Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

DeLong is right. If the US wants to end up like Australia, US trade deficit needs to fall – unless foreigners continue to do terribly on their investments in the US.

by Brad Setser Friday, June 30, 2006

As Brad Delong notes, the big difference between the United States and Australia is that the United States has a  trade and transfers deficit of close to 7% of GDP.    That implies – assuming the stock of US dark matter doesn’t grow – that the US external debt to GDP ratio (really the US net international investment position to GDP ratio) will rise over time.   

Australia’s current account deficit is comparable to that of the United States.  But – see John Quiggin — its trade deficit is far smaller.   That is at it must be: Australia has to pay interest on all its accumulated debt.   The basic rule of thumb is that if you have lots of debt and your economy is growing, you can borrow to pay interest on your external debt.  But you cannot borrow both to pay interest and run a trade deficit.

Indeed, if the US wants its net debt to stabilize at Australia’s levels, it probably needs to start the adjustment process now. 

In the written testimony I submitted for the record at the recent JEC hearing I provided a lot of the details behind my analysis of the US balance of payments data – including my latest estimates of 2005 global reserve growth and the role central banks have played in the financing of the US current account deficit.  One my charts showing the evolution of the US net international investment position in the “no adjustment” and “fast adjustment” scenarios i laid out in a post earlier this week.  

That chart – reproduced here – shows that the US net international investment position would stabilize at around 60% of US GDP if the US trade deficit started to shrink steadily in 2007 and basically disappeared by 2017 or so.  


The NIIP to GDP ration in this chart is a probably a bit high. I didn’t adjust for valuation gains from the dollar falls likely to accompany the adjustment path that brings the trade deficit down.    But it gives some sense of the likely dynamics.

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Levered long/ long funds …

by Brad Setser Thursday, June 29, 2006

An anonymous partner at a mid-sized London hedge fund expressed something I was trying to say a couple of weeks ago fair better than I could have.   From the Financial Times:

"A lot of managers have gone from being long-short funds [funds that make bullish and bearish bets on stocks] to being long-long funds with leverage, which removes the whole point of hedge funds offering protection in the event of a downturn," said a partner at a mid-size hedge fund in London. 

I expressed my argument somewhat less elegantly – saying that that some hedge funds were not really hedged.   And many of my readers pointed out  — quite correctly – that no one that is fully hedged makes money.  

But what I was getting at was that it was quite costly to hedge say a long position in an emerging market equity market with an offsetting short position in the same equity market.    Funds that hedged in the same market didn't do as well as funds that did not hedge.    Until May, a rising tide was lifting all boats.  And punishing shorts. 

So there was a temptation to become a long/ long fund.

Or to find proxy hedges that didn’t cost you an arm and a leg. 

The one that I am most familiar with comes not from emerging market equity markets, but from the market for the local currency debt of emerging economies. 

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Another month, another $30b for China’s central bank … but what happened in April?

by Brad Setser Wednesday, June 28, 2006

China’s reserves increased by around $20 billion in April and $30 billion in May – reaching $925 billion.   

China’s $20 billion April total was rather meager.  Russia added almost as much.  The Middle Kingdom usually doesn’t just top the reserve growth league table; it does so with style.  

May was more like what we have come to expect.

Seriously, China’s April reserve increase seems a bit on the low side. 

China's April trade surplus was around $10.5 billion.  And the euro rose from $1.214 to $1.262 or so during the month of April.   That should have increased the dollar value of China’s existing euro reserves in a big way.   Casson Rosenblatt and I estimated that 70% dollar/ 20% euro/ 10% yen reserve portfolio would have increased in value by $9.8b in April.    Or just assume China had around $200b in euros at the end of March (23% of its portfolio).  Those euros would be worth around $208b at the end of April.    

 The trade surplus and valuation alone should have generated a reserve increase of close to $20b.  Add in a typical month’s FDI inflows and ongoing hot money inflows, and I would have predicted a total closer to $30 billion. 

So why was China’s reserve growth “only” $20 billion” in April?

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A soft landing means sustained $1 trillion plus (7% of GDP) current account deficits …

by Brad Setser Tuesday, June 27, 2006

Over the past few years, US imports have grown faster than US exports.  The result — to no one surprise: an expanding trade deficit.    Because of the gap between imports and exports, US exports need to grow around 60% faster than US imports to keep the deficit from growing.  Even if you exclude oil, that hasn’t happened on a sustained basis.   

