Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Has the IMF been asleep at the wheel, and ignored surveillance of exchange rates?

by Brad Setser Thursday, September 29, 2005

Tim Adams – the new US Treasury Under Secretary – thinks so: 

IMF Article IV requires that the IMF exercise "firm surveillance" over the exchange rate policies of members. After the collapse of the Bretton Woods fixed exchange rate system, the IMF in 1977 developed surveillance guidelines that determine its approach to what is still called the "Article IV" process. Those guidelines included domestic policies, since domestic policies can impact a country's balance of payments position.

Over time, however, domestic policies have come to dominate Article IV reviews, and it is not uncommon to read an Article IV review with only a brief reference to a member's exchange rate policy and its consistency with both domestic policies and the international system. There is almost never discussion of whether an alternative regime could be more appropriate or how to transition to it.

Many large emerging-market countries would benefit from regimes that allow substantial exchange rate flexibility. Research, including by the IMF, has shown that for developing countries integrating into international capital markets, the requirements for sustaining pegged exchange rate regimes have become very demanding.

The IMF also has standing authority to initiate "special consultations" whenever one member's exchange rate policy is having an important impact on another member. However, in over a quarter century, the IMF has held special consultations exactly twice. This has placed increased pressure on bilateral mechanisms and actions to address instances of protracted currency misalignment.

We understand that tough exchange rate surveillance is politically difficult for the IMF. It is also true that a country has the right to determine its own exchange rate regime. Nevertheless, the perception that the IMF is asleep at the wheel on its most fundamental responsibility—exchange rate surveillance—is very unhealthy for the institution and the international monetary system.  (emphasis added)

I am not exactly a fan of the Bush Administration's economic policy, but on this, I agree with Tim Adams and the Treasury.  The IMF did not call out countries with overvalued exchange rates in the 1990s — in 2000 and 2001, with the support of the US, it even financed a country with an overvalued exchange rate.  And it has refused to call out countries that are engaging in massive, sustained intervention to maintain undervalued exchange rates now. 

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Sovereign bankruptcy

by Brad Setser Wednesday, September 28, 2005

Sovereign bankruptcy is hardly a hot topic right now.   Its fifteen minutes of fame are long gone.

But it briefly occupied the attention of top policy makers.  And some of you may be interested in my take on the politics of sovereign bankruptcy. 

I don't think it is much of a surprise that the IMF's proposal for a new sovereign bankruptcy regime (the so called SDRM) failed.  The difficulty successfully collecting on a lawsuit on a sovereign government provides the governments of countries that cannot pay their debts de facto protection from litigation while they develop their restructuring proposal even without a bankruptcy regime.  They lack formal protection from litigation, but litigation still is not much of a threat immediately after default.  And multi-instrument exchange offers have proved to be a practical way of restructuring most types of debt.  Muddling through using existing institutions for debt restructuring always offered a viable (if somewhat messy) alternative to a new international treaty …

And it was hard to ever envision the US agreeing to allow international law to supersede US contracts and US law without an overwhelming case that US contracts and US law could not be made to work. For the record, the relevant contracts are overwhelmingly governed by the law of New York state, as interpreted by the US courts.   To me the surprise was not that the IMF's proposal for international bankruptcy failed, but rather that the IMF ever was given political space to develop a serious proposal.  For that the world really can thank one man – Paul O'Neill. 

But O'Neill, as we now know, was not exactly well positioned to bring the rest of the Bush Administration with him.  For that matter, he never really seemed to bring the rest of the Treasury with him.    Support from a maverick US treasury secretary did not cut it.

That is a big part of the story.  It is not, though, the entire story. 

The IMF's proposal ran into a second problem.   Supporters of "sovereign bankruptcy" were drawn to different aspects of domestic bankruptcy law, and in practice, wanted very different things.  Some liked the aspects of bankruptcy law that provide debtors – particularly municipalities and individuals – with a "fresh start," a chance to clear away their debts and move on.  They believed that the absence of a formal bankruptcy regime for sovereigns tilted the playing field toward creditors.  Others liked aspects of bankruptcy law that allow creditors to assume operation control of the assets of a failed firm.  They believed the absence of a formal bankruptcy regime (or tighter contracts) titled the playing field against creditors.   Some liked the provisions in domestic bankruptcy that allow for "senior" new financing to help support the operation of firms going through a reorganization; they saw such senior private financing as an alternative to IMF financing.  And others (like the IMF) like those aspects of bankruptcy law that allowed creditors to take decisions on the debtor's restructuring proposal by a majority vote. 

Supporters of a new sovereign bankruptcy regime never really agreed on what kind of new sovereign bankruptcy regime was needed, or on what precisely a bankruptcy regime should aim to do. 

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Savings gluts, investment droughts and the current global economy

by Brad Setser Tuesday, September 27, 2005

Low yields in advanced economies lead capital (private capital that is) to head to emerging markets looking for yield.    Emerging markets – whether scared by the crisis that followed the sudden withdrawal of private financing last time around or scared of losing export competitiveness- stockpile the private capital inflows in their reserves.  And when those reserves flow back to industrial countries, they drive yields down even further, starting the cycle all over again. 

