more.

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China reads the Economist. Is the Renminbi undervalued?

by Brad Setser Wednesday, January 26, 2005

While China’s delegation to Davos seems a bit less than enamored with the dollar, the People’s Bank of China seems have read last week’s Economist, and concluded that there is no need to change the renminbi-dollar peg.

The Financial Times has also picked up on the same theme. Both pieces that argue that the renminbi is not really overvalued draw on work by Stephen King at HSBC, but there are no shortage of other economists making similar arguments. Andy Xie of Morgan Stanley for one.

I have no idea when China plans to adjust its peg, though I suspect it is a question of when rather than if. Some small changes seem likely. But the broader arguments made in these articles, and the related argument that a renminbi revaluation won’t help reduce the US trade deficit, are worth examining in some detail. I’ll look at each point in turn, and lay out the reasons why I don’t find the argument persuasive.

A warning though: this is a long post.1. China’s global trade surplus is much smaller than its bilateral trade surplus with the US.

True, but irrelevant. Bilateral deficits and surpluses are not the right measure of a currency’s strength. But just because China’s overall trade surplus is smaller than its bilateral trade surplus with the US does not prove China’s exchange rate is fairly valued. China is still running a trade surplus of 2% of GDP, and a slightly larger current account surplus. More importantly, it is running that surplus in the face of surging commodity prices and a domestic investment boom. Trade deficits and trade surpluses need to be looked at in a broader macroeconomic context, and the context strongly suggests booming China should be running a trade deficit right now. China imports lots of commodities, and it is in the midst of an absolutely enormous investment boom. Capital investment has surged to 45% of GDP, up from the 38%-40% typical from 95 to 00. Had savings stayed constant, China’s trade balance would have swung into a substantial deficit.

Put differently, China is currently undergoing a much large investment boom than the US enjoyed in the late 1990s. But while the US investment boom led the US current account to go from a small to a large deficit in the 1990s, China’s investment boom has not triggered a fall in its current account surplus.

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The US dollar fails the Chinese test

by Brad Setser Wednesday, January 26, 2005

So China wants to adopt a basket peg because it no longer thinks the dollar is a stable store of value.

To quote Mr. Fan, Director of China’s National Institute for Economic Research:

The U.S. dollar is no longer — in our opinion is no longer — (seen) as a stable currency, and is devaluating all the time, and that’s putting troubles all the time,” Fan said, speaking in English.

(thanks to glory for the link)

Maybe the United States’ bankers did not think it was particularly polite for the US President to call them tyrants. Maybe they did not particularly like the new estimate for the FY 2005 budget deficit. Maybe a currency tied to a sinking dollar does not suit their image of a rising China.

Or maybe China’s leadership is not totally immune to international pressure.

It is hard for me to argue with the core point Mr. Fan makes. In the long-run, the dollar pretty clearly will go down further than it already has. A 6% of GDP (and growing) current account deficit and an export base of 10% of GDP usually do not auger good things. The long-run shift in the dollar may need to be larger if David Hale is right, and the United States capacity to produce goods for sale on the world market is already very limited. The real adjustment process won’t start until the dollar falls to the point where investment in the US to produce goods (or services) for the world market makes sense.

If China doesn’t want to keep adding to its dollar reserves, no one else will either. China is the big player in this coordination game, the anchor of the central bank dollar cartel. Thailand will be able to cut the percentage of its reserves in dollars without moving the market far more easily if other central banks are adding to their dollar reserves (Perhaps this should read Thailand was able to … I am not sure if Thailand announced a done deal, or its intent to reduce its dollar holdings)

It sure sounds like China would rather not continue to add dollars to its reserves at its current pace. On the other hand, so far China’s talk of greater currency flexibility has been a bit like the Bush Administration’s talk of reducing the budget deficit. Sounds nice in the abstract, but darn hard to do.

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When will the bond market wake up

by Brad Setser Tuesday, January 25, 2005

I know, I know, Morgan Stanley’s investors have spoken, and there is no bond market bubble.

But the federal government certainly is swimming in a sea of red ink.

