Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

That strong renminbi (ok, that strong dollar)

by Brad Setser Sunday, May 22, 2005

The RMB has appreciated by about 7% against one of China’s major trading partners this year. Not the US, obviously. But that doesn’t mean that China is not exposed to moves in the dollar-euro, or the dollar-yen.

Indeed, right now, it looks like the RMB will move far more against the euro than against the dollar in 2005, even if China makes some small changes in the dollar-RMB peg over the summer.

There are plenty of reasons for the dollar’s rally v. the euro — the upcoming French referendum on the new EU constitution, obvious signs that growth is slowing in Europe, rising policy interest rates in the US and constant policy rates in Europe, and the unwinding of some dollar funded carry trades. For now, “cyclical” concerns trump “structural concerns” about the US trade and current account deficit. Fair enough. Credit is owned where credit is due: so far, Stephen “Current account deficits don’t matter” Jen has been directionally right. He also thinks fair value for the euro dollar is closer to 1.1 than to 1.25 (Jen’s longstanding view), so he thinks the dollar has room to rise a lot further …

The dollar’s rally — and low long-term US interest rates — still worries me. I would be more comfortable if the dollar was depreciating against non-European currencies and holding constant against the euro, widening the base dollar depreciation. And yes, I also would prefer to see a slow rise in long-term US rates.

The world seems to be slipping back towards the growth pattern that everyone is most familiar with — growth driven fundamentally by surging US demand, supported by rising US real estate prices. China contributed substantially to global demand growth too in 2003 and 2004, particularly in some commodity markets. But Chinese import growth has slowed this year. Right now, China, like everyone else, depends on the US consumer.

What’s wrong with this? This pattern of growth presumes growing global imbalances — i.e. an expanding US trade deficit. And it will result in growing domestic imbalances in the US. A real-estate centric economy will become more real-estate centric. If the dollar rally continues, the market incentives to invest in the US tradables sector will fall — yet that export capacity is what the United States needs to grow out of its trade deficit by growing its exports (It should be noted that the dollar has depreciated against the Brazilian real and Korean won this year, even as it has appreciated against the Euro, limiting the dollar’s overall appreciation).

In the short-run, there are advantages to continuing the current pattern of growth. It is far easier for the growing sectors in the world economy — real-estate in the US, exports in China — to keep on growing than to find a new basis for growth. But it also adds to the risk of a hard landing further down the line. To me, the soft landing scenario requires market pressures to slowly emerge to change, gradually, the composition of US growth: a falling dollar increases incentives to export, and to invest in export sectors; rising interest rates reduced the incentive to bet on rising housing prices, and make it harder to cash out home equity. The reverse would happen abroad: slowing demand growth in the US and the drag of a weak dollar would prompt other countries to focus on stimulating domestic consumption. Alas, that, by and large, hasn’t happened.


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Bernanke’s global savings glut

by Brad Setser Saturday, May 21, 2005

Bernanke’s global savings glut argument is quite subtle, more subtle than I perhaps have recognized in the past. Bernanke’s argument goes beyond the “US current account deficits don’t matter since there is a global savings glut” headline that I occasionally push.

Bernanke takes his argument that there is a global savings glut to its logical conclusion. He argues that without a federal budget deficit, the global savings surplus that was invested in US government debt over the past few years would instead have been invested in other US assets. Real interest rates would be even lower, housing prices would be higher, investment in housing would be higher, and consumption in the US would be even stronger. As a result, the US current account deficit would not be much different.

The weakening of new capital investment after the drop in equity prices did not much change the net effect of the global saving glut on the U.S. current account. The transmission mechanism changed, however, as low real interest rates rather than high stock prices became a principal cause of lower U.S. saving. In particular, during the past few years, the key asset-price effects of the global saving glut appear to have occurred in the market for residential investment, as low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. The expansion of U.S. housing wealth, much of it easily accessible to households through cash-out refinancing and home equity lines of credit, has kept the U.S. national saving rate low–and indeed, together with the significant worsening of the federal budget outlook, helped to drive it lower. As U.S. business investment has recently begun a cyclical recovery while residential investment has remained strong, the domestic saving shortfall has continued to widen, implying a rise in the current account deficit and increasing dependence of the United States on capital inflows.

According to the story I have sketched thus far, events outside U.S. borders–such as the financial crises that induced emerging-market countries to switch from being international borrowers to international lenders–have played an important role in the evolution of the U.S. current account deficit, with transmission occurring primarily through endogenous changes in equity values, house prices, real interest rates, and the exchange value of the dollar.

