Brad Setser

Brad Setser: Follow the Money

Rubin doctrine of international finance v. Greenspan doctrine …

by Brad Setser Tuesday, August 30, 2005

The Rubin doctrine of international finance (From In an Uncertain World):

1. The only certainty in life is that nothing is ever certain.

2. Markets are good, but they are not the solution to all problems.

3. The credibility and the quality of a nation's policies matter more for its prospects than anything the United States, the G7 or the international financial institutions can do.

4. Money is no substitute for strong policy, but there are times when it is more costly to provide too little money than to provide too much.

5. Borrowers must bear the consequences of the debts they incur — and creditors of the lending they provide.

6. The US must be willing to be defined by what it is against, as well as what it is for.

7. The dollar is too important to be used as an instrument of trade policy.

8. Optionality is good in itself.

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A small but important point – China’s current account surplus is growing in the face of the oil shock

by Brad Setser Tuesday, August 30, 2005

Emerging Asian economies – as many have pointed out – are more energy-intensive than the US economy.   One reason: the US outsourced energy-intensive manufacturing to Asia, increasing the energy intensity of Asian economies while reducing (in some sense) the energy intensity of the US economy.  Manufacturing heavy economies will tend to be more energy intensive than service-based economies.   But there is more to it than that as well – lots of Asian economies subsidize domestic gasoline and energy more generally, and thus encourage domestic consumption.    The net result: China's terribly energy efficiency.  See this Time article, among others.

No matter the cause, Asian economies are more exposed to the oil shock than most. 

So any effort to explain the resilience of the global economy in the face of the recent oil shock needs to explain the resilience of Asian economies.

Part of the answer is that Asian economies have opted to take the hit  on their budgets (with subsidies) or on the profits of their state oil companies (see China) to reduce the impact on consumers.   But Asian economies are not as dependent on domestic consumption as the US or even most European economies, so that cannot be entire answer.

Part of the answer is that the borrow and spend US consumer keeps borrowing and spending, supporting Asia's export engine.

But I think part of the answer is also that Asian economies – and indeed many oil importing emerging economies – went into the most recent oil shock with large current account surpluses.  

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Dollar crashes, interest rates fall?

by Brad Setser Friday, August 26, 2005

Alan Greenspan's legacy may hinge on whether that headline is written, or whether the headline reads: "Dollar crashes, interest rates surge."

From Reuters:

Although a dollar crash is unlikely anytime soon, a Federal Reserve study says any collapse in the value of the currency is unlikely to hurt the U.S.  Instead, many economists suggest an abrupt decline in the dollar's value would cause pandemonium in both U.S. economy. But few analysts agree. credit and equity markets.

To maintain foreign interest in U.S. financial markets and prevent large investment outflows, which would disrupt the economy, the central bank would begin raising short-term rates aggressively, analysts say.

But rising short-term rates alone would choke U.S. economic growth as American consumers would be inclined both to save more and borrow less. Since the United States buys goods from around the globe, analysts emphasize the spillover would be worldwide. …. 

The Fed though, is at odds with the thinking on the street, according to its recent report.

"Currency crashes do not generally lead to higher bond yields in industrial countries," the study said. "Indeed, over the past 20 years, currency crashes in industrial countries have always been followed by falling bond yields."

While Joseph Gagnon, assistant director of the Fed's Division of International Finance, notes in the study that currency crashes in the 1990s in Mexico and East Asia did push long-term rates up to debilitating levels, he added that rich countries appear better able to deal with the threat because of the inflation-fighting credibility of their central banks.

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Preparing for shifts in the balance of financial power?

by Brad Setser Friday, August 26, 2005

It seems like some in Asia are a bit worried that so much of the world's wealth is denominated in the currency of the world's largest debtor.  Cynic's Delight highlights their concerns well in a recent post.