I hope we have asked the Bank of Japan, the People’s Bank of China, the Central Bank of China (Taiwan), the Bank of Korea, the Reserve Bank of India, the Bank of Russia, the Monetary Authority of Singapore, the Monetary Authority of Hong Kong, the Bank of Mexico and many others to up the limit on our credit card. Alas, our bankers may not be thrilled to be asked to keep on financing us: the US government only pays 4.2% (less for short-term money), a far cry from what American banks charge to Americans wanting to borrow just a bit more on their credit cards.

A while back there was lots of talk about how FY 05 budget deficit would be smaller than the FY 04 budget deficit. I certainly remember this piece by David Greenlaw of Morgan Stanley. Well, the administration now estimates the deficit at $427 billion, including the their latest war supplemental. Last I checked, that is more than the $412 billion FY 2004 deficit. A strong economy and a rising deficit — that is what happens when you try to fight the Global War on Terror on the cheap. Why should anyone take the Bush Administration’s talk of controlling the deficit seriously until they start delivering?

Some think the Administration is back to playing expectation games, and that they have swung from underestimating the FY 05 deficit to overestimated it.

The White House deficit estimate is too high, said Drew Matus, senior economist at Lehman Brothers Inc. in New York. “Given spending initiatives, anything above the CBO estimate of $400 billion including Iraq is too high,” Matus said. It is “better to be too high and announce a positive surprise than too low and adjust higher,” Matus said in an e- mail.

Maybe — the CBO estimated the FY 05 deficit at $370 billion, and they officially estimate than continuing “war spending” at the FY 04 pace would only add another $30 billion to their overall estimate, bringing the deficit up to $400 billion. I think that works out to spending about $60 billion for the year, or around $5 billion a month, on Iraq and Afghanistan. I suspect that is a bit too low; we probably will need to spend more in Iraq this year than last year. The insurgency is not getting weaker. $370 billion + $80 billion, or $450 billion, may be too high: it implies FY 05 spending $105 billion in Iraq and Afghanistan, or about $9 billion a month. We will see — $420-430 billion actually seems like a reasonable estimate to me.

And remember, this deficit comes at a time when the interest rate the US government is paying on its debt (thanks in part to a bit of strategic maturity shortening) is unusually low.

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Memo to John Taylor: In what sense was the Argentine crisis contained?

by Brad Setser Tuesday, January 25, 2005

David Sanger goes back to his roots as the New York Times’ Treasury correspondent, and outlines the tensions that the dollar’s slide over the past few years has created. Sanger digs up a bunch of old quotes — along with a few new ones — to demonstrate the global blame game continues. The euro is too strong — and euroland growth too weak — because the Bush Administration has a policy of benign neglect toward the dollar. China’s reserves are growing faster than China wants because, well, because currency speculators are bad people — not because China’s exchange rate is undervalued and the renminbi is currently a one way bet. The US trade deficit is too big because the rest of the world won’t grow (let’s ignore for a moment that world growth was actually quite strong in 2004), not because US national savings is exceptionally low.

But the quote that really struck me was from Treasury Under Secretary John Taylor. Taylor took credit for “containing” the crisis in Argentina, along with crises in Brazil and Turkey.

There has not been an economic crisis of significant magnitude since Mr. Bush came to office. John B. Taylor, the Treasury under secretary for international affairs, said that was partly a result of preventive maintenance. “My first days on the job we had a crisis in Turkey and one coming in Argentina and Brazil,” he said. “Both were contained.”

Taylor has every right to claim credit for success in Brazil and Turkey. It has been surprising that the Administration has not trumped these successes more: presumably they are still a bit embarrassed that they contained both crises by throwing big sums of money at fiscally responsible social democrats (Dervis, Lula). That is not exactly the response to emerging market crises the Bush Administration economic team came to office promising.

Turkey in particular was no slam dunk. The Administration took a risk, and it paid off — though saving Turkey required going from providing very large, short-term bailouts to not so indebted countries through the IMF to providing very large, long-term bailouts to quite indebted countries through the IMF. Turkey still owes the IMF a large sum of money.

But Argentina? In what sense did the Administration’s policies contain Argentina’s crisis? Argentina’s economy tanked throughout 2001 as the Argentines — backed by the Fund and the US Treasury — vainly defended their own cross of gold (the currency board). And then Argentina’s economy tanked some more in 2002, when Argentina made the painful (but in my view necessary) step of getting off the currency board. And Argentina still has not cured its end 2001/ early 2002 default.