Emphasis added.

Note that the US budget deficit did not play a role in Bernanke’s presentation. To put it a bit crudely, Bernanke’s argument implies that the drain on global savings created by the budget deficit is all that has stood between the United States and an even bigger housing boom.

Implicitly, Bernanke assumes that any fall in the US budget deficit would have a big impact on world interest rates and, in turn falls in the world interest rate would have a big impact on US investment and on US consumption — helped along by things like interest-only mortgages. In formal terms, the elasticities need to be large.

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Korea can not make up its mind either: are they for currency intervention or against it?

by Brad Setser Thursday, May 19, 2005

First, South Korea opts out of the Bretton Woods 2 system of reserve financing. That would be the first really big outright public defection. Korea has lots of reserves — and its central bank clearly thinks it doesn’t need any more.

“I believe that we now have sufficient reserves to secure our sovereign credibility, so I do not anticipate increasing the amount of foreign reserves further,” Park Seung [Governor of the Bank of Korea] told the Financial Times. South Korea’s foreign currency reserves stand at $206bn the fourth largest in the world.

Then, it gets right back in.


Currency traders said it appeared that the central bank in fact bought dollar-denominated assets on Thursday morning, less than 24 hours after Park Seung, the governor, told the Financial Times that he did not “anticipate” doing so. When asked during the interview if that meant the bank would not be intervening in the foreign exchange markets, Mr Park responded: “No, no, we will not be intervening.”

The central bank on Thursday confirmed that Mr Park had been quoted accurately but it nevertheless released a statement saying that he had been “misunderstood.” “The Bank of Korea will take necessary measures whenever the currency markets are unstable. Especially, we will not sit idly by if speculative funds come in to exploit a groundless news report,” it said.

What is going on? It sure seems like the Bank of Korea (the central bank) and the Ministry of Finance (if not the entire government) are in somewhat different places. The Finance Ministry is worried about any slowdown in growth, and Korea’s export growth seems to be slowing. This policy dispute just played out in a very public way.

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Rhetoric that runs ahead of reality

by Brad Setser Thursday, May 19, 2005

I noticed that the US Treasury statement that accompanied the foreign currency report adopted the rhetoric of shared sacrifice.

We are not bashing China in lieu of tackling our own problems; we in the US are committed to reducing our deficit and raising national savings.

The problem: the policies to back the rhetoric aren’t there, and most of the world knows it.

The much-touted partial privatization of Social Security won’t raise national savings so long as it is financed by debt, not cutting CURRENT benefits or raising CURRENT taxes. As best, it is neutral; at worse, it might lead national savings to fall. Gutting the one part of the government with a cash-flow surplus for the next ten years hardly seems likely to improve the federal government’s overall finances.

The “on-budget” fiscal deficit does look likely to fall a bit this year. Alas, it seems to be falling for the same reason why the overall current account deficit is rising. The real estate boom that is driving up investment in residential properties and fueling consumption growth also seems to be contributing to the Federal government’s tax coffers. Tax revenues seem to have outperformed in part because of capital gains on real estate (and also on the equities). In an asset-based economy, it increasingly seems that tax revenues are quite pro-cyclical, rising more than expected in good times and falling a bit more than expected in bad times. The revenues from the amnesty (actually a low tax rate) on the repatriation of profits probably helped too.

The current fiscal improvement risks being a one-off, particularly if the Congress keeps on spending and all the tax cuts are made permanent. And even if real-estate fueled consumption growth continues to help keep the deficit down for a while longer, that won’t exactly reduce the US need for foreign savings. And the longer-term outlook is not pretty if the tax cuts are made permanent.

Nice words from the Treasury, but little credibility.

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Containing China with money borrowed from China

by Brad Setser Wednesday, May 18, 2005

I sometimes find grand geostrategic commentary a bit amusing, in part because there is so little overlap between geostratists and economists. I think Tom Barnett gets some aspects of the global flow of capital a bit wrong, but at least he tries to bridge the two worlds.

I will confess that I was a bit surprised by Robert Kagan’s argument that the US is already implementing a policy of containing China.

The United States may not be able to avoid a policy of containing China; we are, in fact, already doing so.

After all China buys a fair number of Treasuries. If the US already has adopted a policy of containing China, China is helping to finance its own containment.

Wrapping your head around that thought is a bit hard — even unsettling. Kagan may be half-right.

This [The US policy of containing China] is a sufficiently unsettling prospect, however, that we are doing all we can to avoid thinking about it.

