Brad Setser

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Cross border flows, with a bit of macroeconomics

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You know, there are safe havens that do not have a current account deficit of $1 trillion …

by Brad Setser
May 25, 2006

Incidentally, I am not the only one who thinks that the US current account deficit is heading toward a trillion.   The OECD now forecasts $965b current account deficit in 2006 (7.2% of GDP), and $1070b in 2007 (7.6% of GDP) — rather than link to the full report, with the actual numbers, I’ll just link to the summary.   Justin Lahart of the Wall Street Journal reports that the April ports data suggests strong imports and not-so-strong exports, which supports this forecast. And, given the pending surge in net US interest payments as the interest rate on US external debt rises from 3.4% (2005) to something closer to 5.5%, it seems likely to me that the US current account deficit will be above $1 trillion for a long time.  Barring a very hard landing.

Still, David Altig notes that the US remains a safe haven in times of stress.  David Altig asks “where else would you go?”    Actually, he puts it in a slightly more colorful way.

To anyone waiting for the greenback slaughter, I have one question: If, heaven forbid, the global economy goes south, who ya gonna call?

He asks, I answer.

If the global economy goes south because of an oil supply shock, I would run into the Canadian dollar and the Norwegian krone.  I would even rather hold the Russian ruble than the US dollar.  Putin isn’t the nicest guy, but Russia is now a substantial net creditor – and with oil at $70 Russia is adding about $150b to its reserves a year.  I kid not — Russia's reserves have been rising by $5b a week recently. Its external fundamentals are solid.  And I doubt the central bank will be able to resist nominal ruble appreciation forever.

I would also prefer the euro and even the yen to the dollar.  Both Japan and Europe have more energy efficient economies than the US (yep, energy intensity is a structural problem).   Oil exporters want to spend their windfall on European goods, not American goods.   And if oil gets higher, Americans will want to import more Japanese energy-saving technology (hybrids).   But I realize that the euro/ yen over dollar call is a bit more conversial – Peter Garber of Deutsche Bank thinks the dollar would rally in the event of a big oil supply interruption.   Lots of petrodollars would need a home.  My botton line though is simple: in the face of a shock that increases the current account deficits of all oil importers, I wouldn’t want to hold the currency of the oil importer with the biggest deficit.

If the global economy goes south because of a global demand shock and oil falls, Canada, Norway and Russia aren’t the obvious safe havens.   But Asia still looks pretty good to.   Read Bill Gross – he is kind of good at these things.  Asia exports savings – unlike the US.   It imports a ton of oil, so if oil prices fall, Asia’s current account surplus would rise.   Of course, Asia also exports a lot of things – and if US demand growth slows, that would also hurt.  But net/ net I suspect that the impact of slower growth in exports is offset by lower import prices.  And if oil falls because of a global demand slump, US interest rates would likely fall, reducing the interest rate differentials that now favor the US.   

Afterall, a slump in global demand would probably stem in the first instance from a slump in US demand.  The US has been the engine driving global demand – and thus is the biggest potential source of trouble.

And particularly if German consumers start to act a bit more like Spanish consumers (i.e. start spending), the euro also looks like a better safe haven than the US.   Europe doesn’t have a big external deficit that it would need to finance during a downturn, when it is offering international investors a low interest rate.   And unlike the US, Europe is building up its stock of dark matter, not drawing it down.   The eurozone probably took in at least $150b from the central banks of the emerging world, and rather than using the funds to finance big external deficits, it used the flows to finance European foreign direct investment abroad.

Altig and others would probably say I am underestimated the United States strengths.  

But I say that they may be underestimating the problems created by running a current account deficit that exceeds your goods exports.   OK, I should throw in service exports.  But the US is running a 7% of GDP trade and transfers deficit off an export base that is only a bit over 10% with a dollar that is weak against the euro and with global demand for capital goods – the kind of thing the US makes – quite high.  The United States core external fundamentals are not so hot.   The US needs a gradual fall in the dollar that reduces its trade deficit slowly (and increases the value of US assets abroad) to stabilize its external debt at 60% of US GDP, and stabilize US net interest payments at something like 3% of GDP. 

A run into the dollar that pushes the dollar up would imply a trade and transfers deficit of 8 or 9% — and a currnet account deficit of 10 or 11% as interest payments rise.   That doesn’t sound like safe haven to me.  

It also implies a bigger future depreciation of the dollar and a US net external debt level that maybe stabilizes at 80% of US GDP.

Stephen – current account deficits really don’t matter – Kirchner, and lots of others, would say I am underestimating demand for US assets – and the United States skill at creating assets.

I concede that the US is good at selling debt to the People’s Bank of China.   But I would argue that Kirchner and others underestimate the long-term risks associated with depending on the central banks of nice places like China, Saudi Arabia and Russia – along with Japan’s version of day (carry) traders – for financing.  