That is strange treadmill the world now seems to be on.

Private capital has come back to emerging markets in a big way.  More private funds flowed to emerging markets in 2005 than in 1997.  And this time around, private investors are willing (strike that, eager) to buy the local currency debt of emerging markets.  Yields on dollar denominated emerging market debt are now too low to be really interesting …

But those private flows are just driving record reserve accumulation by emerging economies.    And the record US current account deficits that are the counterpart to those rising reserves make the world look risky and unbalanced, and the more risky the world, the more emerging economies want to build up even bigger buffers (reserves) against any bad outcome.  Tis a strange world.  

Savings has been outsourced to the poorest countries.  And their central banks play a huge role in the global flow of funds.  They are the key intermediaries that turn private flows into the emerging world into demand for US debt.  They are thus central to the debate on the savings glut.

Chapter 2 of the IMF's World Economic Outlook – the IMF's most recent paper on global imbalances – puts Ben Bernanke on one end of the debate, and Roubini and Setser on the other.  Bernanke argues US fiscal policy has had essentially no impact on the US current account deficit and continued large current account deficits pose relatively few risks; Roubini and Setser argue US fiscal deficits play a significant role, and large current account deficits pose real risks.    Reserve accumulation figures in to both stories.  Bernanke notes it; Roubini and Setser argue that it is the prime reason why the low savings US has not experienced the usual downside of large, sustained fiscal deficits in low savings economies, namely higher interest rates. 

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Spain, the United States of Europe.

by Brad Setser Friday, September 23, 2005

Growth over the past ten years (all data from the IMF)

USA:  3.3 (05 estimate: 3.5); Spain: 3.7 (05 estimate: 3.2)

Current account deficit (percent of GDP) 


US: -1.7; Spain: -0.1

2005 (estimate)

US:  -6.1  (too low, by the way — -6.6 or -6.7 would be more realistic); Spain: -6.2 

Change:  US: -4.4 (-5.0 if you trust my numbers).  Spain: -6.1  

Growth in final domestic demand, 97-06 

USA: 3.7%; Spain: 4.0%

And for the sake of comparison –

France: 2.4%

Germany: 0.8% (and none since 2001) 

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Did anything really change with the RMB today?

by Brad Setser Friday, September 23, 2005

Widening the trading band around the dollar would be a big deal.

Widening the trading bands around other currencies does not strike me as a big deal.  It – in a sense – just makes it easier to stick with something that approximates a dollar peg when there are large moves in the euro/ $ or yen/ $.  From the FT:

Currency market strategists said that when the euro/dollar exchange rate moved by more than 1.8 per cent, the central bank was left with the option of allowing one of the two bands to be breached, or intervening in the euro/dollar cross rate. "It is theoretically difficult to manage your currency against two different currencies unless you are willing to intervene in those currencies trading against each other," said Derek Halpenny, senior currency economist at the Bank of Tokyo-Mitsubishi.

In that sense, widening the bands around currencies other than the dollar makes it easier to stay pegged closely to the dollar.  It is not necessarily a signal of a desire to allow greater "flexibility" in the renminbi/ dollar.

I tend to agree with Julian Jessop: 

"This may well have been timed to give the impression of greater flexibility ahead of the G7 meeting but in reality it is a red herring," said Julian Jessop, chief international economist at Capitol Economics.

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Where are the world’s reserves going?

by Brad Setser Thursday, September 22, 2005

In my post "has the US outsourced creative thinking about external adjustment to France," I noted that purchases of Treasuries by central banks have fallen off – even though global reserve accumulation has not fallen off.

Consider this graph, which compares the sum of the increase in reserves over the past four quarters with central bank purchases of Treasuries over the same time frame.   Central bank demand for Treasuries – according to this measure – peaked last fall.


The quarterly data tells a similar story.  Quarterly reserve growth has been strong since q4 2004 even without any intervention from the Bank of Japan.  But demand for Treasuries has fallen off.    I estimated central bank demand in q2 using the data that the Treasury releases; the actual data in the BEA may be a bit different – and I estimated global reserve accumulation in q2 using the IMF data through May, and the data various central banks have released.

So what is going on?  Part of the answer is that Japan is no longer adding to its reserves.   Other countries – China, Malaysia, India,  Russia and the other oil exporters – are still adding to the reserves rapidly.    That is keeping the increase in global reserves at around $600 billion a year, maybe a bit higher.


But the countries now adding to their reserves don't invest in Treasuries in the way that Japan did – or at least don't invest in Treasuries in ways that show up in the US data.

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Rita over at Calculated Risk

by Brad Setser Wednesday, September 21, 2005

No one needs to go to a blog to find out that Rita is now a category five storm, and its path may take it toward a decent share of the US energy infrastructure.  As soon a hurricane hits the warm waters of the Gulf, it strengthens.  Go figure.

I suspect a decent fraction of readers of this blog also read Calculated Risk, and know his graphics skills far exceed mine.  He has an impressive feed showing the latest infrared satellite photos of Rita here.

Is the IMF heading toward irrelevance because of a revival in private capital flows?

by Brad Setser Tuesday, September 20, 2005

My answer is no.