The trade deficit grew even as the dollar slumped v. the euro.  That doesn’t mean that changes in exchange rates don’t matter, as some argue.  Recent US export growth has been over 10% — well above its long-term average.  The dollar’s slide (and Boeing’s recovery) is central to that.    But import growth was still stronger than export growth. US demand growth has propelled global demand growth, and foreign producers have captured a large share of the increase in US demand. 

What hasn't happened?  At least not yet?  Interest payments on the United States growing stock of external debt haven't contributed to the growth in the current account deficit.  Yhe US income balance probably is mismeasured – something Daniel Gros has emphasized.  The reported return on foreign direct investment in the US is a bit to low to be believable.  But even with adjustment to correct for the differences in how reinvested earnings on FDI appear in the data, the US income deficit hasn’t grown even as US external debt has increased.  

Why?  Largely because the average interest rate on US external debt has fallen.  The interest rate on interest bearing debts fell above 6% in 2000 to around 3% in 2003 and 04.   That drove the average rate the US pays on all its liabilities – including foreign direct investment – down as well.  That started to change in 2005 – and, in my view, a growing deficit on income payments (think interest on the US debt) will start to drive the expansion of the US current account deficit.   

That is one place where I disagree with Richard Berner.  I don't think the improvement in the income balance in the first quarter of 2006 is sustainable.   And I looked at it in some detail.  The increase in China's May trade surplus and Japan's May current account surplus may also tell us something about the course of the US trade deficit.  Finally, I worry that the fuel that the dollar's past decline has provided for export growth is beginning to run out — and that without further declines in the dollar, current, strong US export growth won't be sustained.   Should US demand growth slow, the world may slow too … slowing US export growth absent further dollar declines.

More generally, the dynamics of adjustment are likely to be daunting — something I explore in some length below (with a couple of graphs)

The following graph shows what happens if the pace of import and export growth moderate a bit – and both retreat to their long-term averages.   As a result, the expansion of the US trade deficit slows.    But the expansion of the US current account deficit doesn’t slow.    Existing debts get repriced at higher interest rates as they come due.  And borrowing $1 trillion a year at 5% plus starts to add up.

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Only some emerging market currencies have corrected this year.

by Brad Setser Sunday, June 25, 2006

Emerging market economies with overvalued currencies now – generally speaking –have less overvalued currencies.   The Turkish lira was too strong at the beginning of the year.  Turkey’s current account deficit was big, and set to get worse.  Folks found ways to rationalize it:  using unit labor costs rather than prices, the real exchange rate wasn’t really at a historical high, exports were still growing and so on.   But the lira was pretty clearly overvalued – even if the precise trigger than would prompt a correction wasn’t.

Turkey isn’t alone.  As Steve Johnson of the Financial Times noted, this past week the currencies of most emerging economies with large current account deficits tumbled.  Call it differentiation.   It wasn’t good for those holding Turkish lira.  Or Hungarian florint.  Or South African rand.  

Or for that matter Icelandic Krona and New Zealand dollars, even if neither Iceland nor New Zealand is an emerging economy.

Who isn’t on this list even though its fundamentals suggest it belongs?  Lex nailed it.  The United States.   The current real value of the dollar is such that the US trade deficit should expand with normal rates of US and world growth.  

What hasn’t happened this year?   Overvalued emerging market currencies have fallen v. the dollar, but undervalued emerging market currencies haven’t risen. 

China continues to experiment with variants of 7.99x.    Chinese authorities plan to cross the river by touching every pebble.   The Saudi riyal hugs 3.75, no matter what happens to the price of oil.   Both China and Saudi Arabia have big and growing current account surpluses.

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Hmmm. Iran isn’t like other oil producing countries …

by Brad Setser Friday, June 23, 2006

Iran has a bit more interest than average in nuclear power.    Setting Russia aside, of course. 

And Iran is actually spending its surging oil revenue rather than salting most of it away, unlike most other oil states.

The fact that Iran keeps its domestic petrol price very, very low doesn’t differentiate it from other oil producers.  Nor does the fact that it has to import refined product. Iraq also sells imported "product" at a very low price.  Even with an IMF program and lots of advice on economic management from the US.  