China presumably thinks that it is winning, or at least not losing, in this trade. Its industrial base is growing rapidly, and that may matter more than anything else. The US presumably thinks its apparent financial dependence on China carries limited risks: if China doesn’t want to buy, another buyer for US debt can be found, at close to current rates.

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So, is the Bush Administration for bashing China or against it?

by Brad Setser Tuesday, May 17, 2005

Let no one think the Bush Administration doesn’t occasionally try to have it both ways.

A month ago the Bush Administration ratcheted up the verbal pressure on China. China was ready to change its peg, they declared. The previous strategy of quiet pressure, patience and financial diplomacy wasn’t working; China was getting the message that there was no urgency.

Today, depending on how you want to look at it, the Bush Administration either upped the heat on China by signaling that it will declare China a manipulator the next time, or wimped out. Setting the clock ticking might buy the Administration the ability to push the Congressional vote on Schumer-Graham off until after October. But splitting the difference also risks pleasing no one.

On one hand, it is pretty clear that China’s commitment to its current peg is “preventing effective balance of payments adjustment” — the key technical criteria for currency manipulation.

On the other hand, it is not entirely obvious the US really wants “effective balance of payments adjustment.” Debtor countries usually quite like getting the financing needed to keep running up their debts. Apart from the manufacturing sector, most of the US seems to quite like not paying enough taxes to finance the current level of government spending, cheap imports that keep down inflation and low interest rates that push up housing prices. Real adjustment means shifting resources out of real estate and into the production of tradable goods and services. Right now, not adjusting seems a lot more fun.

Like the Bush Administration, I am of two minds on this issue. (Post continues below)

If spending $300 billion, almost 20% of your GDP (China’s expected 2005 reserve accumulation), to keep your currency from appreciating is not manipulation, then what is? The criteria for “currency manipulation” are not cut and dried; in practice it is always a political judgment. But intellectually, it is hard to see why heavy intervention to defend the current peg was not (or was not quite) manipulation from July-December of 2004; but heavy intervention to defend the peg after January 2005 is manipulation …

And while not adjusting may be pleasant in short-run, I also strongly suspect that the longer the current real-estate driven expansion powers on, the more difficult it will be for the US economy to ultimately adjust to a world where it cannot import 60% more than it exports. The chances for a soft landing go up if the US starts to adjust now, rather than continuing to defer real adjustment.

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Cows, calves and the interest rate

by Brad Setser Monday, May 16, 2005

Trackback is a dangerous thing. I just have learned that some of my blog posts have been compared to modernist poems. No doubt my last couple of posts have been a bit of a slog, heavy on both data and jargon (though try reading Wall Street research on collateralized debt obligations … ).

So I thought I should lighten things up, at least briefly. In Nicholas Dunbar’s book about the collapse of LTCM, I came across this gem:

“When people first started lending things to each other, it was as friends. You might lend a spear to a friend going hunting, or lend your time to help gather in the harvest. The loans didn’t last long, and were repaid in kind. What about lending for longer periods of time? The most important possession people had was livestock, but animals have a unique property — they breed. If you borrow a herd of cattle for year, you probably will end up with more than you started with.”

Consequently, the Sumerian and ancient Greek word for interest was “was the same as the word for calves.”

Sort of interesting, at least to me. My grandfather raised cattle.

Now the cutting edge of the market is to bet not on speculative credits, but on the correlation among speculative credits (to paraphrase Jade’s comments on an earlier post). We have come a long way.

On a different and more serious note, the Treasury intends to issue its foreign currency report tomorrow, so we soon will soon know whether or not the US is going to formally accuse China of manipulating its currency. Talk about having no good choices.

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Strange trade numbers, strange TIC numbers

by Brad Setser Monday, May 16, 2005

The trade deficit fell in March. So did the capital flows needed to sustain ongoing trade deficits. Net inflows of $45.7 billion a month are not enough to sustain even $55 billion monthly trade deficits, let alone $60 billion monthly deficits. I guess there was a reason why the euro was sort of strong in mid-March.

Take out the $28.4 b (net) of Treasuries the Caribbean bought in March, and net inflows were even lower — only $17.3 billion. If US hedge funds domiciled in the Caribbean for tax and other reasons were behind these purchases and they financed their purchases by borrowing from US banks, these purchases did not generate any net financing of the US deficit.

And what to make of net sales of $14.4 billion by official institutions? After all, lots of Asian central banks spent much of March denying any interest in diversifying their reserves.