"Chalongphob Sussangkarn, president of the Thailand Development Research Institute, a Bangkok based think-tank, said, "It is quite hard to understand why the world's largest debtor (the United States) is the one that controls the world's financial system. We (East Asia) always monitor what the US Federal Reserve says about interest rate movements. (East Asian) creditors should be the ones who determine the world's fate." 

Frankly, the United States' Asian creditors should be worried.  The Fed has made it clear that its preferred solution to the US trade deficit is a big dollar depreciation.  And the required depreciation could be large indeed.  See Rogoff and Obstfeld

Yu Yongding is always worth listening to as well – and while his voice is only one of many that matter in China, the fact that he think China already has too many reserves is significant.

During the seminar, Yu Yongding, president of the Institute of World Economics and Politics in China, said that even if the dollar does not devalue in a big way, East Asia still needs to think about how to deal with their already excessive foreign exchange reserves.

I don't always agree with Ronald McKinnon.  But there is a glimmer of truth in his argument about "conflicted virtue."  The fact that most of Chinese and Japanese savings held abroad are denominated in dollars rather than yuan or yen is not ideal from a Chinese or Japanese point of view.

Asian bankers dissing the dollar.  Unocal.  PetroKaz.   China clearly would rather make a long-term bet on oil than on the dollar, if it can.  After all, the US can print dollars, but there is only so much oil … 

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Oil and emerging economies: the struggle to adjust policies to $70 a barrel oil continues

by Brad Setser Friday, August 26, 2005

It looks like Iraq is not the only emerging economy that exports crude and imports (at huge cost now) refined diesel and gasoline that it then sells a low price.   Nigeria is in the same position.   Strange.   The national oil company of an oil exporter facing financial problems when oil is almost at $70.   I guess that is what happens if you import refined gasoline and sell it too cheaply.

Malaysia is far better managed than Nigeria, but it too has extensive (and costly) fuel subsidies.  

And China's state oil companies are fighting (bureaucratic) war with the rest of the Chinese state …   State cannot get on with Defense here in the US.   Treasury looks down on Commerce.  So forth and so on.  And it seems that the National Development and Reform Commission sets retail oil prices in China, while the State-owned Assets Supervision and Administration Commission actually owns Sinopec and PetroChina.    I guess they don't quite see eye-to-eye. ( Check out the Peking Duck ).  

Steve Roach highlight the results of China's energy policy – gas lines and an energy inefficient economy.   The US, alas, is not the only country that has failed to take the policy steps needed to reduce its vulnerability to (further) oil price shocks.

There seem to be three fundamental reasons why higher oil prices have not slowed global oil demand much:

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Who is the high-tech powerhouse?

by Brad Setser Thursday, August 25, 2005

Country A exports the following to B:

1. Paper and paper waste

2. Mixed metal scrap

3. Fabrics and raw cotton

4. Newspapers

5. Foam waste and scrap

6. Logs and lumber

7. Wood pulp

8. Plastics

9. Frozen fish

10. Other synthetic resins

Country B exports the following to A: 

1. Furniture

2. Toys

3. Footwear

4. Plastic products

5. Computers

6. Tools, screws, latches, etc.

7. Sporting goods

8. Cooking, ironing, heat appliances

9. Kitchenware

10. Electrical and electronic products 

Data from the Dallas Morning News.

I guess the accurate answer is neither.  One country seems to specialize in exporting natural resources and scrap, the other in exporting consumer goods.  And who knows, in the future, the US may be to China as Canada now is to the US – a country that produces and exports natural resources using lots of capital.

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Peter Galbraith and Iraq

by Brad Setser Thursday, August 25, 2005

I think the folks over at TPM CafĂ© are right: David Brooks' latest New York Times column is a real flip-flop.  He has gone from celebrating the United States firm commitment to universal democratic principles to celebrating the United States firm commitment to realistic compromise with the basic social and political realities of Iraq.   Gideon Rose hit the nail on the head — at least for now, the realists seem to be making Bush Administration policy, even if the President's rhetoric lags facts on the ground, or in this case, words on paper.  The basic policy shift was telegraphed by a senior official (Condi? Khalizad? someone else?) in Robin Wright's Washington Post article almost two weeks ago: the United States' grand initial vision was at odds with the United States' (more limited) capabilities.