The smart money betting on the US is betting – I think – that if private demand for US assets falters, central banks will step in.   The US is too big for China and Japan to let it fail (sort of like Russia was too nuclear too fail?).   That may be right.   Central banks so far have stepped up their purchases when the dollar is under pressure – and, as Ted Truman and Anna Wong nicely demonstrate, central banks also bought more dollars and fewer euros when  the dollar is under pressure in 2004, and then relatively speaking more euros in 2005 when the euro was under pressure.   That is the opposite of diversification.   They could act that way in the future too.  Or they could decide that there are limits to the number of dollars they want to hold …    

I recently read that US investors – mutual fund investors – put $20b into emerging markets in 2005, and $30b into emerging markets in the early part of 2006.   Those kind of flows – plus additional hedge fund flows – bid up thin markets big time.  The withdrawal of those funds, in turn, pushed lots of the same market down over the past two weeks.

But relative to the flows the US needs, $20b – or even $30b – is chump change.

China added $20b to its reserves a month in 2005.   And in the first quarter of 2006.  it probably will be more in the second quarter.  In a month, China provides about as much financing to the US as US investors put into all emerging economies in 2005.

The $30b that US investors dumped on emerging markets in 2006 less than what Russia and Saudi Arabia now add to their reserves in month.    Russian reserves are going up by about $20b a month.   Some of that is valuation changes, some may be capital inflows.   But most comes from selling oil and gas.  Saudi Arabia hasn’t released data for April or early May, but it doesn’t take a genius to guess how much it is now raking in.   Bill Gates has nothing on Saudi royal family.  Hell, with only $80b in 2005 profits, the big (western) oil companies have nothing on the Saudis.

61 Comments

  • Posted by mao

    CHANG,
    The Soviets did not “liberate” anything in the Pacific until 1945 after the a-bomb was dropped on Japan.http://en.wikipedia.org/wiki/Operation_August_Storm
    You shame your people and family by destroying your crediblity on this site.

  • Posted by Guest

    One of the reasons Marshall favored using the atom bomb on Japan was his knowledge that the Russians had shifted powerful military forces to Siberia preliminary to invading Manchuria. He hoped to forestall this. Atom bombs were dropped on August 6 and 9 and on the 9th the Russians invaded Manchuria against very weak Japanese resistance. The Russian invasion continued for the next week or so and guaranteed Russia control of most of Manchuria by the time the fighting had ceased.

  • Posted by bsetser

    Ethan J —

    fair point. but if oil prices surge, I would want to hold the currency of countries that produce oil. not necessarily the currencies of countries that import oil. and particularly not the currency of a country with a large non-oil trade deficit, a big oil import bill and a very low market share in the markets of the big oil producers …

  • Posted by Guest

    Yes, it is fair to argue that the relocation of Russian troops to Asia precipitated the decision to drop the A-bombs. It is also fair to argue that the quick Russian success was an important factor in the Japanese decision to surrender when they did. In this sense, the Russian invasion may have been responsible for saving many lives by shortening the war. Nonetheless, no serious person would ever argue that the Pacific War wasn’t won solely by the Americans. Thus, China owes its liberaton from the Japanese to the United States.

    I would never take anything away from the heroic Soviet and British sacrifice in Europe during WW2. It can be argued, however, that they would have never survived the Nazi campaign if they had not received substantial material support from the United States in their darkest hour of need. Much of this took place well before Pearl Harbor. These supplies were shipped with great sacrifice through the Uboat infested North Sea and overland through Iran. Also, the North African and Italian campaigns were designed to pin down as many Nazi divisions as possible in order to help the Russians before the DDay expedition was ready. In addition, the mere threat of the French coastal landing kept many more Nazi divisions away from the Eastern front. Without active American participation, it is very unlikely either Britain or the Soviets would have overcome Hitler. If you would like to learn more about these events, I highly recommend Winston Churchill’s Nobel Prize winning “Memoirs of the Second World War”.

  • Posted by gillies

    “The basic choice that the United States has to make as far as military investment is whether it wants to fight bin-Laden and Middle Eastern terrorism (i.e. the Army) or whether it wants to fight China (i.e. the Navy). It doesn’t have the money to do both.”

    it doesn’t have the money to do either. but the choice is no longer made by ‘the united states.’ the choice is made by those able to syphon the odd trillion through ‘the enterprise’ – the defence budget – without accountability, because they are able to use part of it to subvert the political process to their own agenda. 9/11 was a great naval victory. did you think that the banner ‘mission accomplished’ referred to iraq ? if you have no clue what i am talking about – time to review and overhaul your usual sources of information.

  • Posted by Guest

    “Are Asian goods being dumped in the US, or are Europeans being ripped off?”

    In an unofficial way, yes. I think a certain amount of Chinese manufactures are produced below cost (and, incidentally, creating more bad loans). When China/US trade inevitably cools and we have our hard/soft landing, this unofficial dumping may end and help increase prices.

    By the way, have we reached consensus on the safe haven yet. The Krone seems overvalued, Canadian banks seem to be sitting on questionable MBS, … maybe farmland in North Dakota?