And to be fair, the Koreans clearly did not diversify — the value of their stash of Treasuries grew by $4 billion in March (and on a flow basis, they bought $0.1 b of Treasuries). The Taiwanese bought $2.2 billion of Treasuries. The Chinese did not sell — though their net (recorded) purchases of Treasuries, Agencies and corporate bonds was only $2.3-2.4 billion (Flow data all comes here) — well below their roughly $17 billion in March reserve accumulation.

So what happened?

Quick answer: Don’t forget about the Norwegians. They sold $17 billion of Treasuries in March. That cut their Treasury holdings in half. Norway’s Oil Fund decided to diversify? They certainly did not just shift from Treasuries into Agencies or corporate debt.

The OPEC countries were not found of Treasuries in March either. Their total holdings fell $5.4 billion — and since oil was quite high, we can be pretty sure they were not short on cash.

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It seems like both the People’s Bank of China and W

by Brad Setser Saturday, May 14, 2005

hold lots of worthless IOUs in their portfolios (link via Dan Gross/ Moneyblog).

There seems to be a lot to talk about this weekend, whether the Fed’s various views on the risks associated with the US current account deficit, Argentina’s debt exchange (which now looks set to go forward after a legal challenge was dismissed) or how Kerkorian’s bid for GM wrong-footed a few hedge funds.

Worthless IOUs have done rather well recently — much better than going “long equity/ short mezz.” Apparently, holding the equity tranche of a collateralized debt obligation (the equity tranche has the most default risk) while selling the mezzanine tranche (the next most risky portion) short was another hedge fund trade that hasn’t done so well recently.

“The trade is supposed to make money if spreads move either wider or tighter in a parallel fashion,” wrote analysts at Merrill Lynch & Co. in a May 10 research note. Yet the rating cuts for General Motors and Ford “caused spreads to move in a non- parallel fashion and these trades to underperform significantly,” Merrill said. “We expect a rush to the door to be painful.”

The comments thread on my previous post was getting a bit crowded, so feel free to chat away while I try to read up on collateralized debt obligations.


The best explanation of the underlying logic of the long equity short mezz trade that I have seem comes from Rohan Doctor of Citi (no link available)

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The sustainability of the current account deficit, once again

by Brad Setser Thursday, May 12, 2005

The market seems to have concluded that there is no need to put any pressure on the US to reduce its large external deficits.

The dollar is up, at least against the euro. So is the renminbi for that matter, at least against the euro. Treasury bond yields are down. No bond market vigilantes = no political pressure to reign in fiscal deficits. April retail sales were relatively strong. That suggests a likely pick up in non-oil import growth once the lagged impact of the Chinese Lunar New Year stops impacting the trade data. Remember: even if non-oil import growth stays around 8% and export growth stays around 9-10% going forward, the trade deficit will continue to expand over time.

It sort of feels like the markets have been listening to the Fed. After all, the Fed, with some notable exceptions, has taken something of the lead in arguing that US current account deficits of the current magnitude do not pose a serious policy concern – or at least not the kind of concern that requires any action on the part of the Fed. And for some in the Fed, they don’t really demand much action from the White House: If Bernanke’s savings glut thesis is taken to the extreme, recent large budget deficits arguably have served the usual purpose of preventing the global savings glut from driving real US rates even lower and thus have helped to ward off an even bigger housing boom (or bubble).

The latest don’t worry (very much) argument came from Michael Kouparitsas of the Chicago Fed. Suffice to say that I was less impressed by the arguments put forward by Dr. Kouparitsas than Dave Altig.

I am more in Paul Volcker’s camp. Or more in Robert Rubin’s camp. Probably not a surprise, I know. For a relatively short and non-technical discussion of the reasons why, I recommend this article that Nouriel and I wrote for CES info in Germany.

(much more follows)The funny thing is that Dr. Kouparitsas is using the same basic analytical framework that Nouriel and I used — he jazzes up the basic debt sustainability model to provide a more complex picture of asset returns, but fundamentally, it is the same model. Nouriel and I also noted in our more technical paper that so long as US real growth rates exceed the real interest rate the US pays on US net external debt, small trade deficits are consistent with a stable external debt to GDP ratio.

The Kouparitsas paper argues that the past offers a reasonable guide to the future, and thus that historical returns on US assets and liabilities offer a plausible basis for estimating future returns – at least when it is not emphasizing how valuation gains on US assets abroad brought the US deficit down to close to sustainable levels in 2003.

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