That said, I don't think Peter Galbraith's position (Brooks quotes him extensively) is all that hard to understand.  He was in Iraq to advise the Kurdish leaders on the (still not agreed) constitution, and his basic bias is pro-Kurd and pro-separation.  Iraq is an artificial creation of Winston Churchill – and the US should not try to hold it together at all costs.

Galbraith's quotes in the Los Angeles Times make his position pretty clear.  He advised the Kurds to accept an Islamic Shi'ite south in return for a "regional" constitution.   Sounds like the first step towards independence to me.  If a region can write a constitution that overrides the national constitution, is it really a region?

Although Iraq's charter does not envision installing a "supreme leader" like Iran's Ayatollah Ali Khamenei, questions are already emerging about certain provisions. For example, what are the "undisputed rules" of Islam? What constitutes "contradicting?" Since alcohol is banned in the Koran, should Iraq become a dry nation? Are women required to cover their heads? Does a prison sentence for a thief contradict the Koran, which calls for amputation of the hand?

"The problem is that there are no agreements on these questions," said Peter W. Galbraith, a former U.S. ambassador to Croatia who advised Kurdish politicians on the constitution. "It allows any cleric to make his own interpretation of the law and opens the door to a whole range of abuses."

Galbraith said the draft fell well short of the sort of democratic government the Bush administration hoped to install in Iraq. "The U.S. now has to recognize that they overthrew Saddam Hussein to replace him with a pro-Iranian state," he said.

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Are we ignoring the United States’ strengths?

by Brad Setser Wednesday, August 24, 2005

Anantha Nageswaran of Libran Asset Management in Singapore has submitted a set of (lengthy) comments that respond, in some sense, to many of the points I and others have raised on this blog.   Check them out.

Dr Nageswaran argues that we here are a bit too pessimistic about the US.  Oil may act as an automatic stabilizer for the US economy - rising to cool excess demand, but falling if US demand falters.   A fall in housing-driven US consumption might lead to a fall in oil – and with housing bubbles in Europe too, it is not obvious that the dollar would lose out if there is a global housing correction.   Or – to insert the views of Dooley, Garber and  Folkerts-Landau – the US is simply too important an engine of demand for the United States' biggest creditors to ever pull the plus.  A strong dollar is so important to China that China will continue to prop the dollar, and US demand, up.  And if China wants to lend us the money needed to buy their goods and expand our housing stock, we should do it, even if it makes the US domestic economy look unbalanced to some. 

I have not commented extensively on the US current account deficit recently, largely because there has not been much new to say.    But this seems a good time to reiterate my base case for why we in the US – and everyone in the world too – should worry about the US trade and current account deficit.  That afterall is the basis of most of my concerns about the trajectory of the US economy.

The US current account deficit is now, to state the obvious, quite large.   It was around 6.5% of US GDP in the first half of 2005, and I expect it will head towards 7% by the end of the year and will come in at over $800 billion.  Lewis Alexander of Citibank forecasts a deficit of more than 7% of US GDP in 2006.

That is very large in relation to the United States' small – 10% of GDP — export base.  I think the United States' small export base and its leveraged economy, which makes the US vulnerable to a rise in interest rates, offsets the (very real) advantages of borrowing in your own currency, and having substantial foreign assets whose value rises if the dollar falls.  

Unlike in the 1980s, the US is now a significant net debtor.  US net external debt will likely hit 30% of US GDP by the end of the year.   In 2006, interest payments on the United States' external debt will start to add significantly to the current account deficit.   Looking ahead, rising interest payments on a rising external debt imply that the trade and transfers deficit of the US has to fall just to keep the current account deficit from rising.

