Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

The governor of China’s central bank might want to take notice

by Brad Setser Tuesday, May 31, 2005

The former governor of Thailand’s central bank is being held accountable for squandering Thailand’s foreign exchange reserves defending the Baht peg back in 1997, and in a big way (though he is appealing).

Former Thai central bank governor Rerngchai Marakanond, who oversaw the country’s failed attempt to protect its fixed exchange rate regime on the eve of the 1997 Asian financial crisis, was ordered on Tuesday to pay back the Bt186bn (US$4.57bn) spent in the futile defence of the currency. … a local court chastised Mr Rerngchai for “grave negligence” for exhausting Thai foreign exchange reserves battling currency speculators.

… Mr Rerngchai was the only person sued by the administration of Thaksin Shinwatra, the Thai prime minister, in connection with the debacle, under a law that allows civil servants to be held liable for losses they cause to the government.

… For years before speculators attacked the baht, the International Monetary Fund had warned that Thailand’s fixed exchange rate regime was unsustainable, given a current account deficit of about 8 per cent of gross domestic product.

But Thailand’s intertwined business and political elites supported the system, as the country had well over $70bn in outstanding foreign currency denominated debts.

Note that back in 1997, the Thai elite all wanted to cling on to the peg — they all had dollar debts that they could not pay after a devaluation. Abandoning the peg earlier, no doubt the right thing to have done, would also have been immensely unpopular.

Obviously, the situation in China is a bit different. China has a huge current account surplus (estimated at 8% of GDP in 2005) and is trying to keep its currency from appreciating, Thailand had an equally huge current account deficit in 1996/97 and was trying to keep its currency from depreciating.

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Memo to Kirstof: China has some responsibility for global imbalances too

by Brad Setser Monday, May 30, 2005

Nick Kristof accuses the US — Democrats in Congress in particular — of scapegoating China, and blaming China for global economic problems (more accurately, the risk of global economic problems) that fundamentally are made in America.

Alas, the U.S. is mostly to blame for this. And the biggest culprit of all is the demagoguery of some Democrats in Congress. There are plenty of legitimate reasons to be angry with China’s leaders, but its trade success and exchange rate policy are not among them. The country that is distorting global capital flows and destabilizing the world economy is not China but the U.S. American fiscal recklessness is a genuine international problem, while blaming Chinese for making shoes efficiently amounts to a protectionist assault on the global trade system.

(Emphasis added)

The structural US fiscal deficit certainly contributes to the imbalances that hang over the world economy. The fiscal deficit is falling a tad right now on the back of a real-estate induced boom in tax revenues (corporate tax revenue is also way up), but the same real estate boom also is making the US external deficit bigger. The kind of fiscal adjustment that will reduce the US external imbalance requires slowing US demand growth — not just riding the wave of revenue that comes with a real estate boom.

I don’t necessarily like the way the American policy makers, Republicans and Democrats alike, have gone about trying to change China’s peg. The Bush Administration certainly has been more willing to blame China for the US trade deficit than to look in the mirror.

But China also bears some responsibility for current global imbalances. For every bad borrower, there is a bad lender.

Specifically, I think China’s leadership can be criticized for:

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Non, and loudly

by Brad Setser Sunday, May 29, 2005

France has spoken.

I don’t have any creative or original thoughts on what the French vote means for Europe, though, like many others, I found Henry Farrell’s thoughts interesting. For those interested in reading more about “Europe,” we have put a set of links up on the RGE monitor webpage (link at top). The folks at Democracy Arsenal are talking through the issue as well, and Eric Chaney lays out some of the potential market implications.

One thing is clear: the convergence trade just got a bit riskier …

I will be watching to see how the Turkish markets react to the non — a non cannot be good for Chirac, or for Turkey’s chances of gaining membership in the EU.

