The answer in 2005 was yes.

The answer so far in 2006 is not necessarily.

Every article in Saturday’s Financial Times – the paper version as well as the online version — seemed to note in one way or another that volatility was up, in a wide-range of markets.    Indian equities are the latest example — they went on a wild ride on Monday.

Anyone who bet that large balance of payments deficits in the US – and offsetting large surpluses in Asia and the oil exporters – would generate either macroeconomic or financial volatility didn’t do well last year.     Investors either concluded that there was no reason why the US deficit couldn’t get bigger, or that the adjustment process wouldn’t require major changes in important financial variables.    Bill Gross:

Risk spreads and volatility levels inherent in those spreads are in many cases near historic lows and financial leverage is at historic highs. It appears that these markets expect that we will not only have strong growth but benignly strong growth for as far as the eye can see. 

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It seems like some investors in the US are dabbling in Zambian t-bills.   Or at least were until a few days ago.  

The flow of private money from the US to many emerging economies is one reason why I have some trouble with (quite popular) theories that argue that emerging economies cannot create financial assets that their own citizens want to hold, and therefore, must finance the US.   These theories seem premised on the belief that US is good at creating financial assets that investors in fast growing parts of the world want to hold, while fast growing emerging economies cannot create financial assets that their own citizens, let alone foreign investors, want to hold.  

To quote Daniel Gross:

Yes, people in China—and in India, or Brazil, or the Persian Gulf—are saving tons of money, in large part because they're selling goods and services to wealthy Americans and Europeans. But they don't trust their own poorly developed capital markets, banks, or corporations to take good care of their yuan, reais, and rials … But the U.S. stock and corporate-bond markets offer investors around the world the ability to gain exposure to the global economy.

What's wrong with that picture? 

Well, right now, China's banks aren't having any trouble creating renminbi denominated financial assets that Chinese citizens want to hold.   China is tightening controls on inflows — not on outflows.   Its government is practically begging Chinese citizens to invest more abroad.   Among other things, China has been holding its domestic rates below US rates to try to discourage inflows, and maybe even encourage outflows …

China is an extreme case, but more generally, private capital is flowing into emerging economies, not out of emerging economies.   Private capital outflows from Russia have dried up, while private inflows into Russia have picked up.   Some foreign investors kind of like Gazprom's profit margins, if not its management structure.  That is one reason why Russian reserve growth has been so strong.  And the same holds for most of the emerging world.  Last year, Turkish citizens' desire to move funds abroad paled relative to foreign investors desire to move funds into Turkey. That's why Turkey's reserves went up in the face of a large current account deficit.  And so on.

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The dollar’s strength in 2005 was a bit of  a puzzle to those who worried about  the scale of the US current account deficit.  Afterall, a growing current account deficit – and the deficit grew by around $130b in 2005 – implies a growing need for external financing, and the world’s willingness to extend credit to the US (presumably) is not infinite.    Yet in 2005, a growing deficit was financed with few obvious signs of financial strain.

One way to finance a current account deficit is to sell off your existing assets.  We saw a bit of this on Monday — when investors pulling out of emerging markets provided a source of support for the dollar.    Back in 2005, though, US investors were piling into emerging economies, not running away. 

But the US was able to finance a larger current account deficit in 2005 than in 2004 while placing less debt abroad?  Why — as I will argue below, a fall in FDI outflows meant that the US received net equity inflows for the first time in several years.  Foreign FDI and foreign portfolio equity investments in the US (purchases of US stocks) exceeded US FDI and US portfolio equity outflow largely because US FDI fell to zero. Since the US invested less abroad in 2005 than in 2004, more of the funds flowing in to the US could be used to finance the current account deficit. 

I suspect the fall in US FDI stemmed from the Homeland Investment Act, a one-off tax break that encouraged US firms to bring funds home, not a sustained reduction in the desire of US firms to invest abroad.  

The implication: the US will need to place a lot more debt abroad in 2006 than in 2005.  See the charts below.

