Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Growth slowing, oil rising … not good

by Brad Setser Monday, July 31, 2006

If Roubini  hasn’t done enough to convince you that the US is at risk of a slump … check out Calculated Risk.   A big fall in residential investment would put something of a dent in the US economy.

And perhaps the global economy as well.   Like Dr. Roubini, I am not convinced that Chinese growth is entirely independent of US growth.    China may be more like Mexico than many think.  Exports to the US (using US import data) account for over 10% of China’ GDP now.  Sure, lots of Chinese exports come from the reprocessing trade – importing parts for final assembly.  But Mexico does its own share of reprocessing as well.

It is enough to make me wonder whether oil should be trading at $70 plus.   Particularly with high inventories in OECD countries.   And by some accounts (notably that of Ben Dell of Bernstein Research), global spare capacity is beginning to rise.  Check out the Capital Spectator’s post on fear v. fundamentals – it is my source.

But then, well, pick up a newspaper.   The Levant doesn’t have oil.  The Gulf does.  But the big players in the Gulf have a range of interests in the Levant.  And the Gulf itself has no shortage of flash points.

Even Iraqi seems to be producing a bit more (p. 31 of the Iraq index).  Official exports may be up too, in part because unofficial exports are down.  The FT reports on Iraq’s new oil for fish policy:

(Mr Shahristani) said that the government had managed to curb smuggling by reducing subsidies – a policy initiated last year and which is expected to lift the budgetary burden on Iraq’s government, which spends several billion dollars a year to import refined products.

…. His ministry has also reduced fuel rations to Basra’s fishing fleets, who take it down the Shatt al-Arab waterway to the Gulf to sell – a policy enacted under Saddam Hussein’s government to encourage sanctions-busting smuggling. Basra fishermen freely admit that they make far more from the trade than from fishing.

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Russia’s central bank deserves some serious credit

by Brad Setser Monday, July 31, 2006

Many central banks still don’t report their total reserves in a timely manner.   Many also emerging markets go to great lengths to hide the currency composition of their reserve portfolio.   Most don’t provide data on the currency gains and losses.

Not Russia.  It is about as transparent as anyone about its reserves.  

It reports its reserves data every week, and with only a short lag.    And I just discovered, it also publishes data on the Bank of Russia’s valuation gains and losses (The RBI and Bank Negara Malaysia do as well).

That is a good thing.   More folks should do it.   Even if it makes it easier to infer the currency composition of your reserves.    Central banks should be disclosing more data about that too. 

I do have a bit of egg on my face though.  I have spent a fair amount of time trying to guess the currency composition of Russia’s reserves

And I wasn’t making use of the data on valuation gains and losses that the Bank of Russia put out on its web site.  The data appears under the heading the “international investment position of the international reserves of Russia.”  That data is a big help.

In both q4 2004 and q2 2005, the scale of Russia’s valuation gains (losses) are consistent with holding about 30% of its reserves in euros and currencies that move in tandem with the euro.  Surprisingly, the same is true of q1 2006

The US data led me to expect that Russia had diversified a bit by then.  But the euro’s q1 move came early in the quarter, in January.  Russia may not have really started to increase its euro and pound holdings til a bit later in the quarter.  So it isn’t a great test. 

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The premier speaks, the analysts listen …

by Brad Setser Friday, July 28, 2006

I no longer will be able to make fun of China for letting its exchange rate float between 7.991 and 7.999.   The RMB is now toying with 7.97

China’s top leadership now seems convinced that maybe they should allow a bit more appreciation in the face of clear evidence the economy is overheating.   After Wen’s speech, China watchers in the market (the new Kremlinologists?) now forecast that China’s rate of crawl will accelerate.    That apparently is what Wen’s call to “improve the formation mechanism of the renminbi’s exchange rate in order to gradually increase [its] flexibility” means.

I certainly hope so.   And not just because Schumer and Graham’s bipartisan bill almost certainly will come up for a vote this fall at a time when the US economy is slowing.    A stronger RMB is in China’s own interest.  If nothing else, it would lower the RMB cost of China’s imported oil … 

Yu Yongding, my favorite Chinese policy maker – OK, given the constraints on the central bank, he is probably more accurately described as someone close to the circles that make policy – is leaving the PBoC.   Too bad.   And not just because Yu is generally good for a quote.  He also had a pretty clear idea where Chinese policy should be heading.    Still does:   

““We now have a relatively favourable opportunity to let market forces determine the yuan’s exchange rate,” Yu, head of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, told Reuters in an interview

(Hat tip, Survived Sars

Though no matter how much China lets the RMB creep up, my sense is that the maximum politically acceptable appreciation is still too small to offset the market pressures for appreciation coming from a $200b current account surplus (rolling 12 month trade surplus is now well above $120b – and it looks to be rising) and substantial net capital inflows.    A small rise in the RMB won’t immediately slow China’s rapid pace of reserve growth.