It is worth noting that the Euro is now back around where it was at the end of 2003 — in the 1.25-1.26 range. All the valuation gains that the US enjoyed on its European assets in 2004 have now disappeared. Remember, when the dollar falls against the euro, it immediately improves the US net international investment position by increasing the value of the United States substantial European assets. To repeat the valuation gains of 2004, the US needs the dollar to fall to 1.455 by the end of 2005. That does not seem likely. If nothing changes, the US is looking at a huge increase in its net external debt in 2005. A large current account deficit, and substantial valuation losses.

The OECD puts the US current account deficit at 6.4% of GDP in 05 (a bit under $800b), and 6.7% of GDP in 06 (close to $900b). If the euro stays around 1.25, European growth continues to lag, and Chinese exports continue to surge, that strikes me as a bit too low — the q4 2004 US current account deficit was around 6.3% of GDP. The OECD presentation contains plenty of other interesting information. Note strong domestic demand growth in France, for example, fueled by rising real estate values — which in a way makes current French unhappiness more striking. But real wage growth has slowed in France recently, and real wages are falling in Germany — there is a reason why European voters are unhappy. Adjustment through deflation is never fun.

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A prediction: China will eventually protect its agricultural sector

by Brad Setser Saturday, May 28, 2005

You know, the global norm is not free trade in agriculture …

If China doesn’t want its peasants to compete against subsidized US and European agricultural exports, I suspect that it has a range of possible options. Korea and Japan — two other East Asian countries with relatively little arable land — protect their (remaining) farmers like mad.

Formerly agricultural economies with little arable land that shift into manufacturing typically have the highest rates of agricultural protection around. Look at Japan. Look at Norway — which, in a sense, uses its oil revenues to “buy” traditional Norwegian farms rather than import agricultural goods.

Holding the RMB down to prop up rural incomes by keeping imported agricultural goods cheap is probably not a viable long-term strategy. Chinese farmers certainly could complain that they are competing against subsdized agricultural imports. But China’s policy of spending between 15 and 20% of its GDP to build up its reserves and provide “vendor” financing for its manufactured goods exports can be thought of as a kind of an export subsidy too. The cost of that subsidy are deferred: they only will be realized after the RMB is revalued, but they are still real.

The status quo — protecting China’s farmers with an undervalued exchange rate and providing what amounts to subsidized financing for its manufactured exports through massive reserve accumulation — is not, at least in my view, sustainable, either politically or economically. But China clearly wants to avoid creating even stronger incentives for peasants to migrate to urban China (letting peasants actually own land is one idea … but apparently that is a step to far in a still Communist country).

Free trade purists won’t like aquiescing to more agricultural protection. But keeping trade in manufactured goods relatively free requires a Chinese revaluation — actually a series of Chinese revaluations that, over time and as Chinese productivity continues to increase, bring Chinese wages and prices more in line with industrial country norms. And a Chinese revaluation — if it is a real revalution, not a cosmetic one — may need to be combined with measures to limit the potential impact of now much cheaper rice and grain imports on Chinese farmers.


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Housing bubbles, the great plains and the coast

by Brad Setser Friday, May 27, 2005

Not all parts of America are enjoying a housing bubble. $65,000 will buy a brick home with three bedrooms and a two car garage in Stafford Kansas, though maybe not ten acres of prairie as well.

Low interest rates are the common denominator linking together Greenspan’s frothy local housing markets, but local conditions can dominate low national, if not global, interest rates. If there are more houses than people, it is hard for housing prices to increase much — even if interest rates are low. Without new investors chasing the windfall gains from the initial surge in prices, there is not as much speculative froth. In those parts of the US where the population is shrinking and incomes are generally low (Note: Timothy Egan’s reporting on the plight of great plains small towns has been excellent), there does not seem to be much of a housing bubble.

To paraphrase Paul Kasriel’s summary of Greenspan, there is no housing bubble in Manhattan KS (where I grew up), but there is one in Manhattan New York (where I now live). That characterization is a bit off. Manhattan KS (a growing university town and regional medical center) is far more frothy than say Stafford or St. John’s KS, but it has a grain of truth.

