Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

It is hard to bet on curve flattening when the curve is already flat

by Brad Setser Monday, January 30, 2006

Or spread compression when spreads have already compressed.

As David Altig kindly noted, I was quoted in Clint Riley's Wall Street Journal story about the impact of a flat yield curve on bank earnings:

There is a very flat yield curve globally for different reasons, even in some emerging markets," said Brad Setser, head of global research for the Roubini Global Economics Monitor, a New York-based economics Web site. "I really don't see where the easy money is. No matter how sophisticated you are, you can't get away from the basics of banking: Borrow short, lend long."

Why no easy money?   Here is what I see:

A flat yield curve in many advanced economies.  There is no money to be made borrowing short and lending to the US government, for example.   The globally flat yield curve probably has a thing or two to do with oil – with oil at $65, the big oil exporters could earn something like $830 billion on their oil exports this year (assuming OPEC and Russia produce about 45 mbd of crude and similar product, and consume maybe 10 mbd, leaving 35 mbd in net exports).  And a lot of that money is being saved, not spent. 

Thin credit spreads.  Last year, William Pesek spoke of Kate Moss thin credit spreads.  That hasn't changed much.    Low spreads mean that the banks cannot make much money by taking on additional credit risk – and are exposed to losses should credit spreads widen (if they mark to market).

A flat yield curve in many emerging economies.   There is no money to be made taking in short-term deposits in say Brazilian real and then buying longer-term real denominated bonds.    Yes, you can make money if long-term real rates fall.  But it not so easy to make that bet when the Brazilian yield curve has inverted, and you lose money waiting for long-term spreads to fall.  Brazil's over night rate is 17.25%, one-year Brazilian bonds yield 16.1%.

Where is there money to be made?   Well, by taking on a bit of currency risk.

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Another great irony of history: The Chinese Communist party is a very profitable real estate company

by Brad Setser Saturday, January 28, 2006

Max Sawicky noted that key source of recent job creation in the capitalist United States has been the US government, which itself is financed, in no small part by the People's Bank of China.  The ex-KGB guy running Russia chips a bit too, as do the traditional monarchies in the Gulf …   

That prompted prominent press critic Brad DeLong to add:

One of the great ironies of economic policy is that the historical role of the Vietnamese Communist Party has turned out to be that of a union-busting gang labor boss for Nike and other first-world manufacturing corporations

Let me add another: the Chinese Communist party may have the most valuable real estate franchise in the capitalist world.

The revolution ended private land ownership in China. So if you want to develop a bit of real estate outside Shanghai, you negotiate with the party.  Not with the peasants who work the land, often under a long-term lease.  And in a country with lots of people, not so much land, rapidly expanding cities, and banks flush with deposits that they would love to lend out, the right to turn rice paddies into apartments and factories can be rather valuable.

Joseph Kahn of the New York Times:

Peasants are not allowed to own the land that they farm and have little say if the government decides to sell it for commercial development. Compensation is assessed according to complex formulas but rarely approaches the market value of the land, leaving many feeling disenfranchised by the development around them.

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Imports surge, GDP and exports don’t …

by Brad Setser Friday, January 27, 2006

The market thinks that the (bad) q4 GDP number is old news; the economy is looking far better in q1.   The market is also banking on stronger export growth to help support US growth in 2006.  See Justin Lahart.   I hope they are not banking on a mirage.

There isn't much in the q4 data that supports the argument that US export growth is accelerating.   The quarterly data is actually more consistent with a pick up in US imports, and a slowdown in US exports.

Exports were up 7.5% in q1, 10.7% in q2, 2.5% in q3 and 2.4% in q4.   Imports were up 7.4% in q1, fell 0.3% in q2, rose 2.4% in q3 and rose another 9.1% in q4.

Neither the fall in import growth in q2 nor the rise in q4 matches up with consumption growth – personal consumption grew by 3.5% in q1, 3.4% in q2, 4.1% in q3 and 1.1% in q4.  All numbers are q/q.   And they all can be visualized more easily if you take a look at the decomposition of GDP growth that Dr. Hamilton of Econbrowser has put together.