All big oil producers tend to sell petrol at artificially low prices – it is one way of sharing the oil wealth with the people.   The real outliers are oil-consuming countries like China that subsidize (rather than tax) petrol.   What differentiates Iran is that it has a lot of people relative to its oil – so demand for cheap oil is higher than in say Saudi Arabia.  

Yesterday’s Wall Street Journal article reminded me of one of the more surprising outcomes of the survey of  the spending – really importing – patterns of the big oil producers than Malcolm Easton and I did as part of our work on the oil surplus (alas, that paper is not something I can give away).    It turned out that Iran was at the top of the league table when it comes to oil spending – ahead of even Venezuela.     Ahmedinejad isn’t just emulating Chavez, as the Wall Street Journal argues. 

Mr. Ahmadinejad is emerging as an Iranian version of Venezuela's Hugo Chávez: a pugnacious politician, buoyed by oil money, whose anti-elite message and defiance of the West is causing his popularity to soar.

Iran is setting the pace – topping Chavez.  Iran spent 64% of the increase in its exports revenue between 2002 and 2005 on imports ($18.6b of $29.1b). Venezuela lagged a bit, spending only 56% of our estimate of the increase in its export revenues on imports ($11b of an estimated $19.6b increase). 

Iran stands in stark contrast with its neighbors to the south.  Most Gulf oil states are importing (and basing government budgets) as if oil was at roughly $30 a barrel.   See the IMF’s quite good Middle East Regional outlook.

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So, is Michael Mandel right? Did intangible income (dark matter) ride to the rescue in the first quarter, offsetting rising US debt?

by Brad Setser Wednesday, June 21, 2006

As Michael Mandel has noted, the US income balance improved in the first quarter – contrary to the expectations of “pessimists” like me.  I would say “realists” – rising debt usually implies rising interest payments – who expected the US income balance to deteriorate.

The income balance is the difference between what the US earns on its overseas assets (US direct investment abroad, US lending to the world) and what it pays on its liabilities (foreign direct investment in the US, US borrowing from the world).   

Certainly the improvement in this balance in the first quarter is consistent with one of the core predictions that Hausmann and Sturzenegger made – namely that the net income that the US earns from its investment abroad  — all those intangible assets — would continue to rise, offsetting rising interest payments on growing debts.    That is exactly what happened in the first quarter.  Anualized, the first quarter data suggest that the US earned $172b more on its direct investment than it paid on foreign direct investment in the US.  That is up about $30b from the 2005 total.   A nice little gain.   Something like $600b in new dark matter, to use Hausmann and Sturzenegger’s terminology.  And US net interest payments hardly rose at all – they went from $161.6b in 2005 to $162.5b (annualized) in q1.   The paid more on its debt, but it also earned more on its lending …

On the surface, it certainly fits the dark matter story.  Michael Mandel noted (in a comment on my post) that Goldman must have earned a ton of money abroad in the first quarter … all sorts of intangible trading profits.    But is it so?     What does the more disaggregated data tell us?  Lots of charts and graphs follow.

First, the balance on FDI — which accounts for the majority of the income flows from US equity investment. 

Let’s divide FDI income into two components – dividend payments and reinvested earnings.  Dividend payments are real flows, cash that moves across borders.  Reinvested earnings are virtual flows.   Income from say US investment in Ireland is theoretically paid to the US foreign company and the parent company then uses those funds to invest in its Irish operations (something that it does, of course, for reasons utterly unrelated to Ireland’s low tax rate on corporate profits).   No money actually crosses any border.

 As Daniel Gros of CEPR has noted, there has been a consistent gap between the amount US firms reinvest in their operations abroad, and the amount foreign firms reinvest in their operations in the US.   That gap remains – though in 2006, both foreign firms and US firms seem to be reinvesting a bit more than in the past.    Q1 data has been annualized for the sake of comparison.

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Paging Edward Hugh: Demographics do not explain the recent rise in Chinese savings

by Brad Setser Monday, June 19, 2006

Louis Kuijs’ latest analysis seems to suggest – based on my reading — that three common perceptions of China are more myth than reality.    

Myth one: foreign direct investment has been a big driver of China’s growth.   

The reality: most investment in China has been financed domestically.   FDI accounts for no more than 10% of total investment.    That is consistent with the analysis in Goldstein and Lardy’s critique of Bretton Woods 2 as well.   Obviously, that FDI is concentrated in China’s export sector, so foreign firms account for a much larger share of exports than of total investment.     