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And the money keeps rolling in …

by Brad Setser Thursday, July 27, 2006

Russia’s reserves are up $12.3b in the first three weeks of July.    Expect a $15b increase this month.  I like to check on Russia because it reports its reserve growth on a regular basis (unlike some; the Saudis haven’t released their end June data) and because it has a ton of oil and gas.   So it is decent proxy for the growth in oil state foreign assets.  Reserve growth is the sum of the current account and capital account, and Russia does not attract private inflows.  But let's asume the current accout explains the entire $15b expected July increase.

Russia accounts for roughly a quarter of the total production (around 40 mbd) of the main oil exporting regions and countries.   The US and China obviously produce some oil of their own, but they are equally obviously net importers of oil.   Russian exports are substantially lower than its production, but it also exports a lot of gas.   So it isn’t a bad proxy for the oil exporting world. 

Multiplying Russian reserve growth by four consequently generates one estimate for the increase in the foreign assets of the big oil exporters.    $60 billion is real money.    Some of it shows up in central bank reserves, some of it is hidden in the offshore accounts of the big state oil companies, some shows up in various countries (non-reserve) oil investment funds and some is hidden in offshore accounts of other kinds. 

There is another way to get a $60b estimate.    Assume that the oil states are spending producing 40 mbd for export, selling that oil at $75 and spending $25.   $25 is actually about right for spending – budgets haven’t been adjusted up.     Some spend more, but some still spend less.   40 mbd*30 days*$50 net savings per barrel = $60b a month.

How did I get 40 mbd in oil exports?  From the supply and demand data in this IEA report, I calculated that Russia and Central Asia (the former Soviet Union) exports a bit over 8 mbd, the Middle East and Latin America (OPEC+non-OPEC Middle East + non-OPEC Latin America) export around 29 mbd and Africa produces 4.1 mbd – and probably exports a good chunk of it (I didn’t find African consumption numbers).  It works out to around 40 mbd. 

And that leaves out Norway.

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Is Saudi Arabia the new IMF?

by Brad Setser Wednesday, July 26, 2006

Last week I was beginning to think the IMF might be back in business.   A couple of press reports hinted that Lebanon’s central bank was facing real pressure.    Folks fleeing the country wanted dollars.  Dollars cash.   Not dollar, or Lebanese pound, bank accounts.  

And Lebanon’s tenuous financial stability hinged on growing deposits – not shrinking deposits.  Lebanese banks take in dollar deposits by offering a slightly higher interest rate than you can elsewhere (and take in pound deposits by offering a higher interest rate than they offer on their dollar deposits).   And then they lend those dollars to the government for a profit, financing the country’s fiscal and current account deficit in the process.

Right now, though, Lebanon’s reserves are shrinking.    That usually means a call to the IMF.  

Unless you can call the Saudis instead.  Saudi Arabia’s central bank now has about as much hard currency as the IMF (SAMA now has around $190b in foreign assets).   And it tends to lend it out to its friends in the region on somewhat more generous terms.    Lebanon got $1b in cash (along with a commitment of $500 million for future rebuilding).  

I suspect it will need a bit more.  To prevent an old fashioned bank run as well as to rebuild (eventually).   

Lebanon was effectively bankrupt even before the current conflict.  Its debt to GDP ratios are obscene – the government’s $40b of total debt doesn’t seem like much, but it is around 150% of Lebanon’s GDP (See the IMF’s Staff Report).  Lebanon has long been the country that should have had a crisis but didn’t.  Largely because bank depositors never ran, in part because Lebanon has a history of paying its debts.  But it is all a bit circular.  Lebanon only could pay its debts so long as depositors didn’t run.  A bit of Saudi help at crucial points in time also helped a lot.

Back in 2002, when Lebanon was in a bit of trouble, Lebanon got a French/ Saudi bailout.  The so-called Paris II deal provided Lebanon with $4b in financing, in return for Lebanese pledges to reduce its fiscal deficit.  The IMF’s terms would have been a bit more onerous.   At the time – it was just after Argentina – the IMF was rather concerned about injecting tons of money into countries with way too much debt.  It was supposed to bail out the illiquid, not the insolvent.  Lebanon got its banks to pledge to help out by deferring a few payments, but it wasn’t much.

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A trillion dollars does tend to concentrate the mind …

by Brad Setser Tuesday, July 25, 2006

Statistical agencies usually are not the authoritative source of information on a country’s reserve portfolio.  Nor do they usually comment on exchange rate policy or the investment decisions of a country’s firms.  But then again China may be different.    

There is no doubt that China would love to see its companies invest more abroad, slowing its reserve growth.    And China clearly has figured out that buying an asset that is likely to decline in value has a cost, even if the carry is positive.   That said I am more confident that the RMB will rise in value v. both the euro and the dollar over time than I am that the euro will rise (further) in value v. the dollar. 

