Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

So, have central banks lost interest in Treasuries?

by Brad Setser Saturday, April 30, 2005

Two apologies in advance: First, this is one my wonkier/ data-intensive kind of posts. Second, this post responds to a subscription only Wall Street Journal C4 article by Agnes Crane that ran last Tuesday that draws on a Goldman Sachs Global Viewpoint paper (Asian Central Bank buying — the Beginning of the End, 20 April, by Dominic Wilson) that also is not available to the public.

The conclusion of the Goldman Study:

“This year is likely to see significantly less buying of US Treasuries — and US fixed income in general — by Asian central banks”

I think the Goldman study is only 1/2 right.

There will be less central bank support of Treasuries. Every Asian central bank now adding to its reserves has said that they intend to hold a more diverse portfolio of dollar debt — think Agencies, mortgage backed securities, corporate debt, perhaps even CDOs. You name it.

But if China holds on to its peg for the full year, or only makes cosmetic changes, the overall dropoff in demand for US assets from Asian central banks is likely to be a bit smaller than Goldman estimates. Moreover, focusing on Asian central banks misses a key part of this years’ story: very rapid reserve accumulation by oil exporters.

All in all, I don’t think global reserve accumulation will fall off much. When the financial history of 2005 is written, the big story will be same as in 2003 and 2004: unprecedented global reserve accumulation.

However, with constant reserve accumulation and a rising US external deficit, central banks will supply a smaller fraction of the net financing the US needs.

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Japanese reserve management v. Chinese reserve management; transparent v. not.

by Brad Setser Saturday, April 30, 2005

Billmon has an interesting post up that lays out his take on the current state of the economy. It includes an interesting analysis of how a slowing US will interact with the new Bretton Woods 2 system of reserve financing. His bottom line: it increases the probability that Asian central banks will keep on financing the US, though he expresses that view in considerable more colorful language.

I want to take issue, though, with one specific point Billmon raises in his post, namely that Japanese purchases of US securities during the course of 2004 constitute potential evidence for the reemergence of the yen carry trade.

I’ve tried to get a sense of how important the yen carry trade already is for the U.S. balance of payments, which isn’t easy from the sources I have available. The Commerce Department doesn’t break its international transactions data down enough to tell what’s going on. However, I see from the Treasury’s monthly capital reports that Japanese purchases of Treasuries and agency securities totaled over $200 billion in 2004 — even though the Bank of Japan itself withdrew from active dollar support operations (and thus stopped adding to its U.S. bond portfolio) in March of last year.

I certainly think it is important to watch for signs of the reemergence of the yen carry trade (yen carry trade =borrowing in yen to invest in dollars since US interest rates exceed Japanese interest rates). But I don’t think the 2004 data provides the needed evidence.

Here is why:

Japan stopped intervening in the foreign exchange market in March. But it took some time for the Bank of Japan to invest all the dollars it bought (on behalf of the Ministry of Finance) into US markets. This shows up clearly in the data that the Japanese authorities make available to the world on the IMF web page.

At the end of March 2004, Japan had $625.8 billion in “securities” and $180.2 billion in various bank accounts. By the end of September, Japan had $688.6 billion of securities and only $122.6 billion in the bank. That is more or less how it ended the year, with $699.4 billion of “securities” and $124.9 billion in the bank. (This link provides the raw data)

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So, is something about to happen to the RMB/ $

by Brad Setser Friday, April 29, 2005

China now thinks its financial system is ready for a bit of exchange rate flexibility, at least if you believe the China Securities Journal.

I am not sure what has changed, but since I — like the Goldman Sachs team — tend to think that the peg is weakening, not strengthening the banking system, I am not going to quibble.

Usually, the Chinese RMB sticks tightly to the 8.276 upper limit of its (tiny) trading band. But ever so briefly, it rose to 8.270 today …

Don’t forget, Chinese citizens (along with folks in Hong Kong and Taiwan with close ties to the mainland) are doing most of the speculation on the RMB. They — not Western Hedge funds — know how to skirt China’s capital controls. And they sure seem to be betting on an RMB appreciation.

And lots of other people around the world are watching the RMB closely right now as well, with good reason. Few prices matter more the world economy right now.

Who knows? I certainly don’t. But pressure for change certainly seems to be building. The Chinese leadership knows that it has to move before the fall — and may well want to move sooner rather than later to try to nip building protectionist sentiment against China in the bud. Looking ahead, they have to know that surging Chinese exports to the US, a surging Chinese trade surplus with the world and a slowing US economy will produce the political equivalent of a perfect storm if they cling closely to the current peg …

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China Trip Report

by Brad Setser Friday, April 29, 2005

Nouriel and I put pen to paper and laid out our take on China.