Even if the trade and transfers deficit stabilizes at around 7% of US GDP, the US current account deficit will keep on rising as a result of rising (net) interest payments on the US debt.   A current account deficit of over 7.5% of GDP in 2007 and close to 8% of GDP in 2008 is quite possible even if the trade deficit (as a share of GDP) stabilizes at roughly year-end levels. 

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Is Alan Greenspan encouraging moral hazard in … China?

by Brad Setser Wednesday, August 24, 2005

Listen to one Chinese fund manager in this morning's Wall Street Journal

"Mr. Zhu (who helps manage US dollar investments for the Bank of China) expresses confidence in the US dollar and the health of the US home market.  Housing is so vital to the US economy, Mr. Zhu and some of his counterparts at other Chinese banks reason, that US authorities will prevent a bust."

Sounds like Chinese fund managers believe in the Greenspan (Hubbard? Lindsey? Bernanke?) put

Actually, Greeenspan's successor can lower short-term rates to try to put a floor under the US housing markets, but cannot do that and also put a floor under the dollar.   The Chinese are betting that the US won't let the housing market falter — and that China's central bank will prop up the dollar even more than it does now should US rates fall.

I certainly agree with the basic conclusion of the Wall Street Journal article.  Foreign demand for mortgage backed securities (MBS) has picked up recently, and some of that demand no doubt comes directly from central banks.  Still, foreigners hold a far smaller share of the total stock of MBS market (6%, according to the Journal, at the end of 2004) than of the Treasury market.  I wonder what share of the MBS market is held by US banks – and US hedge funds – plying the carry trade.  See Edward Chancellor's Wall Street Journal oped (another good piece on the oped page.  Add in Makin's piece from last week … are there subtle signs of improvement and openness to a broader set of opinions?).  Hedge funds are certainly big in credit derivatives; I am not sure about their role in the MBS market.   But with a shrinking two year to ten year spread in the Treasury market, making money off the carry trade may require taking a bit more risk.

I also suspect Mr. Zhu would be on to something.  If interest rates ever were really to rise, I would not be surprised if (some) homeowners – if one can call folks with big debt and little equity homeowners – started to demand, loudly, protection from higher rates.   And i suspect politicians here in the US would take notice.  Florida likes to flip condos — and it is a swing state.

Most cries of protection recently have come from sectors facing increased foreign competition, and therefore seeking protection from imports.  But those complaining about imports really are seeking protection from economic shocks – or just economic changes – that are adverse to their interest.  Over the past twenty-five years, as the trade deficit has expanded and imports have risen relative to US GDP, those sectors that compete with imports have been under consistent pressure.   But over the past twenty years or so, as interest rates have marched downward as part of the "great disinflation,"  interest-sensitive sectors have had a pretty nice run. 

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How to turn $120 million into $4,180 million in less than ten years

by Brad Setser Tuesday, August 23, 2005

PetroKazakhstan is not quite Unocal.  But it is nothing to sneer at either.  To no one's surprise, CNOOC's failed bid for Unocal did not end Chinese oil firms' interest in foreign acquisitions .   In a harbringer of the future, CNPC outbid India's state oil company for PetroKaz, and looks set to complete the largest foreign takeover ever by Chinese firm.

And to no one's surprise, Western firms (Ok, a Western lawyer in this case) are complaining that China is over bidding. 

In the oil industry, "China has consistently been willing to overpay for assets; it's more of a security issue for them than the absolute price," said John Kuzmik, a partner and China specialist at Baker Botts, a big Houston energy law firm.

I suspect Western oil firms will have to get used to Chinese over-bidding.   The equilibrium price of oil reserves just went up.  Particularly oil that can be piped into western China.  No risk of a US naval blockade. 

From the New York Times:

PetroKazakhstan has had a series of legal skirmishes with Lukoil of Russia, its main partner in the oil fields. Lukoil's main pipeline from Kazakhstan into Russia is already full, but C.N.P.C. is expected to finish at the end of this year a pipeline from Kazakhstan into western China.

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