Even within “bubble” America, there are differences. Interest-only markets like California seems to have a bit more froth than someplace like almost interest-only Washington DC. The rent to price ratio is a bit higher in California than in DC, where rental prices have trended up. All that homeland security and global-war-on-terror related work … The real estate bubble has generated big money — at least on paper. Dollar turnover in the housing market was equal to 10% of US GDP in q1. Housing accounts for 40% of all bubble job creation. The US real estate to GDP ratio is now approaching the US equities to GDP ratio back in 2000.

Update. Calculated Risk has drawn attention to this NY Times article, which notes that real estate may account for 25% of the US economy …

Since real estate is relatively widely owned, as far as financial assets go, the capital gains are probably not as concentrated as the (paper) gains from the .com bubble. But the surge in housing prices still has enormous distributional consequences. The net worth of those who already own homes — generally an older group — has gone up, along with the net worth of those lucky (or smart) enough to get in early. Those who don’t already own homes are worse off; the cost of buying a home has gone way up.

And there is a regional component — the coasts have generally had more real estate froth than the interior. Alan Greenspan’s everyday low interest rates have been kinder to blue states than red states.

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Bretton Woods Two and Trade Politics

by Brad Setser Friday, May 27, 2005

The interest rate on the 10 year Treasury note is somewhere between 4.0-4.1% — and the US seems to be having no trouble financing its current account (or its budget) deficit right now. The risk of hard landing remains just that, a risk — right now the market hardly seems worried about the United States’ still growing external deficit.

Consequently, this is a reasonable time to step back and look back at some of the arguments that Nouriel and I laid out in February, when we put forward the case that growing external imbalances posed a growing risk to the US economy. We did not suggest that the hard landing was imminent — we thought the risks were far higher in 2006 than in 2005. In 2006, the US external deficit would be bigger, one-off factors like the corporate tax holiday would have played themselves out, and Asian central banks would hold even more reserves than they do now — calling into question their willingness to keep on adding to their holdings of dollars. But we did argue that the risks were more immediate than most thought.

Some of the arguments that we made in February look pretty good three and a half months later. Korea’s central bank governor has not mastered the art of communicating with the markets. But it is still pretty clear that Korea thinks it has all the reserves it needs and would rather not continue to add to its reserves. Japan is out of the market, but its past intervention seems to have left a legacy in the market — the willingness of private Japanese investors to buy US debt hinges in part on expectations that the Japanese authorities will keep the yen from appreciating too much, and thus prevent dollar depreciation from wiping out the positive “carry” generated by higher US interest rates. Change those expectations, and US rates might change to compensate Japanese investors for the greater exchange rate risk. Above all, the burden that China has to bear to support the system seems to be rising. We don’t know the pace of China’s reserve accumulation in April or May, but I would not be surprised if both numbers turn out to be very high — reserve accumulation of $30b, or even $40 b, in May is not out of the question. Annualized, that works out to $360 b (20% of GDP) or $480 b (25% of GDP) — a phenomenal sum.

This was a key component of our argument: the burden China has to bear to support the system would rise, until it exceeded even China’s threshhold for pain – though the pain in this case is rather abstract. The pain comes from the growing gap between the coast and the interior and resulting social tensions from China’s unbalanced growth, future financial losses and difficulties keeping surging reserves from leading to a surge in the money supply. Jonathan Anderson of UBS estimates that China’s money supply should grow by about $70b a year, any reserve growth in excess of $70 b needs to be sterilized. If China’s reserves grew by $40 b in May (this is a pure guess), and 75% of those reserve were invested in dollars that provides $30 b of financing to the US. The US needs about $65-70 b in monthly financing to cover its current account deficit, so China’s central bank ALONE would be supplying just under 1/2 the needed financing.