What happened – well, there was an electronics inventory correction earlier in the year, which seems to be over.  Note that sales of computers added 0.3% to q4 GDP, twice as much as in q3.  And in q3, there was a surge in auto sales as US producers cleared inventory.   Auto production added 0.55% to US GDP in q3, and subtracted 0.6% in q4.  Is what's good for GM is still good for America?   

The US economy is still not quite driven exclusively by New York banks serving as prime brokers for hedge funds and California and Nevada real estate …

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But what is in the other 50% of China’s basket? Hong Kong dollar?

by Brad Setser Friday, January 27, 2006

China's central bank governor Zhou said the dollar accounts for 50% of China's currency basket.  From Market News International:

The weighting of the US dollar in the currency basket which China uses as a reference for the value of the yuan is less than 50 pct, state  media reported. The US dollar accounts for "much less than 50 pct" of  the currency basket, Zhou Xiaochuan, central bank governor, was quoted as saying.

Yeah, right.  So how come market estimates last fall put the dollar's share of the basket far, far higher — as high as 98%?  See Sun-Bin.

This ranks up their with the assistant Governor's statement that the market sets China's exchange rate (see my previous post)

I haven't seen estimates of basket weights based on what has happened since the dollar started to fall a bit against a range of currencies.  But when the dollar was rising during the fourth quarter, a basket peg — particularly one with only 50% dollars – would have implied letting the RMB fall against the dollar to limit its appreciation against the euro and the yen.   That didn't happen.

Last fall, China decided not to irritate Mr. Grassley and others in the US congress by letting the basket's operation undo the the tiny July revaluation.   That means China either changes the basket weights rather frequently to suit its purposes, or it still pegs to the dollar …  or a mix of US and Hong Kong dollars …

The intent is good …

by Brad Setser Thursday, January 26, 2006

The Governor of the China's Central Bank said pretty much all the right things at Davos – at least from my point of view.    China does need to base its growth far more on domestic consumption.  And it is not in China's interest to continue to add $200 b (a bit more actually, once you factor in funds transferred to ICBC, the currency swap and valuation effects) to its reserves every year from now until eternity.  Chris Giles of the FT:

China is committed to slower foreign exchange reserve accumulation, Zhou Xiaochuan, the governor of the People's Bank of China told the World Economic Forum, in rare comments about China's exchange rate policy.

 Mr Zhou said that his country was committed to increasing domestic demand, rebalancing the economy gradually away from net exports, promoting consumption, particularly in rural areas, all of which would reduce the pressure on the country to keep increasing the rate of reserve accumulation at an annual rate of $200bn a year.

He said: "We need to make a change to stabilise the [foreign exchange reserve] situation".

"China has no intention of faster acceleration of foreign exchange reserves," he said, adding that he believed "the pace of foreign exchange reserves will be reduced".

But he damped hopes that China was on the verge of another, more substantial, currency revaluation. Speaking to Reuters, he said: "our foreign exchange policy is already in a good position".

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Chart envy. China’s goods exports v. US goods exports

by Brad Setser Wednesday, January 25, 2006

Every now and again, I run a across a chart that is so good that I really, really wish I had thought to do it myself.

James Pressler of Northern Trust's chart comparing Chinese goods exports v. US goods exports is one such chart.  Check it out.  It is on page 3, and is nicely paired with a graph showing China's reserve growth.   I cannot think of any simple chart that captures so many key trends in the global economy quite as well –

What does this chart tell us?

1.  Exports – trade really — have been a big source of China's recent economic dynamism the Chinese economy.   True, China both import and exports a lot, so if you disaggregate China's growth, net exports matters less than the surge in domestic investment.   But that doesn't change the fact that the investment required to expand China's exports (and imports) at this pace has been a big driver of overall growth.

2.  Dollar depreciation has been really, really good for China.  There are lots of reasons why Chinese exports took off in 2002.    The WTO.   The shift in electronics manufacturing to China.   And the weak RMB.   If look at disaggregated export growth data since 2002 the impact of the weak RMB shows up very cleanly.   Chinese exports to Europe have grown faster than Chinese exports to the US (in dollar terms).  Wanna guess why?