From 2002 on, US equity investment abroad exceeded foreign equity investment in the US – so the US financed both its equity investment and its current account deficit by selling debt abroad.   Put slightly differentl665-670 b current account deficit required placing $800b or so of debt abroad.  Actually, there was a large error term in the 2004 BoP data, so the actual debt flows were a bit over $700b, and  “errors” generated the remaining $100b or so. Read more »

In the first quarter. Russia's reserves increased by about $20b.

Over that same time period, Russia cut back its exposure to the US — judging from the TIC data — by almost $5 billion.   Russia's holdings of short-term US securities and its US bank deposits fell by $10.2 billion, while its holdings of long-term debt increased by only $5.5b — for a net fall of $4.7b.

Rising reserves. reduced claims on the US.  Evidence of reserve diversification?  Or evidence of custodial bias, and short-term debt held in the US was converted into long-term debt held by London custodians?  Who knows.

One thing is clear: the very weak official inflows in the March TIC data are hard to square with the growth in global reserves in March.    China's holdings of US debt went up by about $5 billion — with around $6.3b in purchases of US long-term debt offset in part by reduced short-term claims.  But overall official inflows were only $1.8b in March.

Why? Russia isn't the explanation — the run down in its short-term claims on the US doesn't show up in the data on purchases of long-term debt.  Look to Norway, which sold lots of Treasuries in March.  It did the same thing last March, only to buy them back in April.  It is not necessarily following Sweden's lead.

Still, i find it harder and harder to use the TIC data to track official inflows, particularly now that so much reserve growth is coming from the oil exporters.  Chinese purchases also tend to be small relative to Chinese reserve growth.   The result: that data on inflows just doesn't track the data on reserve growth — and it is hard to tell if central banks are buying through other channels or looking for other places to part their funds from the US data alone.  

The global reserve growth numbers were quite strong in March — though nothing like those in April.  Asian reserves — setting China aside — were up $38b.   Not all that was valuation gains either.  China's reserves are likely up $30b.   The oil exporters probable added $60b … and so on.  Maybe $35b of that is valuation gains, but it still leaves $95 in real reserve growth.

Despite what David Brooks says.  

The rising debt seems to be a direct consequence of cutting taxes and raising spending — decisions the Bush Administration made.    The US may not be able to stop Chinese "mercantilism," but Chinese intervention in the foreign exchange market also is a rather direct consequence of a government decision.   Brooks list of "ungoverned forces surging out of control" consequently seemed a bit odd.

Update: China seems intent on stepping on every stone as it crosses the river, and perhaps stepping on some stones twice.   The PBoC set the RMB's central parity at 7.9982 today.   However, the RMB closed back above 8, though only just at 8.003.   Of course, there is no real difference between 7.998 and 8.003 … but it seems like the Chinese wanted to test the waters before they let the RMB close above 7. 

I will be on the spring conference circuit this week.  I intend to post here, but no doubt at slightly odd hours and perhaps somewhat less frequently.  

Not quite as good as the headline fall suggests.

That is my initial take on the March US trade numbers

China didn’t surprise by the way.  It posted another $10 billion plus trade surplus in April — $10.5 precisely.  Exports were up 23.9% y/y; imports increased by a much smaller 15.3% y/y.  For all the talk about rebalancing Chinese growth, the data so far suggest that China is becoming more, not less, dependent on exports – and that its trade surplus is poised to increase further.

The US trade deficit dipped to $62 billion in March.   That wasn’t expected.  Certainly not by me.  I probably spent too much time looking at the Asian data, and too little looking at oil … 

More on that later.

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I have been quoted rather extensively in the past few days on Treasury’s foreign exchange report –

And in this debate, you are either a dove or a hawk.   Doves (Roach) don’t think that the US should have named China as a manipulator.   Hawks (Goldstein, Morici) think the Treasury wimped out, and failed to call out China’s obvious manipulation.  

And that puts me in the uncomfortable position of being a dove.

Not because I support China’s peg.   Regular readers know that I think that China’s peg  is a huge impediment to global adjustment.    Not the only barrier, to be sure.   The US current account deficit of  $1 trillion exceeds even China’s considerable capacity to mobilize its domestic savings to lend to the US – it truly is a global problem.   And I think most readers know that I clearly don’t think it is in the United States’ long-term interest to have an economy that specializes in the production of debt for sale to China’s central bank.