Our paper reflects on the trip we took there last month, along with the reading we did to prepare for the trip.

There is nothing new here about the peg; we laid out our assessment of China’s most likely course as soon as we got back. I suspect the real debate in China is not “the current peg” v. “change,” but rather “what kind of change.”

As we indicated before, many technocrats are well aware of the downside of a small move, namely, that “speculators” and ordinary Chinese citizens alike would start to bet on the next move. A small move probably would not have a meaningful impact on China’s overall trade balance, slow capital inflows into China, slow China’s extraordinary reserve accumulation, or provide China with more monetary room to maneuver. However, a big move still might be more than China’s political leadership can stomach at this time —

Our trip report covers far more than just the renminbi peg.

China is one of those rare countries that both the right and the left hold up as an example. Someone like Reagan-era guru Arthur Laffer claims that supply-side economics explains China’s success:

What China has done since 1978 is unbelievable. They have become a supply side, sound money country. … China has fixed the yuan to the dollar. They followed sound money and big tax cuts and as a result are really coming out of the development stage as being a very serious and positive power in this world.

Joe Stiglitz is not exactly close to Arthur Laffer on most economic questions, but he too sees much to like in China. China, after all, hardly followed “Washington Consensus” policies and it now has the fastest growth in the world. To Martin Wolf and others, China offers the best evidence out there that trade promotes development.

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Central banks, cheerleaders and paper losses

by Brad Setser Thursday, April 28, 2005

This week’s Economist looks at the “paper” losses that central banks issuing local currency (or selling local currency debt) to buy foreign exchange reserves would incur in the event of the revaluation. Call me biased, but I think it covers ground that readers of this blog know well quite nicely.

Perhaps of greater interest is another Economist article, one that highlights concerns that the Federal Reserve — or at least some Fed governors — have been a bit too willing to downplay concerns about the US current account deficit. After all, a current account deficit of over 6% of GDP is, in Fed Vice-Chairman Ferguson’s words “now larger than it has ever been in our nation’s history.” A current account deficit of this size in the world’s largest economy is unprecedented; we don’t know what sort of risks it brings with it. That ought to generate a bit of caution.

I cannot do better than to join the Economist in quoting Ted Truman:

Ted Truman, of the Institute for International Economics, who spent more than 20 years as director of the international finance division of the Fed, wrote recently that too many Fed officials are seen as “cheerleaders” for a smooth adjustment, rather than giving warning that the process might be unpleasant. “Overconfidence”, he argued, “can undermine the credibility of monetary policy.”

I certainly was amazed that Roger Ferguson gave a speech on the US current account deficit and hardly mentioned the fact that most of the 2003 and 2004 US current account deficit was financed by his fellow central bankers, not by the private markets. At least to me, that seems like germane information, and certainly something that needs to be factored in to any assessment of the current balance of risks.

The only reference I could find in Ferguson’s speech to the role of a set of investors who are not exactly flocking to the US for high returns was somewhat muted:

The East Asian economies that went through financial crises in the late 1990s have seen a plunge in their investment rates even as their saving rates have remained extremely high; the weakness in domestic demand has likely motivated the authorities in these countries to keep their exchange rates competitive to promote export-led growth, a strategy that has also contributed to the U.S. external deficit.

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The comfortable road to ruin …

by Brad Setser Wednesday, April 27, 2005

Read Martin Wolf’s latest column. His focus on emerging economies — particularly in Asia — is dead on.

The “glut” of global savings originates there, far more than in Europe. The Euro zone’s current account surplus actually has fallen from around $100 billion in 1997 (when the US current account deficit was only $136 billion) to $36 billion in 2004.

The big current account surpluses of the world right now are in Asia and the oil exporting countries.

Wolf has called the US the world’s borrower of last resort — the country that is most willing to absorb the rest of the world’s excess savings and make up for the (relative) lack of consumption in the rest of the world — running up its external debtin the process. That puts him in Dr. Bernanke’s camp, though he worries far more than Dr. Bernanke about the consequences of ever increasing US current account deficits and rising US external debt.