3. Don't look to the past to predict the future.  China has changed.  One example: Jonathan Anderson of UBS found that the electronics slump of 2001 had a far bigger impact on the rest of Asia than on China (Goldstein summarizes Anderson here).  True.  But that was before electronics production shifted to China.   A similar slump now will likely have a different impact.   China exports three times as much stuff as it did as recently as 2001.   China's exposure to the global economic cycle must be growing.

4.  China will soon top the US (and then Germany) as the largest goods exporter in the world.

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Robert Rubin still worries about the risk of a hard landing …

by Brad Setser Tuesday, January 24, 2006

From Rubin's Wall Street Journal oped:

The effects of these fiscal conditions are exacerbated because they occur, uniquely in the U.S. amongst the developed nations, in combination with a very low personal savings rates, high levels of personal debt and enormous current account deficits (currently in excess of 6% of GDP, and caused at least in part by our fiscal deficits).

….  And the far greater danger is that these various imbalances could at some point lead to fear of fiscal disarray and concern about our currency, causing sharply higher interest rates in our bond markets and the risk of a sharp exchange-rate decline. ….  The adverse impact on interest and currency rates has not yet occurred, partly because business has had relatively low levels of demand for capital — but most importantly because of vast capital inflows from abroad (until recently, predominantly from central banks supporting the dollar to subsidize their exports). This is not indefinitely sustainable; at some point, which could be near in time or still some years out, continued imbalances, increasing fiscal debt levels and ever-greater overweighting of dollar holdings abroad are highly likely to lead to loss of confidence, and trouble.

There are lots of reason to worry about this scenario.  But one is that any reduction in foreign confidence in the US would undermine one the economy's key shock absorbers: the tendency of interest rates to fall as US economic activity slows, helping to moderate the fall in economy activity.

A savings "supply shock" that reduced the flow of global savings to the US could imply that US interest rates would rise even as the US economy slows.  The Fed would cut short-term rates in response to the slowdown, but foreign investors would not be willing to add to their dollar balances at those low rates.

The market would find an equilibrium:  policy rates might fall, but market (long-term) interest rates might not.  So a US slump might not lead to lower US rates.  Or in the worst case scenario, might be accompanied by higher long-term rates.

Remember, the US will still run a very large current account deficit even if the economy slows.   It will still need to attract very large flows of savings from abroad.   The price the US has to pay (the interest rate) to attract that saving matters.

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Geithner states the obvious; dollar falls

by Brad Setser Monday, January 23, 2006

Obvious point number one: The adjustment process that brings the US external deficit down could be smooth, or not-so-smooth.   We don't know. 

No country as big as the US has run a deficit this large for a sustained period of time off an export base as small as that of the US. New York Federal Reserve President Geithner

"The plausible outcomes range from the gradual and benign to the more precipitous and damaging"

Obvious point number two: Even if modern financial technology and greater cross-border capital flows allow "greater dispersion" of current account deficits and surpluses globally, a US trade and transfers deficit of 7% is not sustainable forever.

A 7% of GDP trade and transfers deficit implies a rising level of net indebtedness, rising net interest payments and a rising current account deficit.

However, it is not difficult to see that if the deficit continues to run at a level close to 7 percent of GDP—and most forecasts assume it will for some time—the net international investment position of the United States will deteriorate sharply, U.S. net obligations to the rest of the world will rise to a very substantial share of GDP, and a growing share of U.S. income will have to go to service those obligations. This fact alone suggests that something will have to give eventually, and this raises the interesting question of how these imbalances have persisted on a path that seems unsustainable with so little evidence of rising risk premia. 

I suspect Geithner read Higgins, Klitgaard and Tille, among others. 

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Too many currencies? Or too many dollar pegs?

by Brad Setser Sunday, January 22, 2006

The world has too many currencies.   The dollar is too good a currency not to be shared.    The US has a clear comparative advantage in central banking.   National pride – and a desire to maintain "monetary sovereignty" — should not stand in the way of outsourcing monetary policy to Ben Bernanke.