China says it does not want to give in to US pressure — though I would note it also did not move when the Bush Administration refrained from public pressure. But if China tries to “punish” the US for its public criticism by holding on to its peg, China, in effect, has to keep on financing the US at a low rate. Rather than kow-towing to US demands to change its currency, China will just keep writing large checks to buy low-yielding US securities …

However, I think Nouriel and I did miss a couple of things in our Bretton Woods Two paper.

1) US assets could become more attractive relative to European assets if European interest rates fell sharply, not just if US interest rates rose. On the short-end, US rates have risen while European rates have stayed constant. On the long-end, US rates certainly have not risen (hence, the conundrum), but European rates have fallen. Bunds now yield 3.3% — well below Treasuries.

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A new open thread

by Brad Setser Wednesday, May 25, 2005

Thanks to the generousity of Carnegie (who donated the building), Gates (who donated the computer) and the public library of Stafford, Kansas.

I’ll try to chime in with some thoughts on Bretton Woods two late tomorrow — [UPDATE — MAKE THAT FRIDAY]

For the moment, though, I’ll just note that it is strange, at least to me, that the current account surpluses (savings surpluses) of the world’s resource exporting countries and many of the world’s biggest resource importing countries are both rising right now. An oil exporter might save the windfall from an unexpected price surge, but I would normally expect an oil importer — including an oil importer like China — to save a bit less. The net effect on the global savings surplus is a bit ambiguous.

Afterall, Asia’s economies are very dependent on imported raw materials, and those raw materials cost more today than in say 2002. That makes the current surge in Chinese savings all the more surprising …

Five myths (or half truths) about China and the renminbi

by Brad Setser Monday, May 23, 2005

China’s exchange rate peg has attracted a lot of attention recently, in the market, among the public and in the press. (also here, here and many other places)

Alas, too much of the commentary seems to me to reflect arguments that at least to me don’t seem to be true, or seem to be only half true.

Arguments that appear often include:

1) China runs a surplus with the US, but a deficit with the world; its overall trade is close to balanced. This is a myth. China’s trade surplus with the US exceeds its trade deficit with the rest of the world. It ran a trade surplus of $32 billion in 2004. That surplus is set to widen significantly in 2005, since China’s exports are growing far faster than its imports. China’s trade surplus in 2005 could reach $100 billion or more, according to Jonathan Anderson of UBS. China’s overall current account surplus is larger as a share of GDP than Japan’s, and it is rising rapidly — it could be 7% or 8% of China’s GDP in 2005.

2) China hasn’t changed its currency peg since 1994, it therefore cannot be trying to keep its currency down. Back in 1998 there was concern that China might devalue. The last statement is true (counting back to 1998), but the rest I would argue reflects a myth — namely that so long as China is not pushing its currency down in nominal terms, it cannot be “manipulating” its currency to impedge effective balance of payments adjustment. Put simply, a lot has changed since 1994. China’s economy is far more productive. It now exports $595 b of goods, and it is on track to export 750-770 b in 2005 (One note, i previously used a Goldman estimate of end 2004 “exports” that was around $700b; Goldman’s definition of exports was very broad — goods exports are closer to $600b. My apologies.) v well under $200 b back in 94. That increase in productivity should have led to an appreciation of china’s currency in real terms, whether through higher inflation rates in China or through a rise in the renminbi’s value against other currencies. Neither has happened. One other thing has changed, particularly since 1998. From about 1995 to 2002, the dollar was generally rising; from 2002 (leaving aside its recent rally v. the euro) the dollar has been falling.

There is a reason why China’s current account surplus has been rising, and why China’s reserves are rising even faster. Lots has changed since 1994, and since 1998.

3) Chinese wages are so far below US wages (and for that matter wages in other industrial countries, and many emerging economies) that a change in the renminbi won’t have any impact. Myth. Goldman Sachs estimates that a 1% rise in the renminbi’s real value (which can come either if Chinese inflation is 1% higher than inflation in the rest of the world, or is China’s currency rises by 1% and inflation is unchanged) leads to a 1% reduction in China’s export growth rate.

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