It does seem like the amount of noise about China’s reserves has picked up recently (hat tip Macroblog).  I don’t think it is entirely random noise either.  I suspect – without knowing – that there is an active debate inside China’s leadership about Chinese reserve growth.

A trillion dollars is just a number.  But it is a big number.  And a big milestone.   By my count China already has over a trillion dollars in reserves and reserve-like assets.  But I am counting the funds the PBoC shifted to the state banks.   In a couple of months, though, China will formally announce that its reserves now top a trillion dollars.   So it isn’t exactly a surprise that Chinese policy makers would be spending a bit of time thinking about how to use those funds.

The key fact for the global economy is not that China holds a trillion dollars in reserves.  It is that those reserves are growing at a pace of around $20b a month/ $250b a year.   This reserve increase has continued even as interest rate differentials have moved steadily in the dollar’s favor.   China constantly struggles not just to invest its existing reserves productively, but to find new places to park its ever growing reserves.

Right now, there is no reason to think that China won’t have $1,500b in reserves in about two years time.   Not unless Chinese policy makers show an ability to act far more decisively than they have so far. 

$250b is a lot of money to invest every year.    I suspect there are some constraints on how China can invest it.  There aren’t many – strike that, there aren’t any – emerging markets that could absorb inflows on that scale.    Modest sized industrial economies like Australia and the UK are also too small to absorb more than a small fraction of the total.    Look at their respective current account deficits in dollar billions.   

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Dwindling foreign demand for Treasuries …

by Brad Setser Monday, July 24, 2006

Floyd Norris of the New York Times highlights something that was also on my radar screen:  a sharp fall off in foreign demand for US treasury bonds. For the first time in years, the US budget deficit is being financed by domestic investors.

Foreign inflows to the US haven’t fallen off, to be sure.   But the composition of these inflows has changed.  Foreigners are buying more agencies and US corporate debt and fewer Treasuries.  First quarter data is here; the TIC data from April and May do not indicate that the story has changed. 


Well, one theory is that foreign central banks have stopped financing the US.   I don’t believe that.  I do believe that the set of central banks now adding to their reserves is far different than the set of central banks adding to their reserves in 2003 and 2004.  Oil exporters have replaced Japan and (to a lesser extent) many Asian countries other than China.    And as I almost constantly note, the oil exporters generally don’t show up in the US capital inflows data directly.   Their presence is felt, but not directly observed.

In 2005, there was a sharp fall in (recorded) central bank demand for Treasuries, a fall off the coincided with the end of Japanese central bank purchases in the fall of 2004 (it took Japan a while to place the huge sums of dollars bought in late 03/ early 04 in the bond market).   However, there was no fall-off in overall foreign demand for Treasuries.   Some of that demand came from the Caribbean – think hedge funds.  But lots came from London – think oil state central banks and investment funds. 

In 2006, both central banks and private (or not so private) investors abroad stopped buying Treasures.   What happened?     Here is my guess:

  • Caribbean holder of Treasuries sold in the first quarter.  Net sales were around $8.5b.  See the Treasury bulletin.  Hedge funds unwinding curve flattening trades?   
  • Some oil exporters reduced their Treasury purchases.   Russia isn’t the culprit: it never bought treasuries, only agencies for some reason – but it has reduced its agency purchases this year.     But the others must have shifted their portfolios around a bit – either buying more agencies and corporate debt, or just parking their cash in bank deposits.  Don't look in the offiical data to confirm this — OPEC holdings of Treasuries are up.  But the total observed flows here are so small relative to the oil surplus that it is likely that most of these flows show up in the data from London.  Looking only at what shows up in the US data as "OPEC" holdings can be misleading.
  • Some central banks may have opted to hold short-term t-bills rather than longer-term bonds.   Though the TIC data doesn’t support this story in the aggregate – there hasn’t been a surge in overall central bank holdings of Treasury bills.
  • Norway sold.
  • Japan seems to be shifting its reserve holdings slowly out of the Treasury market and into the Agency market.  At least that is my interpretation of the data from the New York Fed’s custodial accounts.  Look at the 52 week changes in Agency and Treasury holdings.  This story is supported by the q1 data in the Treasury bulletin: Japanese investors sold $19b of Treasuries and bought $11b of agencies.  That data aggregates the activity of the central bank and private investors, but it is suggestive. 