So says Benn Steil of the Council of Foreign Relations in a Financial Times oped (free link) and in a new book with Bob Litan.

Most macroeconomic problems in emerging economies – according to Benn –
could be solved if countries just abandoned their local currencies and either adopted the dollar or another sound currency.  Benn has no problems with the euro – just with various pesos, liras, dinars, reals and rupees. Maybe RMB too.

For Benn, Ecuador is the model.   It dollarized back in 1999 (after a huge devaluation).   And it grew faster than anyone else in Latin America in 2004.  Benn attributes Ecuador's star performance to dollarization.   Dollarization is a surefire way to generate counter cyclical capital flows and lower interest rates. 

It is a fair to say I have a somewhat different opinion.  On Ecuador.  And on dollarization. 

I suspect Ecuador's strong 2004 performance had more to do with the price of oil than its use of the dollar.   And Ecuador certainly has not enjoyed low interest rates after dollarizing – Ecuador's (dollar) debt trades at a wider spread than the dollar debt of just about any other emerging market.   Market chatter suggests Iraq's new dollar bonds – when they are issued – will trade at a lower spread that Ecuador's dollar bonds. Hardly a vote of confidence in Ecuador.

Dollarization certainly doesn't end the risk of default on dollar-denominated debt.  Ecuador's dollar bonds carry a juicy coupon, unlike Iraq's bonds.  That's part of the problem in a sense: it isn't clear that Ecuador would pay that coupon if oil ever should fall back to $40, let alone $30.   

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The New New China

by Brad Setser Friday, January 20, 2006

I asked DOR — an active participant in the comments section of this blog — to do a guest post on the recent revisions to China's GDP numbers.   He has a real job, so his identity has to remain (somewhat) masked.   His post follows:

US$214 for everyone. That's the per capita increase in China's GDP under the adjustments announced in the second week of January. Its about the same price as a month-long ISDN connection in Shanghai, a night in a good hotel in Guangzhou or the rent on a 10 sq m room near the Oriental Plaza in Beijing. 

The revisions, the first since the early 1990s, were derived from a detailed, two-year economic survey. The results show an economy that was larger by Rmb 2,336.3 billion (US$281.9 billion) in 2004, or 17.1% (note that the Rmb appreciation since July 2005 has no effect on the revisions to 2004 data). According to the survey, the services sector is now thought to be 49.4% larger than before, manufacturing 2.3% and the primary agricultural, forestry and fishing 0.9% larger.

On the supply side, the revisions are mainly in domestic trade, catering, transport, storage, telecoms and real estate. Flip the national acccounts to the demand side, and one discovers an extra 22% (Rmb 1,087.9 billion). Fixed capital formation, by way of comparison, is now thought to be Rmb468.5 billion larger. Consumption thus rises from 36.3% to 37.8% while investments drops from 52.9% to 48.1%. Net trade also declined, from 9.1% to 6.3%, which leaves an unfortably larger residual (7.8%, up from 1.7%) in the new data. Inventory build-up, anyone?

Among the 18 provinces for which I have found revised data (more complete data would be most welcome), the average change among those showing larger economies is 11.1% while those reporting smaller economies shrank by an average 4.2 %. These 18 (of 31 sub-national entities, which for convenience will be referred to as provinces) represent 67.5% of the pre-adjustment provincial total or 80% of the pre-adjustment national GDP. The difference between the two figures is due to an inconsistency: the sum of the provinces' economies has exceeded the stated national GDP for many years, often by as much as 20%.

Guangdong Province, the largest sub-national economy, increased in size by Rmb282.5 billion (17.6%, equal to US$34 billion) whereas centrally located Hubei Province shrank by Rmb 67.8 billion (10.7%). The largest percent increase was in Beijing (up 41.7% or Rmb177.7 billion) while the smallest was Chongqing at 1% (Rmb2.7 billion).

Given the expected ease of documenting government activities, the adjustment to Beijing's data are puzzling. The municipal press release states that Rmb 154.4 billion (86.9% of the total) arises from revised service sector data.

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