But rather because I doubt that calling China a manipulator will lead China to stop manipulating.  

I think that there is meaningful chance that China will move more over the summer in the absence of a formal declaration of manipulation and a meaningful risk that it might refuse to move at all if the US found it guilty of manipulation, just to prove that it won’t move under pressure.

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The Treasury couldn’t determine that “China’s foreign exchange system was operated during the last half of 2005 for the purpose (i.e. with the intent) of preventing adjustment in China’s balance of payments or gaining China an unfair competitive advantage in international trade.”

Intent is always hard to prove.  And it is a bit subjective.   So it gave the Treasury an out.   

The Treasury decided that this was not the right time to name China as a manipulator.  But the Treasury also stressed that China needs to do more:

“China’s advances are far too slow and hesitant given China’s own needs, and its responsibilities to the international financial community.   The delay in introducing additional exchange rate flexibility is unjustified given the strength of the Chinese economy and the progress in China’s transition.   China needs to move quickly to introduce exchange rate flexibility at a far faster pace than it has done to date.  With a still rigid exchange rate, China lacks effective monetary policy tooks to avoid the boom-bust cycles it has experienced in the past.   Given our strong disappointment and the importance of China to the world economy, the Treasury Department will closely monitor Chinals process in implementing its economic rebalancing strategy”

The US also noted that China’s exchange rate is not just of concern to the US:

“China’s exchange rate policies affect the entire world.  Increased renminbi flexibility would greatly facilitate increased flexibility in other Asian currencies.”

The most interesting part though, at least to me, was the section listing the considerations that led the Treasury to conclude that it could not (yet) determine intent.   The Treasury emphasized quite that the report covered only developments during the second half of 2005 – the period when China formally removed its peg to the dollar and moved toward “a managed floating exchange rate regime.”  We all know that China still has a de facto peg, but the Treasury noted that “the examination period of this Report … is the first that includes the Chinese exchange rate policy change.”  

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I was interviewed by Adam Davidson of NPR about the Treasury’s forthcoming foreign exchange report (to be released at 4 pm today). You can hear the results here.    Adam Davidson also interviewed the person actually making policy, Tim Adams. 

Adams didn’t give any hints about what he plans to say in tomorrow report.  If I had to bet, I would say that the Treasury will not name China as a manipulator.    That seems to be the current market consensus. 

For me, it is a very close call but, on balance, I also think giving China a bit more time would be the right move.  In part because there are multilateral approaches that might work.  But I am not that far behind Fred Bergsten either. 

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The US consumer seem to have opted out of any rebalancing.  Higher oil prices?  No reason not to keep buying more of everything else too …

The only rebalancing I see is in the set of folks financing the US.

In 2005, by my calculations (which have a higher total for official financing than the formal data as I think the formal data understates official inflows signficantly), private investors provided about ½ the net financing the US needed, and central banks the other ½.   Each chipped in about $400b. 

After the G-7 called for Asian currencies to appreciate against the dollar,  Europeans decided they didn’t want to finance the US.  Or Americans decided they didn’t want to hold dollars.  No matter.  The dollar started to tank v. the euro.

Calling for an Asian appreciation is not really a huge, huge deal, I would think – both the RMB and the JPY are very weak in real terms.   The IMF’s regional outlook explains that flexibility in the current context means appreciation.  No duh. 

But after the G-7, the Asian economies made it clear that they were not on board with the G-7’s call for an appreciation.  Or for its call for more flexibility.  

Japan walked away from the communique — to the displeasure of the US.  So much for the end of the blame game and common agreement on a new coordinated approach to addressing imbalances.   And China's Vice Minister of Finance says China intends to address imbalances its own way: without much appreciation.   McKinnon, Mundell and Stiglitz should be pleased.

China isn't part of the G-7 and never signed on to the G-7 communique, so I understand why China might want to show that it won't do the G-7's bidding. China wants a seat at the table.  At the same time, I don't quite see how letting the RMB follow the dollar down helps China cool its over-heated economy.  Or helps to shift the basis of China's growth away from exports.

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