Brad Setser

Brad Setser: Follow the Money

In an attempt to be fair and balanced

by Brad Setser Monday, October 31, 2005

Here is a link to a paper by two IMF economists (Aizenmann and Lee) that concludes China really is building up its reserves as a precaution against a crisis, not just to support its export sector (impeding global adjustment in the process).

Personally, I think the choice of variables dictated the study's results, and I don't particularly like the choice of variables.  China has an unusually high broad money to GDP ratio, so its reserves to broad money ratio is not all that high, even though its reserves to GDP ratio is very high for a major continental-sized economy.   And since China trades a lot for a continental economy, it imports are a lot for a large economy that too keep keeps China from being an outlier.   The model basically assumes that since Chinese imports/ GDP is about two times those of a country like the US (for the record, Chinese exports/ GDP are about four times that of the US, 40% v 10%) it should have more reserves than the US.   Since small city states like Singapore and Hong Kong trade a lot and have high levels of reserves, the source of the more trade/ more reserves correlation is not hard to find.
Consequently, by looking at imports/ GDP and M2 (broad money) to reserves, the author's happened to pick the variables most likely to show that China really is just accumulating reserves for precautionary reasons.

However, I am not convinced that trade flows are the best way of measuring reserve adequacy; I prefer short-term debt to reserves.  For dollarized economies with open capital accounts, i would add in a measure that includes the potential outflow of domestic dollar deposits — but this is not an issue for China, which has a closed capital account and very few domestic dollar deposits. 

China's huge M2 to GDP ratio reflects financial underdevelopment (all savings in the financial system take the form of bank deposits, and thus count as money; securities markets are underdeveloped) reinforced by extensive capital controls.  Yet those same capital controls reduce China's external vulnerabilities – Chinese depositors with RMB cannot convert their savings into dollars, or euros.  So I am also not convinced M2/ reserves is the right measure for China — it is low because both M2 to GDP and reserves to GDP are unusually high.

If you look at a variable that is left out of the Aizenmann and Lee study —  reserves to short-term debt, China clearly has far more reserves than it needs.   Hell, China has far more reserves than it has external debt, let alone short-term external debt.   Consider this graph, which shows China's reserves to short-term external debt at the end of 2004 v. the reserves to short-term debt of selected Asian economies at the end of 1996.  A number below one is a sign of danger.  But, setting aside heavily dollarized economies, I am not sure that you need more than 2 times as many reserves as short-term external debt (for wonks, on a residual maturity basis) either.

The World Bank put more emphasis on reserves to short-term debt in their assessment, and came to a rather different conclusion in their spring report on Global Development Finance.  Indeed, the World Bank, to be honest, seems a bit ahead of the IMF on this issue.  I should emphasize though that the output of a couple of economists in the research department does not reflect the collective judgment of the IMF.  But I have not seen a clear statement from the IMF that China now has more reserves than it needs either.

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Yet more on Bernanke and the savings glut

by Brad Setser Friday, October 28, 2005

Brad DeLong seems to have dug up what Dr. Bernanke thought about fiscal deficits before he discovered the global savings glut …  namely, structural fiscal deficits tend to raise real interest rates. 

Suppose the government increases spending without raising taxes, thereby increasing its budget deficit…. An increase in the government budget deficit… reduces public saving… [and] will reduce national saving as well…. At the new equilibrium F', the real interest rate is higher at r', and both national saving and investment are lower… the government has dipped further into the pool of private savings to borrow the funds to finance its budget deficit… investors [must] compete for a smaller quantity of available saving, driving up the real interest rate… mak[ing] investment less attractive, assuring that investment will decrease along with national saving.

In his savings glut speech, Bernanke makes a slightly different argument.  The US fiscal deficit is all that stands between the US and even lower real interest rates and even more investment in housing.  Actually, the US fiscal deficit and the US consumer's willingness to spend is all that stands between an even larger savings glut (equivalently, a global shortage of consumption and investment) and even lower real interest rates around the world.

The key quote (emphasis added): 

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.

Note the variable that Bernanke left out – namely the increase in the US fiscal deficit.

Bernanke's thesis (taken to its extreme) suggests that the US is doing the world a favor by spending so much and being so willing to borrow their funds; that implication – and the implication that US policies bear no responsibility for the rising US current account deficit – certainly bothers me.   I don't think today's US current account deficit is the simple response to a shortage of spending abroad, and would be the same irregardless of US fiscal policy choices.  Nor does borrowing abroad to finance fiscal deficits, high levels of consumption and investment in residential real estate obviously create the future export revenues needed to pay the interest on the United States' rising external debt.