  • Posted by Guest

    That brings me back to my comments about liquidity. It is ridiculous to talk about Scandanavian or Canadian investments as an alternative to the US. They can work out for small investors and some large investors, but if we are talking about a wholesale flight from the USD, the fixed income, FX and equity markets of those countries would explode. Even if you were to assume that people could get in, as a very large investor you also have to have a plan for how you are going to get out of something. Canadian capital markets are very unattractive from this perspective.

  • Posted by LP

    I’m kind of tired of hearing about the low American savings rate. If anybody in the world had access to such low-interest loans, they would add to their home/buy a new car (on loan)/buy some new things too. The very ppl complaining about Americans’ low savings rate are the people financing it.

    Despite this, I *do* agree that the rate is dismal, and that Americans should be saving instead of spending to such a ridiculous degree, but in many ways I think it’s more human than it is American.

    re: where to put your money, Canada feels safe but I don’t have any real evidence to support that (and it seems like others on the board disagree on Canada, anyway). As for putting money in oil-producers, sure that’s a good plan if you’re positive on an oil surge, and it’s only short-term gain that you’re looking for.

  • Posted by Derkar

    Guys,

    While you are discussing where, under the circumstances, safe havens are, international investors have already found the most appealing one. It is gold. Its prices have soared recently.

    As Alan Greenspan once remarked: “Gold still represents the ultimate form of payment in the world. Fiat money in extremis is accepted by nobody.”

    Jill Leyland of the World Gold Council gives an even more straightforward account: “It is seen as the safe haven people turn to in times of doubt. Because gold is nobody’s liability, so if you have gold, nobody can take it away from you and no government can reduce the value of gold in the sense that they can, for example, be responsible for a fall in the value of their own currencies through inappropriate economic policies.”

    Regards,

  • Posted by madphycom

    “JPY’s recovery will not last. My colleagues in Japan tell me all kinds of bad news about Japan. Simply put, Japanese 30 years ago were determined to overcome the US, as if to say, “We lost the war, so we’ll win in economics!” Today, spoiled Japanese youth have no motivation whatsoever. Plus, they make no kids.”

    kz –

    I dont know who you talk to in Japan, but this is the prevailing wisdom there, NOT the truth. The reality you see when you actually speak to these kids and actually spend time “on the street” is fantastically different. There is generation now in Japan that is both financially capable and see the world close to how it actually is; in fact, like in the United States it would seem that it is the baby boomers in Japan that have a somewhat mistaken view of the world, and of the younger generations.

    I rarely see bright futures – but in Japan I do. Asset prices are reasonable, the cost of living has become more reasonable, they sit on a huge currency reserve and their economy is much less dependent on oil. And the lack of dependence is structural; looking at current oil consumption does not let you know that IF there ever was a supply shock, Japan would be able to without too much difficulty cut a lot of oil use pretty quickly without causing dramatic effects in the economy. The same cannot be said for the United States, where in most parts of the country you MUST drive to get to work, logistics relies critically on highways and trucks, and no alternative to fuel intensive transport is readily available.

    I see a few things happening in Japan going forward that is likely to be a boon – first, I see a great transfer of wealth from the older generations to the younger generations. Japan has accumulated a lot of wealth and the wealth is fairly well distributed, to the point that many banks even have quippy booklets about inheritances, and they’re NOT about taxes. I have never seen a similar booklet in the United States – namely because most people do not inherit too much wealth. I’m sure they exist in the offices of major wealth management firms and tax law firms – but I havent had the pleasure of going to those places.

    This wealth is now being used for not so much; it is sitting in a bank getting miserly returns. I think that once the younger generation gets a hold of this wealth, the likely effect is to spur both more aggressive investments, both domestically and overseas to find good return opportunities; and a boom in small business ventures. Forget Japan as a stogy place with stodgy companies – all of them started small; the Japanese are people too and a generation of kids who are somewhat freed from work but looking for good returns are probably just what the country needs in order to spur innovation.

    There are risks of course – but the ones you highlighted are myths held dear by the older generation who view their sacrafices and intelligence a bit too highly. The younger generation has their fair share of idiots and idle people – every society does; but it is also the generation most open to and most likely to change Japan into a completely different force.

    They, nor the world, has probably realized this; but as long as Japan can manage with the peaceful rise of China and the Rest of Asia, the future for the country is much better IMO than the future for the United States.

  • Posted by a

    ” …would also prefer the euro…” I’d have to agree with many of the others criticizing this comment. One of the reasons why the euro softened in 2005 vs the dollar is that the political risk with the euro, with the French no vote, came to the fore.

    This political risk will probably grow, rather than weaken, with time. The Europeans can’t think of a way out of their political problems. So long as times are good, they will be able to muddle through. But once there is a hard recession, there is quite likely to be some kind of crisis. The value of dollars may be inflated away, but at the end of the day, 50 cents out of 100 is better than holding worthless currency of a country which doesn’t even exist.

    The euro may strengthen vs the dollar in the medium-term. I certainly hope so, I have plenty of them sitting in a bank account… But strengthening will unleash corrective forces – higher unemployment in Euroland, more attacks on ECB independence – which will then undermine euro strength.