Wolf argues that the US external deficit is largely the product of other countries policies, not the US fiscal deficit:

For some years a number of non-US observers, including Cambridge University’s Wynne Godley (and me), have argued that US current account deficits are explained more by the behaviour of the rest of the world than by that of the US. Ben Bernanke’s Homer Jones lecture, in March, marked official recognition of what the Federal Reserve governor called the “somewhat unconventional view” that it is the surplus savings of the rest of the world that have created US deficits.***

If foreign savings was not flowing into treasuries to finance the government, it would be flowing into the mortgage market to finance US housing, or into US corporate debt to finance investment …


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An unbalanced economy gets more unbalanced

by Brad Setser Tuesday, April 26, 2005

I look at the latest evidence that the US housing market continues to be red hot in the same light as I look at the latest evidence that Chinese exports continue to grow at an amazing pace.

I don’t see either as good news, at least not in any but the very short-run.

Calculated Risk and Macroblog have the details on the continued boom in US home sales.

I would much happier if the US real estate market was cooling down, and other sectors were taking up the slack and supporting the economy. Sectors like durable goods (oops).

Similarly, I would be a lot happier if there were signs that domestic consumption growth was taking over from exports (and real estate) as the motor behind China’s expansion. But if Chinese data are to be believed, the combination of rising investment and a rising current account surplus implies that Chinese consumption is falling as a share of GDP. That’s what it takes for domestic savings to be rising even faster than investment, leading China’s current account surplus to grow.

In the long-run, the more resources (capital and labor) that flow into housing and other non-tradables sector, the harder it will be to move resources out of those sectors and into the tradables sector when the US eventually is forced to adjust. DeLong’s model gets this right. Shifts across sectors are not frictionless.

Current growth by and large is coming from the sectors of the US economy (and sectors of the Chinese economy) that would need to slow in an orderly rebalancing story. My worry: the more dependent the US economy becomes on housing, and the more dependent the Chinese economy becomes on exports, the higher the risk the “landing” will be hard rather than soft. Remember, we in the US eventually will have to pay back all the external debt we are taking out now to fund budget deficits, housing investment and consumption — or, at least, we will have to limit the pace that we add to our external debt. Over time, more and more of the current account deficit will reflect interest payments on our old external debt. That implies at some point in time the US will have to export about as much as it imports, not export about 2/3s of what we import.

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Some good news

by Brad Setser Monday, April 25, 2005

Boeing seems to be making a bit of a comeback on the back of a new small, light plane (the 787). Airbus is left hawking a heavier, lumbering giant (the A380) in the face of rising fuel prices.

That kind of sounds like GM.

I don’t know all that much about planes, and to be fair, I suspect that if you can fill up the A380, it can transport a large number of people at quite a low cost. But filling up that big of a plane is something of a challenge. It will be interesting to see if the success of the 787 will deter Airbus from launching the A350 (an updated A330), and if the presence of the A380 will deter Boeing from ever launching an advanced 747. Duopolistic competition gives rise to lots of strategic games.

To quote the FT:

Heidi Wood, analyst at Morgan Stanley, said: “With Northwest, Air Canada and today’s Air India, Boeing’s announced 787 orders stand at a fairly breathtaking 244, which makes this plane inarguably the most successful aircraft launch ever.”

The momentum behind the 787, which has so far secured 217 firm orders and commitments, according to Boeing, raises questions about the future of the Airbus A350.

… it has not yet attracted any big orders from established airlines and the recent snubs from Air Canada and Northwest – strong candidates for the aircraft as they already have a fleet of wide bodied aircraft dominated by Airbus – will damage it further. The A350 has just one order to date for 10 aircraft from Air Europa.

According to one executive involved in a recent order, Boeing’s success also reflects that under Scott Carson, Boeing’s new head of sales, it has become more aggressive on pricing in an effort to prevent the A350 from being launched.

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US policy (once again) fails the Chinese test

by Brad Setser Sunday, April 24, 2005

Lots of folks in Washington don’t think the Bush Administration and the Congress are serious about cutting the fiscal deficit, and reducing the strain the federal government places on anemic US savings.

Seems like our creditors in Beijing are not all that happy either.

They think the US is blaming China for economic problems made in Washington DC. Listen to Wei Benhua — the number two man at China’s State Administration of Foreign Exchange (SAFE), the United States’ second largest creditor (after Bank of Japan):

“I made it clear to them: this is your problem. You should put your own house in order before you blame your neighbors,” said Wei, referring to a recent meeting with U.S. counterparts. …

Wei blamed the U.S. trade deficit on “a flawed US economic policy” and said China would make currency decisions based on its own economic needs. To date, China has not put its money where its mouth is: it could rather easily increase pressure on the US to do something about its fiscal deficit rather dramatically if it ever was willing to play hardball. The fund managers at China’s State Administration of Foreign Exchange would not even need to sell dollars. All they would need to do is let it be known that they intended to aggressively reduce the duration of their dollar portfolio.