Analysis based on the total amount of FDI may understates its impact, as innovations that start with foreign firms diffuse through the economy.

But there is little doubt that most investment in China is financed domestically.  FDI this year will probably by something like $70b or so.  That is small relatively to the $1300b in total investment that Stephen (a bit more bearish once again?) Roach expects in China this year. 

Myth two:  China’s state banks do little more than finance investment by China’s unprofitable state-owned enterprises.

The reality: There is some truth to the argument that state banks finance money losing state owned enterprises.   But it also may be a somewhat dated argument that ignores some recent reforms.  Jon Anderson of UBS consistently argues that there reforms have increased the profitability of (many) Chinese state firms.   And Kuijs’ data suggests China’s increasingly profitable state-owned enterprises finance lots of investment out of their own retained earnings, without having to turn to the banking system.   A surge in business savings, according to Kuijs, is why overall national savings have risen so strongly in the past few years.  Some of that surge comes from a surge in private profits.  But a decent chunk of it comes from a surge in the profits of state-owned companies.   And rather than paying out dividends, state-owned enterprises plow their current profits into new investments.

Incidentally, some of the big state commercial banks seem to have been rather active in the mortgage market recently.

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A hard landing in 2006 – just not in the US?

by Brad Setser Sunday, June 18, 2006

Nouriel and I postulated back in early 2005 that there was a meaningful risk that the next “emerging market” crisis might come from the US – and it might come sooner than most expected.   The basic quite simple: Ferguson’s debtlodocus might find that it no longer could place its debt with the world’s central banks, the dollar would fall, market interest rates would rise, US debt servicing costs would go up, the economy would slow and the value of a host of financial assets would tumble.    

Why the emphasis on central banks?  Simple: they have been the lender of last resort for the US, financing the US when private markets don’t want to.  See April 2006.  Consequently, a truly bad scenario for the US seemed to require a change in central banks’ policies.   Real emerging markets aren’t so lucky.  When private markets don’t want to finance them, they typically aren’t bailed by someone else’s central bank.  

It sure doesn't look like sudden stops in financial flows and sharp markets moves have been banished from the international financial system.   Certainly not this year.  They just didn't strike the US, but other countries with large and rising current account deficits. 

Iceland’s currency is way down (its stock market too) even though interest rates on Icelandic krona are up.   The private market’s appetite for krona disappeared.     

Inflation is up too, driven by the weak krona.

The Turkish lira is way down.  Lira interest rates are way up – as is Turkish inflation

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The first quarter current account statistics are kind to the USA

by Brad Setser Friday, June 16, 2006

The 2005 current account deficit was revised down to $791.5b or so.

The q1 2006 deficit was $208.7b — down from $223.1b in q4.   We knew the trade balance improved a bit.  But the income balance also improved, contrary to my expectations.  And the transfers deficit went down.

To my surprise, net official flows (recorded central bank flows) to the US in 2005 were revised down, to $199.5b.   Adding in the growth in central bank dollar deposits in the BIS data increases the known increase in dollar reserves by $80b or so.  But $280b in dollar reserve growth is very, very small relative to my and most other estimates for the total increase in official assets in 2005 — which, including all Saudi central bank assets, likely topped $650b.  Something still doesn't add up.

Here though the Q1 data makes more sense.  Recorded official inflows to the US were nearly $75b.    FDI flows also reversed.  In 2005, inflows into the US topped outflows by about $100b.   Thank you Homeland Investment Act.   Outflows dried up.   In q1, outflows once again topped inflows by about $30b.   That increased the US borrowing need …  

So what happened to the income and transfers balance.    

I need to dig a bit more, but it seems like US government aid flows fell by $4.3b, improving the transfers balance.  Is this result of the end of the big aid package for Iraq?  Perhaps.   Private transfers were also on the low side for a non-hurricane quarter.

On the income side, payments of interest and dividends increased by about $9.3b — but US interest and dividend receipts increased by $7.1b or so, limiting the damage.  I suspect the fact that most US lending abroad is very short-term is helping the US here, as US lending "reprices" faster than US borrowing.  

But the big gains came from foreign direct investment.   The earnings of US firms abroad increased by $2.6b in the first quarter (v. q4).   But even more importantly, the earnings for foreign firms fell by $3.7b.    The net swing was $6.3b or so — overwhelming the US interest bill.

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