Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Things that keep the President of the New York Fed up at night

by Brad Setser Tuesday, February 28, 2006

The current account deficit, obviously.    NY Fed President Geithner isn't quite in the same place as Bernanke, at least in Bernanke's White House incarnation.

And credit derivatives.   Particularly in combination with leverage.  Geithner pretty clearly is more worried than the folks invited to the Goldman Sachs' conference on global risks last fall.   He worries that a market that has grown up under very benign conditions (low and stable long-term US interest rates, falling credit spreads, high levels of cash on corporate balance sheets) may not fare so well should conditions turn.

The money quote:

And when innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances. The past several years of exceptionally rapid growth in credit derivatives and the larger role played by nonbank financial institutions, including hedge funds, has occurred in a context of very low realized credit losses, low expectations of future default risk, a high degree of confidence in the financial strength of the major banks and investment banks, relatively strong and significantly more stable economic growth, less concern about the level and volatility in future inflation, and low expected volatility in many asset prices. Even if a substantial part of these changes prove durable, we know less about how these markets will function in conditions of stress, and the most sophisticated tools available for measuring potential losses have less to offer than they will with the benefit of experience with adversity.

Geithner doesn't go as far as Michael Lewitt of Harch Capital, who argues that "offering credit derivatives to hedge funds" is like "offering alcoholics a nightcap."   But he does highlight a series of concerns, including:

1. The amount of credit derivatives outstanding relative to the cash market. Credit derivatives decouple credit bets from the constraints of the cash bond market.  If you like the credit of a company (or country) that doesn't actually need to issue, no problem – sell a credit derivative (insurance against default).  The problem: the notional amount of credit derivatives outstanding now often exceeds the amount of actual debt – which can make things interesting in the event of default.

"Large notional values are written on a much smaller base of underlying debt issuance. The same names show up in multiple types of positions—singles-name, index and structured products such as CDOs. These create the potential for squeezes in cash markets and greater volatility across instruments in the event of a default"

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Read Richard McGregor’s FT article on China

by Brad Setser Tuesday, February 28, 2006

I follow the data coming out of China pretty closely, at least for someone whose linguistic limitations crimp any long-term ambitions to be a professional China Watcher.    

Not every article on China impresses me.  But Richard McGregor's big FT piece certainly did.   If you cannot read it in its entirety, read Mark Thoma's excerpts.  It offers a window into the political debates raging inside China – and the political future of Central Bank governor Zhou.

Is Hu a reformer seeking to correct some of the inequities that arose during the initial phase of market reforms?  Or a defender of status quo, unwilling to take the difficult decisions required to really loosen the state's grip over the commanding heights of the Chinese economy?  Is Zhou pushing financial sector reforms (including foreign participation in the financial system) faster than the political traffic will bear?  Is China's economic miracle poised to continue, or set to unravel?

I certainly don't know – but I felt I got a better sense of  the debate in Beijing (and Shanghai) after reading McGregor's article. 

McGregor also highlights that – depending on your point of view – you can tell a story about China based on how far China has moved toward the market, or based on how much remains to be done to make China into a real market economy.

A couple of other points jumped out at me.

First, the vast gulf between urban and rural land prices in China.   This is not just a Chinese phenomenon.   A modest New York apartment goes for about as much as a section of land in central Kansas – and, as in China, the price discrepancy is growing, not shrinking. 

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A butterfly flapped its wings in Iceland …

by Brad Setser Monday, February 27, 2006

If you read the financial press closely, it was hard not to learn a bit about the Icelandic krona over the past week.   The krona pays a high interest rate, you see – enabling Iceland to attract the funds needed to cover its (significant) current account deficit.    It is a mini-New Zealand, in other words.  Everbank was offering Icelandic krona denominated accounts. 

It is good to get into carry trades early – you get the high interest rate and watch as other investors bid up the currency too.  But it is not so good to get in late – falls in the currency can offset the gains from higher interest rates.

And I guess some folks started to get a bit nervous.   Fitch downgraded Iceland, the krona fell sharply, and downward movement in the krona led to downward moves in Brazil, South Africa, Indonesia, Poland, Mexico and Turkey.

Why, you might ask, does what happens in Iceland matter to Brazil?   Or Turkey? 

Their economies are not exactly any more similar than their cultures. The answer is that all are linked together by common set of carry-driven investors.    Tony Northfield of ABN Amro:

"These countries are unrelated geographically, but they are not unrelated in portfolios."

The FT described last weeks dynamics in terms anyone who still remembers 1997 or 1998 would easily understand:

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Is China’s peg creating more problems than benefits for China?

by Brad Setser Saturday, February 25, 2006

 Stephen "current account deficits don't matter, at least not in the dollar zone" Jen is starting to sound a bit like Brad "Doom and Gloom caucus, trade deficit division" Setser. 

At least on China's peg.    In his weekly note — which appeared in abridged form in Monday's Global Economic Forum  — Morgan Stanley's Jen makes a bunch of arguments that could have come straight from my mouth.