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Tyrants beware (except those we need to keep on financing us)

by Brad Setser Monday, January 24, 2005

Today’s FT highlights the risk that the US will not benefit from cheap financing from the world’s central banks growing dollar reserves forever. Apparently, a new survey of central bankers suggests that they like the euro, and — more importantly — want to slow their overall pace of reserve accumulation.

One small puzzle: another FT article — or perhaps the original version of the current reserves article — indicated that all of China’s 2004 reserve increase was invested in dollars (via the Angry Bear). That truly would be news. Most folks thought China increased the share of euros it bought with its growing reserves in 2004; the real debate was over the fraction of China’s reserves increase that was going into dollars. Alas, that particular claim is not part of the FT’s current story, and I don’t think it has been confirmed. But there is little doubt that China’s $200 billion plus in reserve accumulation has translated into signficant financial inflows into the US.

The leaders of the world’s largest one-party state can rest assured that W’s call for freedom everywhere won’t materially change their relationship with the US. W’s definition of freedom does not include freedom from debt: The Bush Administration needs China to keep on snapping up US debt if its “deficits-do-not-matter” domestic agenda is going to have any chance of passing. China is to US debt exports what Saudi Arabia is to US oil imports …

The real question is how the United States’ growing need for external financing can be reconciled with central banks’ desire to scale back on their dollar-reserve accumulation. It is hard to see how the US could raise the $800 billion plus it could well need in 2005 (assuming oil stays high) by selling private investors abroad ten year Treasury bonds that pay 4.14%.

UPDATE: For more on global reserve accumulation in 2004, and (hopefully informed) speculation on net dollar and euro reserve accumulation by the world’s central banks, check out this post that I did last week. By the way, the consensus forecast for the 2005 US current account deficit — $694 billion — strikes me as way too low. With realistic assumptions about transfers and income, a $694 billion current account deficit translates into a $600 billion trade deficit. That works out to $50 billion a month. November’s deficit was $60 billion — or $720 billion on an annualized basis. The trend line is still up.

Lots of folks must be predicting that the lagged impact of the 2003 fall in the dollar (and maybe the small additional fall in 2004) will have a big impact on the monthly trade balance by the end of 2005, and wipe out the impact of still strong US demand growth on US imports (non oil US imports are currently growing at a 15% clip). That is possible, but there is no evidence that it is happening. Either that, or they are just not thinking — particularly if the dollar’s recent mini-rally is sustained. $695 billion sounds an awful lot like the estimate you get if you take this year’s deficit and assume it won’t change much or will just get a little bigger in 2005. Project out the likely Q4 2004 trade deficit, and you would get a higher estimate, all the more so if you assume higher short-term interest rates will have an impact on net interest payments on US external debt …

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Hubbard is in pole position: the Sunday New York Time buried the lede

by Brad Setser Monday, January 24, 2005

Apparently the Federal Reserve is beginning to worry that the Administration is not all that serious about reducing the fiscal deficit …

Wonder why. It seems like Martin Feldstein’s concerns about Reagan’s fiscal deficits are not exactly helping his chances of taking over the Fed. Not sufficiently loyal. If the best the White House can say about Dr. Feldstein is that he is “not out of the running,” it seems to me like he is out of the running. And the White House now says that John Taylor is not even under consideration. That is sort of rude: Taylor is the Bush Administration’s top economist at the Treasury, and he has served Bush loyally.

No Taylor, and it sounds like no Feldstein. That leaves the field open for L. Glenn Hubbard — not exactly a deficit hawk. The White House can trust Hubbard not to worry too much about big deficits that stem from the zealous pursuit neo-Republican supply-side dreams, like dismantling Social Security and exempting all investment income from taxation.

Ben Bernanke still seems to be on the short-list to replace Greenspan; The White House did not rule him out. But then again, the White House needs to convince Bernanke to accept the top job at the White House’s Council of Economic Advisors (CEA), and dangling the prospect that a successful stint might enhance his chances is one way to make the CEA job more attractive. But it hardly sounds like he is in the lead either.