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A new Chinese oil strategy? Buy into BP and other oil majors

by Brad Setser Friday, October 28, 2005

I think this is potentially very good news.   It is not quite Tom Barnett's scenario – that would imply BP and Exxon buying up Chinese oil firms or building infrastructure to supply the Chinese markets so that they profit (or profit even more) from rising Chinese demand for oil.  That is not really happening.  China can finance its own oil infrastructure, thank you very much.  It also would like to finance the development of the new oil fields needed to meet growing Chinese demand.  But that is proving a bit difficult.  China has plenty of cash, but much of the oil that is left seems to reserved for the national oil companies of the producing country.  Other assets are owned by Western oil companies who got in early and who are not inclined to sell their cash cows right now.

So Chinese firms buying into western oil firms (and buying into their overseas reserves) – or just swapping assets — is a rather constructive way for China to address its concerns about energy security.  Better than cozying up to Iran.  Or Richard Clark's scenario.

Who would sit on today’s “committee to save the world”

by Brad Setser Friday, October 28, 2005

That is one of many interesting issues raised by Times selectman Floyd Norris today.

As Norris notes, Alan Greenspan never had half the power people thought he had.  All he does is set short-term (credit) risk free US rates.   The markets set most other rates. And increasingly, policy decisions elsewhere shape some of those key rates (ten year Treasuries, anyone).

More importantly, the US is not the financial power it once was.  That reality likely implies, should something happen, that the composition of the Committee to Save the World (that was the name Time magazine gave to Greenspan, Rubin and Summers after the 97 Asian crisis and the 98 LTCM/ Russia/ Brazil crisis) would need to change.

"Mr. Greenspan's power and prestige probably peaked in the late 1990's.   That was symbolized by the 1999 Time magazine cover that proclaimed the "Committee to Save the World" with him as chairman, and Treasury Secretary Robert E. Rubin and his deputy, Lawrence H. Summers, as lesser members.   Now the financial power of the United States, and thus of the Fed, is reduced, a trend that Mr. Bernanke has been a leader in analyzing.  Given who owns dollars, if a similar committee were needed now, it would not be an all-American one, and probably would have to include someone from China."

The US has become dependent on an interest rate subsidy from our external (official) creditors.  That gives them a seat at the table.   A sudden withdrawal of the subsidy would be rather disruptive.  If oil prices stay high, the Russians and Saudis probably get a seat at the table as well.   Talk about change.

The composition of the Committee particularly needs to change if in some sense it is the US – not the world – that needs to be saved.  The US obviously has an enormous impact on the rest of the world, so the US cannot be separated out from the rest of the world.  But capital (on a net basis) pretty much flows one way right now: from the rest of the world to the US.  That is big change from 97-98, which was all about managing the consequences of a big drop in private flows to the emerging world; the next crisis is likely to be a bit different.  See Roach, who, after flirting with being a bond bull, is back to his bearish current account obsessed self.

Another point, one also highlighted by Paul Krugman.  

The Federal Reserve Board is not the only economic policy making institution that matters: 

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Why does Saudi Arabia peg to the dollar?

by Brad Setser Thursday, October 27, 2005

Subtitle: China's currency regime is not the only impediment to global adjustment.

Consider these two graphs (follow the links):

Oil, in dollars

And the export revenues of Gulf oil exporters, in dollars.

Canada also exports a lot of energy.  Lots of autos too.  The "unfair" competitive advantage created by national heath care has made Ontario the new Michigan.  But Canada's currency still tends to move in line with commodity prices – see this graph.  If I had a bit more time and technical skill, I would invert so it could be more easily compared with the oil price graph.  But you will have to use your imagination.  Trust me: it now takes more US dollars to buy both a barrel of oil and a Canadian dollar.

That is how the world should be.  The currencies of commodity countries should rise as commodity prices rise.  Now look at the Saudi currency v. the dollar.  It is basically flat (check the scale).  Saudi Arabia pegs to the dollar at a rate of 3.75 riyal to the dollar. 

Stephen Jen is certainly right to note that rising oil prices have shifted the world's current account surplus to the Middle East and Russia.   Saudi Arabia and Russia are likely to each run current account surpluses of around $100 billion this year – not that much less than China.

And relative to GDP, there is no doubt that the world's biggest current account surpluses are now found in the world's oil exporters.  Japan's surplus is actually shrinking.  The same is true of most of non-China Asia.  India and Thailand are looking at current account deficits.    According to the IMF, the surplus of Russia and the Middle East will surpass the combined surpluses of the Asian NICs (Korea, Taiwan, Hong Kong, Singapore) and emerging Asia (China plus).