If the IMF is irrelevant (I don't think it is), it is not because private capital inflows to emerging markets have rebounded to pre-crisis (i.e. 1996/97) levels.  It is because emerging markets hold far more reserves now than they did then.

But let's get one thing straight.  Private capital inflows to developing countries right now are not financing "development" in emerging economies, at least not if "financing development" means "making up for a shortage of savings in emerging economies" or "allowing investment in excess of savings in emerging economies."  Right now, private capital inflows to emerging markets lead to higher reserves, and end up supporting the US Treasury market, the US agencies market, the mortgage-backed securities market, the German bund market and the UK gilt market.

The argument that private capital is once again financing "development" will be bandied about a lot this weekend.  It already showed up in a recent Bloomberg article, which argued: "Private capital markets are increasingly supplanting it [IMF] as the main source of credit for developing nations"

Of course, the IMF was never the main source of credit for developing nations.  Its role was (and is) to step in when private investors – both foreigners and a country's own residents — suddenly decide they want to get out.   The IMF is not a substitute for private capital flows; it is a substitute for holding more reserves to cover sudden interruptions in private capital flows.   But let's set aside that point, and all the complexities associated with determining when the IMF should lend when private investors will not, and when it should not. 

Instead, I want to focus on the argument that private capital flows from investors in advanced (or industrial) economies have become a huge source of financing for development irritates me a bit.  Is it true?  I would say not really, at least not anymore.   Private investors were an important source of development financing back in 1996 or even 1997.  But not in 2005, even though private capital flows to emerging economies have revived.  At least not in aggregate. 

Why not?  Simple.  Almost all emerging economies now (Eastern Europe and Turkey are the exceptions) run current account surpluses, and thus save more than they invest.   They don't need foreign savings to finance their current levels of investment.  They would be adding to their reserves – i.e. financing the US and Europe – even without private capital inflows.  Don't get me wrong.  Private capital flows still bring important benefits.  Emerging economies clearly like the technology transfer and know-how that comes with FDI.  And offsetting flows from emerging economies to advanced economies and from advanced economies to emerging economies allow savers in both sets of countries to diversify their portfolios even if there are no net flows.

But most emerging economies don't need US and European savings to finance their current levels of investment.  At this point in time, more capital inflows to the emerging world simply means more reserves, and thus more support for the bond markets of industrial countries.  Think of China. 

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China’s reserves increased by $29b in July.

by Brad Setser Tuesday, September 20, 2005

They rose from $711 b at the end of June to around $740b at the end of July. if all $29b flowed into the US, it would be enough to finance about 1/2 of the July trade deficit

And since the euro/ dollar was basically flat in July (end June = 1.2098, end July = 1.2129), the rising dollar value of China's euro reserves cannot be the main explanation for the increase.

China's trade surplus is around $10b a month, and it typically is getting about $4.5-5 billion in net FDI inflows.  So a $29 billion increase in July implies large – almost $15 billion – in hot money in flows.  That answers some of my questions about the impact of the revaluation. 

Memo for the Cleveland Fed: your analysis of China's capital account needs to consider inflows and capital controls that currently limit inflows as well as potential outflows and controls that limit outflows.  Right now, the inflow controls are being tested far more than the outflow controls.  The controls on inflows leak, but they still have an impact.  They make it harder to bet on RMB appreciation.

The August reserve total will be interesting.  It will include some valuation gains – the euro ended August at 1.233.  And it will include any post-revaluation not money flows.  Unless something changed in August, the increase could be very large indeed.
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What did central banks do with their reserves in 2003 and 2004?

by Brad Setser Tuesday, September 20, 2005

The only honest answer is that we really don't know.

The IMF released its revised estimates for the currency composition of the world's reserves at the end of 2003 and 2004.  The most important change?  The IMF clearly indicated that it simply has no data on a large (and growing) fraction of the world's reserves.  Some central banks, including many key central banks in "emerging Asia" do not report the currency composition of their reserves to the IMF.

The IMF lacked data on $705 billion of foreign exchange reserves at the end of 2002 (roughly 27% of total foreign exchange reserves), and $1265 billion at the end of 2004 (roughly 34% of total reserves).   Assume a big enough change in the currency composition of those reserves, and pretty much any flow number is plausible. 

The BIS estimate for the currency composition of new reserves added in 2003, an estimate that showed a very large share of dollar purchases (about 90% of the underlying – that is adjusted for valuation gains/ losses – was doing into dollars) looks to be a simple extrapolation of what the central banks who reported information to the IMF were doing.  But one of the reporting banks is Japan, and there is no guarantee that the central banks who did not report were doing anything similar.   

The same is true of 2004.  Though the combination of the US data and the BIS data on the growth of offshore bank accounts suggest a pretty high fraction of the global increase in reserves went into dollars.  The BIS recently estimated a $498b (call it $500b) increase in dollar reserves in 2005.  If that estimate is right, that works out to about 78% of the overall global increase (leaving out valuation gains).  The percent of all new reserves going into dollars in the (less complete) IMF data?  Also 78%.

Some numbers:


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