Rice to State, Hubbard to the Fed. It certainly would fit the pattern of rewarding W loyalists with plum jobs …

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If Asia is financing Europe, who is financing the US?

by Brad Setser Thursday, January 20, 2005

The global flow of funds in 2003 was pretty easy to figure out once the BIS annual report come out. The US ran a current account deficit of $530 billion. Most other countries – though not Australia, the UK and a set of Eastern European economies — ran current account surpluses. Most of the US current account deficit was financed by $442 billion in dollar reserve accumulation by the world’s central banks ($487 billion if you include the $45 billion transferred to a couple of Chinese state banks).

Overall reserves increased by a bit more than $442 billion in 2003. The world’s central banks bought around $60 billion of euros and yen, and the value of the central banks’ pre-existing holdings of euros and yen increased by around $100 billion because of moves in the dollar/ euro and dollar/yen. So total reserves increased by $615 billion. The world’s central banks ended 2003 with about $3 trillion in reserves, $2.1 trillion in dollars, and $0.9 trillion in euros, yen and everything else.

But the basic flow of funds was simple. The central banks of the world captured most of the world’s current account surplus and invested most of that surplus in dollars, financing the US in the process. Since Asian reserves went up by more ($475 billion) than Asia’s current account surplus ($310 billion), Asian central banks actually did more than their share.

This year is a bit more of a conundrum. The US current account deficit has widened significantly, to at least $650 billion. If you lump together Europe’s deficit countries (UK, Eastern Europe) with Europe’s surplus countries (everyone else — Euroland, Switzerland, the Nordics), Europe as a whole ran a surplus. Australia and New Zealand have deficits, but they are too small to put a huge dent in the global flows. More or less all of every major region’s current account surplus ultimately has to find its way back to the US. The US likely accounted for something like $650-660 billion of the $690 billion total current account deficit run up by deficit countries.

Global reserves continued to increase. Asia’s reserves are up by at least $535 billion in 2004. Global reserves probably increased by $700 billion, to 3.8 trillion (JP Morgan’s estimate, reported here). Only $70-80 billion of that likely comes from valuation gains. Central banks probably bought around $620 billion in new reserves.

But did it go into dollars? That would be by far the easiest way to fund the US current account deficit.

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Prepare for the 50 year Treasury bond …

by Brad Setser Wednesday, January 19, 2005

Since our newly inaugurated President seems intent on partial privatization of Social Security (despite lukewarm support from his own party), I thought I should offer him a bit of somewhat constructive advice.

Fund your plan by issuing 50 year bonds.

After all, long-term investments should be funded with long-term debt.

Is the partial privatization of Social Security — something along the lines of the Commission’s plan 2, even though Dick Cheney is right in that it keeps costs down by only providing puny private accounts, not manly Texas-sized private accounts — the kind of thing that should be financed with ten year bonds? I am afraid not. The plan moves forward the date when Social Security benefits exceed payroll tax revenues from 2018 to 2006. Do nothing and in 2015, an unreformed Social Security system would still be lending a (small) surplus to the rest of the government; adopt the Commission’s plan 2, and Social Security will be paying out more than it takes in.

What about twenty year bonds? Alas, The scale of the net transfer of general funds required under the Commission’s plan 2 is larger in 2025 — even with the benefit cuts — than it would be if we did nothing (1.03% of GDP v 0.64% of GDP). That’s right: the cash flow pressures placed on the rest of the government for the first twenty years of the plan 2 are unambiguously bigger than the cash flow pressures associated with doing nothing.

Maybe we should revive the thirty year bond? Or the other hand, maybe not. The Commission’s plan 2 would exhaust the Trust Fund in 2036, not 2052. A maturing thirty year bond would come due just as the government needs to be gearing up to provide the transfers of general revenue the Commission proposes to keep Social Security cash flow solvent between 2037 and 2050.

Don’t believe me? Let’s see what the CBO says:

CSSS Plan 2 would enable the government to pay the benefits scheduled under that law without transferring additional money from the general fund until 2036. From 2036 through 2050, transfers from the general fund would be required.

These transfers are a form of cheating. The Trust Fund — past payroll tax surpluses — is already depleted at this stage with plan 2. But benefits still exceed revenues, since the shift to inflation-indexing is gradually phased-in. The Commission squares this circle by just giving Social Security the money it needs. Give money to the current Social Security system, and it would be solvent after 2052 too.

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