And Saudi Arabia is not alone.  Many other oil exporters also either peg to the dollar or intervene heavily to resist currency appreciation.  Those pegs, like China's peg, are impediment to global adjustment.  In real terms, the currencies of many oil exporters has followed the dollar down since 2002 – the dollar has rallied this year, but its rally still pales relative to its overall slump v. the euro.  That depreciation – at least of their broad nominal exchange rate — has come even as oil revenues are way, way up.

I have long argued that it does not make sense for China, a country with a large current account surplus, to peg its currency to currency to the dollar, the currency of a country with a large current account deficit.  That same logic holds for Saudi Arabia.

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Some thoughts on the Bill Gross blog

by Brad Setser Thursday, October 27, 2005

Fitzgerald now has an office above the TREASURY Starbucks?!? 

UPDATE: Guess not.  Fitzgerald is still across the street from the Treasury Starbucks.

And Bill Gross is hip.  He is a BLOGGER.

He does not confine his blog to the bond market either; his transformation from moderate Republican to Deaniac is sort of interesting.   The money (political) quote:

"The war, Katrina, gas prices, and Republicans' continuing focus on tax cuts as the elixir to cure everything are getting ordinary citizens downright depressed."

His bigger point though is that a more leveraged US economy is now more exposed to interest rate rises (seems right to me).  The 230 bp rise in the five year Treasury note over the past few years will slow the economy significantly in 2006 (he forecasts 2% growth), leading the Fed to cut rates. 

No doubt that implies additional pressure on the dollar – pressure that will test Asian central banks' willingness to step up their reserve purchases (and in China's case step up from already high levels) to keep their currencies from rising against the dollar (see my previous post).

One should assume that Gross, like other portfolio managers, talks his book.  Still it is interesting that he is squarely in the low interest rate school of adjustment – which I think means he thinks Asian central banks will step up their intervention should the dollar come under new pressure/ not demand compensation for the risk of further dollar depreciation, allowing US rates to remain low even though the US remains dependent on inflows from abroad.   In some sense, that is the core debate.  Pretty much everyone thinks the dollar has to fall at some point (when is more of a question), but the implications of a falling dollar for the fixed income market are very much up in the air … 

But if Gross is right, and:

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What to say when the markets are listening to Stephen Jen?

by Brad Setser Wednesday, October 26, 2005

The Economist's Buttonwood struggles with something I have also struggled with:

Stephen "Interest rate and growth differentials, not current account deficits" Jen has basically been right on the dollar this year; Buttonwood, Buffet, Volcker, Rogoff and Obstfeld, Roubini and Setser and other dollar bears not so much.

Or, to quote, another dollar bear — Donald Tsang, Hong Kong's current Chief Executive link: "What's happened to gravity?"

Roubini and I did not necessarily think the dollar would fall below 1.35 against the euro, but we certainly predicted that the dollar would fall against other currencies.   There has been some convergence between the euro and other currencies, but it largely has come because the dollar has risen against the euro this year, not because the dollar has fallen against other currencies.  That is not what we predicted – though I think (and now hope) we were always clear that we saw more risks in 2006 than in 2005.

Just to be clear: the dollar has fallen a bit against the Korean won (if you include the tail end of 2004) and Brazilian real; the dollar/ euro and dollar/ yen are not the only currency pairs that matter.  But generally speaking, the dollar has risen against the other g3 currency pairs and remained broadly stable or fallen ever so slightly against key emerging economy currencies — so on net, the dollar is getting a bit stronger.

Incidentally, it is a good thing Mr. Jen thinks current account deficits do not matter, because he sure cannot do a current account forecast.   The US current account deficit in the first half of the year was around $395 billion, so I am not quite sure how Jen predicts a $760 billion deficit for the entire year.  There is no sign the current account deficit is shrinking.  Remember, the US oil import bill is likely to be way, way up in September, October and November.  Imports are making up for lost production in the Gulf.  For a tiny fraction of what Mr. Jen earns I would be happy to check his current account forecasts against the recent data … .

But that is sour grapes – Jen predicted a dollar rally back when the market was expecting the dollar to fall further, and he was right.  

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Earthquake Aid to Pakistan

by Brad Setser Wednesday, October 26, 2005

Seems missing, at least by recent standards.   Both private giving and government help from the US and Europe seem far smaller than the outpouring of generosity that followed the tsunami – look at the chart on p. A 17 of the Wall Street Journal, or this Reuters article.   That seems like a mistake to me, or at least an opportunity missed.

Obviously, the US is struggling with the consequences of a warmer Gulf of Mexico and the shift in the US population toward hurricane zones.   I am still waiting for a fully developed federal "plan" for rebuilding, and I am sure New Orleans is too.   Financing reconstruction with a diminished tax base ain't gonna be easy.