  • China has as many reserves as it wants (if not more).  Jen writes "no longer is it clear to the policymakers in China that "the more reserves, the better" 
  • Intervention without full sterilization is contributing to excess capacity in China - presumably because it is leading to rapid credit growth – and thus is putting downward pressure on prices.  I am not fully with Jen on this  one point: lots of money growth usually is inflationary, not deflationary.  But then again, China is different.
  • The cheap RMB doesn't just make Chinese goods cheap; it also makes Chinese assets cheap.   Amen, brother.   China deals with this problem by prohibiting foreigners from trading dollars and euro for real Chinese assets.  Foreigners can do Greenfield investment, but not snap up existing Chinese firms.    But it also means that foreign assets are quite expensive for Chinese buyers – something that deters Chinese firms from venturing forth on the world stage.
  • The lack of meaningful currency risk inhibits the development of "hedging" markets – why buy insurance against currency risk when the government is already insuring against currency risk?  Amen.  I can see why exporters might want to hedge against faster than expected RMB appreciation (if they don't trust the government), but I don't see why any importer would want to hedge.   The RMB just isn't going to fall v. the dollar, and if the RMB appreciates more than expected, that only cuts the importers costs.

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Selling off pieces of yourself (or not)

by Brad Setser Thursday, February 23, 2006

The 2006 US current account deficit looks to be a bit under $1 trillion.  $1 trillion sounds big, but remember, the annualized fourth quarter current account deficit will almost certainly be close to $900 b.  Continued strong consumption growth suggests that the trade deficit is still trending up, and in 2006, rising interest rates are set to push the income balance into negative territory.  

And if US companies want to invest abroad and American investors want to buy foreign securities (and they do – just look at how Brazil's equity markets have performed in 2006?), the US needs to attract inflows of over $1 trillion.

So it is not at all unreasonable to say that financing the US current account deficit  requires that the US raise $20 billion a week, whether by selling debt, selling stocks or selling off real US assets.  52 * $20b = $1040.

That is equal to selling one Unocal a week to China (CNOOC was willing to pay $20 billion). Or selling three companies the size of P&O to the Emirates a week.   

P&O is a bad example though.  It is British company, so its sale finances the UK's current account deficit, not the United States' deficit.   And most of the value of the $6.8 billion deal doesn't come from the P&O's American assets.

But the broader point still stands.   If the US was financing its current account deficit with equity not debt, the Committee on Foreign Investment in the US (CFIUS) – the group that approved the port deal – would be very, very busy.

Moreover, if foreigners who already hold dollar-denominated bonds ever decided they wanted to shift into equities, the potential sale of physical US assets would be even larger.

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Shrinking dark matter watch

by Brad Setser Wednesday, February 22, 2006

Or maybe shifting dark matter watch.

Via Barry Ritholtz comes news that increasing US investment (according to Mandel) in one key intangible asset – US brands – may be yielding diminishing returns.    Global surveys of teens suggest that US brands are slipping.  Danish brands probably are not much competition in certain parts of the world.   But, globally, the Finns (Nokia), Germans (Adidas) and Japanese (Sony) seem to be doing quite well.   The US is not the only country with intangible assets.

One of the great mysteries of the whole debate over dark matter is how the US will continue to create all the dark matter needed to offset annual $1 trillion current account deficits.  Hausmann and Sturzenegger have argued over at Martin Wolf's (youth-free) forum that the pace at which the US is creating dark matter has accelerated.  They now accept that it may not stay at this pace, but they are argue that the US can bank on adding 2-3% of GDP annually to its stock of dark matter.

Delong has put together a spreadsheet showing how this might happen.

The US makes $600 billion in foreign direct investment annually – and, when it does so, the US should add an additional $300 billion in intangible assets (dark matter) to its balance sheet.

I have to confess I initially found DeLong's spreadsheet confusing.

Largely because the numbers seemed a bit off.   US direct investment abroad is not likely to totally anything like $600 b in 2005.  In the first three quarters of 2005, total US FDI totaled only $20b.  That total reflects the Homeland Investment Act.  But even in 2004 – a peak year – the US direct investment abroad only totaled $250 b.   Between 2001 and 2004 US direct investment abroad averaged a bit under $135b annually (Foreign direct investment in the US averaged $75b).

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The (strange) politics of globalization

by Brad Setser Wednesday, February 22, 2006

Maybe the US would be better off if China owned Unocal's Asian oil fields

Not economically.  Unocal's oil and gas fields are presumably worth a bit more now than they were last summer.  But strategically.

The US might prefer Chinese investment in Indonesian gas fields to Chinese investment in Iranian gas fields.  Though maybe China would want to do both.

And at times, I also wonder if China might be better off if its state oil companies refrained from certain investments.  

Not financially.   I strongly suspect China could get a better long-term return if it invested its spare savings in oil and gas fields than in long-term fixed-rate dollar-denominated US treasuries.   China can probably get more on its reserves if it lends them out in dollars at 6% to its state oil companies to invest in places like Iran than if it buys US agencies and mortgage-backed securities.

But strategically.  China's footprint in resource-intensive parts of the world is still small – Chinese firms offshore reserves pale relative to those of US or European oil firms – but it is growing fast.  And most of the attractive oil and gas investment opportunities (at least those not reserved for national oil companies) are likely to be found in states that the US considers pariahs of one kind or another.