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Adding to echo chamber started by the New Economist, with a bit on China thrown in

by Brad Setser Friday, July 21, 2006

I second the New Economist’s description of Tim Duy as the John Berry of the blogoshere.   I thought Tim retired from Fed Watching when he moved to Oregon, but the internet gave him a second life … 

I personally am more of a reserves watcher.   Rather than recite my usual litany of complaints about some central bank policies , I’ll just follow the New Economist’s lead for a second time and link to the Roubini/ Atlig econoblog on China's peg. I tend to side more with Roubini than Altig (surprise, surprise) – though I still am not quite sure why Nouriel thinks China will do a step revaluation now (read Survived Sars) …  there are other ways to get a bit of a revaluation if China so decides. 

I do share Altig’s sense that not much has changed since last summer.  At least so long as he is referring to the policy debate.  China certainly has changed.   The evidence that China is over-heating seems a quite a bit stronger.  I wonder if China’s decision to scale back its sterilization last summer had something to do with the current bout of activity.  China has indicated that it scaled back sterilization in part because it wanted to drive down domestic interest rates to deter speculation.  But perhaps China was also worried that the small revaluation would slow the economy. 

If China did want a bit of offsetting monetary stimulus, they may have gotten a bit more than they bargained.  The line of the week comes from Stephen Roach – Morgan Stanley’s resident former bear.  

Roach’s new found optimism (at least as much as is left) stemmed from confidence that central banks were taking imbalances seriously.  But he doesn’t seem to have much confidence in the PBoC’s ability to reign China’s economy.   Roach:

Most believe the People’s Bank of China will lead the charge in acting to slow the Chinese economy.  I don’t.  

The PBoC’s influence is limited, whether by political constraints that keep it from using the policy tools it has (interest rates, exchange rates), limits on the effectiveness of those tools in China’s unique context or a bit of both.

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Is bad news for the world good news for the dollar …

by Brad Setser Thursday, July 20, 2006

I have long been puzzled by the notion that the currency of a country with a 6% of GDP trade deficit and a 7% of GDP (maybe a bit less in q1 … ) constitutes a “safe haven.”   Safe havens are supposed to have rock solid financials.  And it is pretty clear to all but the true believers in dark matter that the US dollar has to depreciate (particularly against the currencies of the emerging world, not a relic index like the DX) at some point to reduce the US trade deficit.   

I suspect Bankim Chadha and Jens Nystedt of Deutschebank (full disclosure: Jens is a friend from my DC days) are also puzzled. 

They decided to test the proposition that the dollar is a safe haven during times of stress (no link because it DB prop content).   They defined stress as equity market volatility.  Obviously, there are other potential definitions of stress.   

But the logic behind testing for a correlation with equity market volatility is pretty straight forward.   Equity markets tend to be correlated, and the US equity market tends to be less volatile than most. 

It turns out that there is a correlation between equity volatility and dollar moves (on the Fed’s index) in the daily data – at least over the past ten years.    That makes intuitive sense to me.    The big fall in dollar (02-04) came during a period when equity market volatility was generally declining.  And the big rise in the dollar (95-02) came during period when there was a fair amount of volatility.

But Chadha and Nystedt didn’t stop there.  They looked further back – way back.  And they discovered this effect is a rather recent phenomenon.   During past periods of adjustment, equity volatility wasn’t good for the dollar …  

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Chinese growth accelerates, RMB depreciates

by Brad Setser Wednesday, July 19, 2006

That was yesterday’s headline.   Or, given the time differences, perhaps the headline from two days ago. Chinese second quarter growth picked up to 11% plus.  The only real surprise here was that the Chinese government reported an acceleration rather than a smoothed number.   And the RMB moved back into the 8s on Tuesday and started Wednesday there as well.    The basket peg you know.  If the dollar appreciates v. the euro, the RMB needs to depreciate.  China has to make sure its products are competitive in Europe. 

I am not sure where to begin.   

Survived Sars lays out why China would be well served by RMB appreciation.    Yu Yongding has made the case as well.    And I am pretty sure he has a line into the PBoC.  

There is now even a bit of price pressure in China.   Inflation remains well below US levels, but it is creeping up …  for all the talk about how China’s integration into the global economy would be deflationary, right now China sure seems to be putting upward pressure on prices globally.

And who knows, with the anniversary of the RMB’s initial step revaluation approaching on the 21st, China might even surprise us — despite their promises not to.   But if they did, I would really be surprised.   The striking thing to me – and many others – is that China hasn’t made use of the flexibility that it created over a year ago. 

Another striking thing – at least to me — is the extent that the policy process remains paralyzed inside China.    George W. Bush’s foreign policy seems to be to be premised on not making hard decisions and hoping Iraq (maybe the entire Middle East?) becomes someone’s problem in 2009 – while praying that the financial flows needed to sustain a no-savings economy don’t give out in the meantime.   China’s exchange rate policy seems kind of similar.    Do nothing (Ok, fiddle around the edges) and hope the problem – the pressures that rapid reserve growth places on China’s domestic financial system, no matter how hard China tries to limit or suppress these pressures with administrative measures — goes away.

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