To be fair, China’s steps to clean up its own equivalent of the budget deficit — the enormous overhang of bad loans in its banking system — have been small and timid relative to the scale of the underlying problem. China needs to be wary of using the US tendency to put too much blame on China as an excuse for its own inaction.I suspect both Ronald McKinnon and Joe Stiglitz would agree with Mr. Wei. I do too, though I think both McKinnon (see the Mary Kissel column in the Monday Wall Street Journal) and Stiglitz understate the China-centric case for a Chinese revaluation. China imports too few goods from the world for its own and the world’s good, and buys too much US debt instead; a revaluation could help change that. China is not so rich that it makes sense for China to finance the rest of the world.

I am drawn instead toward Jeff Frankel’s analysis. I’ll summarize his argument this way: countries that can produce cars that compete effectively in the US and European markets usually have a per-capita income (in dollar terms) of far more than $1,500. China’s domestic prices are very low, relative to world prices — China’s current dollar income understates its true level of development. Over time, the gap between Chinese income and US and European and Japanese income will fall. I would much rather see China’s incomes rise toward world levels than see US and European income sink toward Chinese levels.

One aside: I don’t think McKinnon’s conflicted virtue argument (China has lots surplus savings to lend to the world because of its high savings rate, but it cannot lend in renminbi abroad, so it is left saving in dollars, which generates all sorts of problems) works perfectly for China. Not all Chinese investment abroad takes the form of dollar debt, for one. Think, for example, of China’s growing investment in the production of oil and natural resources. McKinnon’s argument that renminbi appreciation would be to China today what yen appreciation was to Japan in the 80s needs to be considered seriously. I don’t quite see it though. China today is not quite as wealthy as Japan in the 80s, for one. And Japan’s bubble economy came about when Japan responded to yen appreciation with loose money (which for strange reasons did not lead the yen to fall, but did inflate Japanese property prices). China seems to be generating its own version of the bubble economy (check out Shanghai property prices, which some folks seem to think will keep on rising) with a loose monetary policy created by the combination of an undervalued renminbi and hot money flows.

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A glass half empty, in three different ways

by Brad Setser Saturday, April 23, 2005

It seems to me that there are three big risks – the result of what economists like to call imbalances — hanging over the global economy, even leaving aside the possibility of an old fashioned oil supply shock.

The first is one that Nouriel and I have discussed extensively: US dependence on the export of its debt to finance an enormous trade deficit. In 2004, Central banks supplied about 3/4 of the net financing of the US current account deficit ($475-500b of $665b), at least ½ the total foreign demand for US debt (the US needs to sell debt abroad to finance both the current account deficit and net equity outflows), and maybe one third ($400 b of $1150 b) of ALL demand for new (or more accurately, net new) US long-term bond issuance. So any cut back in central bank demand could have serious implications for the US economy.

What could prompt central banks to buy less US debt? Reserve diversification. A revaluation that reduced East Asia’s current account surplus. Or a fall in net PRIVATE capital inflows to certain emerging economies: right now, hot money flows into China finance the US, not China.

The result: higher interest rates as the US has to pay more to attract private capital from abroad. The key questions are the magnitude of the increase in interest rates required to attract private capital flows and the impact of higher rates lead on US consumption, savings and investment. This scenario has already been covered at length, both here and elsewhere; no need to go into more detail now.

The second is that US consumers are already overstretched, and the health of the US and world economy relies on their willingness to become even more overstretched. US consumption has been rising faster than US income (consumption as a share of GDP has been rising). It would be a bit of shock for the global economy for US consumption to stop rising relative to US income, let alone fall. Yet there are no shortage of potential reasons why US consumers might start to pull back: stagnant real wages; rising oil prices; a somewhat less robust housing market. Or simply the Fed’s decision to raise policy rates a bit (check out this interesting post by Dan Gross over at Slate, via Battle Panda).

Calculated Risk has done Herculean work documenting how housing price increases support US consumption, and how the housing boom has led to a boom in employment in real estate and related sectors of the economy. No competition from China there. Fed governor Don Kohn has observed that residential investment is now at a fifty year high (relative to GDP). Again, no competition from China there.

On the external side, central banks do not need to diversify their existing stock of reserves to deliver a nasty shock. They just to stop adding to their reserves. Similarly, housing prices do not need to fall to stop supporting US consumption growth. All they need to do is to stop rising at their current rate.

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