But donor and disaster fatigue are not a great excuse; Pakistan is not exactly a strategically insignificant country in the war v. terrorism.  The Wall Street Journal:

"A thinly stretched international aid machine is sputtering in a politically volatile region.  The aid crunch is unfolding in an area populated with Muslim militants who once received tacit support from the Pakistani government  …. Some analysts say a humanitarian crisis could further inflame sentiment against Western countries that are viewed as coming up short on compassion and cash."

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The Joint Economic Committee

by Brad Setser Tuesday, October 25, 2005

Last Thursday, I had the opportunity to testify before the Joint Economic Committee on the US current account deficit, as part of the panel that followed Dr. Bernanke's testimony.

I strongly suspect that I will never testify in the same hearing as Bernanke again.  If you have not heard, he just got a big promotion.

I am sure you all will be shocked to discover that I do not think trade deficits of the current magnitude are sustainable, and that the United States' need for perhaps $900 billion net capital inflows is a risk to next year's economic outlook.   I am pretty sure that I did not say anything that would surprise regular readers of this blog – or, for that matter, anything that Mr. Geithner did not say better last Wednesday. 

Among other things, I did update my "what happens to the US net external debt" in a gradual adjustment scenario graphs for my testimony.  It turns out that if the US trade deficit starts to fall by about 0.4-0.5% of US GDP in 2006, the US external debt would stabilize at around 60% of US GDP.  Actually, it would be a bit lower, since that kind of fall in the trade deficit likely implies a fall in the dollar, and thus a rise in the value of US assets abroad.   My simple graphs did not take into account valuation gains. 

The scenario where the US trade deficit gradually falls to zero requires something like 9-10% export growth and 5% import growth over the next ten years.  It is in many ways an optimistic scenario, one where the deficit comes down gradually without any sharp interruptions in financial flows.  It now seems likely that the adjustment won't start in 2006, which implies either that the US net external debt stabilizes at a higher level or a sharper and more painful adjustment path.

One small point about these scenarios.   In the future, it is likely that net interest payments will make up a larger and larger share of the US current account deficit.  Debtors, after all, generally do have to pay interest on their debts.   The US net external debt is the difference between gross US external debts (and foreign investment in the US) and gross US assets (including US investment abroad).  Consequently, assumptions about the future rate of return (from interest and dividends) that foreigners will receive on their investments in the US and the rate of return that the US will receive on investments abroad can have a big impact on these forecasts. 

Back in 2004, Nouriel and I assumed that the overall interest rate that the US had to pay on its external liabilities would likely converge with the overall interest rate that the US earned on its external assets.  Bill Cline has argued that this assumption is too pessimistic (See Chapter 3 of his book).  That doesn't bother me much – I would worry If was not somewhat more pessimistic than Bill Cline.   The real news here is that even an optimist like Cline thinks the US is on an unsustainable path.

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No one forced China to import US monetary policy: Commentary on yesterday’s China commentary

by Brad Setser Monday, October 24, 2005

Andrew Browne did something somewhat unusual in Monday's Wall Street Journal (see p. A2 of the print edition, unfortunately, I have not been able to find the link). He wrote about China, and got the key facts right.  

As he noted, China's demand for imports collapsed in 2005, largely because of the "2004 government crackdown on investment."  And as a result, China  provided far less impetus to the world economy.   China's impact on commodity exporters – so far the big winners, along with the US government (cheap financing) from China's boom – is less positive than it was in 2003 and 2004.  Continues.

There is a reason why Brazil – which unilaterally opened its market to Chinese goods in the hopes of reaping a big investment windfall – is now feeling a bit disillusioned.  Chinese goods are competing with Brazilian goods, and the huge investment boom Brazil anticipated has yet to materialize.  Brazil now seems likely to pull back a bit, and impose a few more restrictions on Chinese imports.  I guess higher iron ore exports don't fully compensate for job losses elsewhere.

Browne is right on another point as well: there are some signs that Chinese demand is bouncing back.   That could help to limit the building global concern about China's impact on the world economy.  If Brazil is having second thoughts, lots of others are too …

And guess what happens when you invest over 50% of your GDP?  Capacity increases fast.  This is incredible: "UBS estimates that China will add about 80 million tons of steel capacity this year as a result of frenzied overinvestment.  That is 1 ½ times South Korea's overall capacity and three quarters of US capacity."  Amazing.

That brings me to Bill Pesek, who blames Greenspan for China's investment boom:

One of the more obvious manifestations can be found in China. In 2003, Andy Xie, Morgan Stanley's chief Asia-Pacific economist, noted that speculative capital flows into Asia had reached a record high, surpassing the previous peak in 1996, just before the Asian crisis. In 1996, the big recipients of capital were South Korea, Hong Kong and Southeast Asia. In 2003 it was China, and it still is. Like the capital destinations of the 1990s, China experienced an investment bubble.

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