Iran.  Sudan.  And so on.  China's "quiet" strategic posture ("peaceful rise") is hard to square with massive investments in Iran.   Particularly right now.  

The lesson of Unocal – and perhaps the lesson of Dubai Ports World – is that the most politically potent anti-globalization coalition comes when concerns with the national security overlap with economic fears – whether fears about jobs or fears about a loss of control over key assets.  Or even a shift in control from a company headquartered in one long-standing (but politically and culturally similar) ally to another long-standing (but politically and culturally different) ally.

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Frederick Kempe of the Wall Street Journal gets an awful lot of things wrong

by Brad Setser Tuesday, February 21, 2006

As, I suspect, does Joseph Quinlan of the Bank of America- the source of much of Kempe's analysis.  

Kempe's core argument: consumers in emerging markets are driving global demand.  

His evidence: imports from emerging markets constitute a rising share of global imports.

The problem with his argument: he only looks at half the equation – imports – and ignore exports.

Emerging markets are importing more because they are exporting more.  China, obviously.    The oil and commodity exporters too.

But emerging markets in aggregate are not yet driving global demand growth. 

After all, consumption is the opposite of savings (not exactly – investment figures in too), and if there is a global savings glut, it pretty clearly is in emerging markets. 

Remember, many emerging economies have surging savings surpluses.   Current account surpluses are rising even as investment is rising – which implies savings is growing even faster than investment.  China's current account surplus rose substantially in 2005 despite strong investment growth.   The oil exporter's current account surplus soared even more.

Kempe's argument works for Eastern Europe – which does have a large current account deficit, and has been supporting demand growth in the rest of Europe.  It works for India.

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Gone (Ice) Fishing.

by Brad Setser Thursday, February 16, 2006

Not literally.  But I am taking a few days off.  

I am sure you all will find a few things to discuss.  I have put a few suggestions below the fold, but there are not meant to be limiting.

Is the Treasury bluffing, or is it about to label China a currency manipulator?

Slightly more esoteric.  Should Brazil be changing its tax regime to encouraging foreign money to flow into its local market when everyone and their dog already wants to go long Brazil?

What has been the biggest surprise of the past year and a half.

For me, the answer to that question would be:

  • That $60 a barrel oil (sometimes closer to $70 a barrel) hasn't exerted a bigger drag on US growth – if you had asked if retail sales (including non-oil sates) would be as strong as they were in January with oil pushing $70 for a while two years ago,  I would have said no way.
  • That emerging market central banks would be so keen to keep adding $500b plus to their already substantial reserves every year.  I expected reserve accumulation by emerging markets to peak in q4 of 2004.  It almost certainly didn't (if you include the assets of various oil funds).
  • That Wall Street is now so willing to bet on the central banks of emerging markets – not to bet against them.   The bond market sure seem to be betting the bubble in reserve accumulation by emerging markets will continue, and continue to keep US rates down, US housing prices up, US consumption strong and US credit risk spreads low … 
  • And, as a result, that a looming $1 trillion current account deficit is generating so little market strain.   Maybe the markets believe current account deficits don't matter — afterall, a lot of the (younger) traders on the Street have spent their entire career watching the US deficit rise, with no major consequences.  Maybe the markets believe in dark matter.  Or maybe they believe that the world's central banks will finance big US deficits no matter what.  Pick your explanation — the absence of greater signs of stress certainly has surprised me. 

So where exactly are all the world’s reserves going?

by Brad Setser Thursday, February 16, 2006

We don't yet formally know the BEA's estimate for the end of the year current account deficit, but we have a pretty good idea

We also now have a lot of data about how the US financed its current account deficit (try selling debt to foreign investors).  One thing is already clear.  There is going to be a big fall off in recorded central bank flows to the US.  A really big fall off.    

In 2004, central banks provided the US with close to $400 billion in financing — something the President's Council of Economic Advisors somehow forget to mention in their report.  

The 2005 TIC data shows that central banks bought only about $115b billion in long-term securities, down from $236b in 2004.   Add in the fact that in 2005 central banks seem to have reduced their holdings of short-term treasuries by $43 billion and it seems, in net, central bank holdings of US securities increased by only $71-72 billion (v. $324 billion or so in 2004).

Foreign central bank's "onshore" dollar deposits are up by 19.2 billion in the first three quarters 2005 – so a reasonable estimate for the full year total is $26.6 billion (v $70b in 2004).  That would put total recorded central bank financing of the US – if you believe the US data – at a bit under $100 billion, or about ¼ the level of 2004.

If you read this blog regularly, you know I don't believe the data.  Why?  Simple:  there hasn't been a comparable fall off in global reserve accumulation.   See Bill Pesek.  Or read the rest of this post.

The IMF put global reserve accumulation in 2004 at about $700 billion.  Roughly $60 billion of that came from the rising dollar value of euro reserves, so the "flow" or "valuation adjusted reserve increase" was closer to $640 billion.  The dollar/ euro started 2004 at around 1.26, and ended above 1.35.

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