Brad Setser

Brad Setser: Follow the Money

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Poor countries financing rich countries watch

by Brad Setser
September 14, 2006

Table 1.2 of Chapter 1 of the WEO makes one thing abundantly clear. 

When the IMF talks about the need for investors to “increase the share of their portfolios in US assets for many years” (p.16) in order to avoid nasty slum, they aren’t really talking about private investors.

OK, private investors need to be willing to continue to hold onto their existing exposure to the US.  And that may be a challenge.

But the new financing the US needs to sustain large current account deficits – at least right now – is now coming overwhelmingly from the governments of the world’s poorer countries.   Private investors the world over are quite willing to finance the emerging world.   Only the intervention of the governments of the emerging world turns these private flows into the emerging world into massive net capital outflows out of the emerging world.

Let’s go to the data tables.   And yes, I am the kind of guy who looks forward to reading the data tables in the WEO … 

The IMF estimates the emerging world will add $666b to its reserves in 2006.  And there will be another $239b of “official outflows” from the emerging world.  Some of that will come from paying back the emerging world’s debts to the IMF, to the World Bank and to the Paris Club.   But most of it will come from oil investment funds and the like.    The net outflow from the emerging world’s governments will be around $905b.

$905b is real money.  It is about the size of the US current account deficit. 

How did the emerging world generate enough money to finance the US deficit.   Two ways.  With a current account surplus of $666b.   And with net private inflows of $211b.  Those private flows are important, since they demonstrate that private capital still flows downhill … from the rich to the poor.   The uphill flow of capital comes entirely from the policy choices made by governments.

Compare that to 2001.  The reserve build-up then was only $122.  Add in $3b in net official outflows, for a total outflow from the governments of the emerging world of $125b.

That was financed by a current account surplus of $87b and net private inflows of $65b – a total of around $150b.  The totals don’t quite match because of errors in the global balance of payments data.    

2001 wasn’t entirely atypical either – 2000 and 2002 don't look all that different.   The governments of the emerging world were building up their external assets then too, but the annual increase was in the $150b to $200b range.  Not in the $900b range.  

The defining feature of the world economy since then has been the huge surge in official outflows from the emerging world.   And the huge surge in the current account surplus of the emerging world – a surplus that the world’s financial markets transformed into a surge in investment in residential real estate in the world’s advanced economies. 

Much as I enjoy the WEO data – there really is nothing comparable – I couldn’t help but notice that the IMF forecast for China’s current account surplus ($185b) is too low.   Its forecast for the eurozone’s deficit also looks a bit low.    

One reason why China’s overall export growth hasn’t slowed even as the growth in US imports from China have slowed (and the pace of deterioration in the overall US trade deficit slowed) is that European imports from China picked up and the European (either Eurozone or EU-25) current account deficit grew.   A small widening of the European deficit allowed the broad surplus of the emerging world to keep growing even as the pace of deterioration in the US deficit slowed a bit. 

But the overall story of the past five years is overwhelmingly simple: the current account surplus of the emerging world soared even as private capital poured into emerging markets.  And the offsetting deficit is found almost entirely in the US. (Graph here)

Felix asks if “Could foreign official assets in the US start falling any time soon?”

My answer is that it is bloody unlikely.     

Central banks have been providing the US with between $400-500b of financing (in my estimation) of financing for the past several years.   Going from $500b to zero would produce a very hard landing.    Going from $500b to $200b would be enough, I think, to produce the dreaded hard landing.

The IMF estimates $750b in reserve growth in the emerging world in 2007.   That seems about right to me.    And it seems rather unlikely that all $750b would go into euros. 

That said, Europe does play an important role as a financial intermediary.  In 2005, both the eurozone and the UK attracted bigger gross inflows of capital than the US.  See the statistical appendix of the IMF’s global financial stability report.  Those inflows were just offset by big outflows.  More on that later.   

My baseline scenario is that the only way global imbalances unwind in an orderly way is if the same folks who financed the expansion of the US deficit end up financing the slow and orderly contraction of the deficit.    

That’s the rub.  Financing the expansion of the US deficit generated all sorts of fun for the emerging world.    Hell, it might even have produced a cover jinx.   

I suspect financing the contraction of the US trade deficit (and the rise in US interest payments to the world’s central banks and oil investment funds) won’t be half as much fun.   Rather than subsidizing the growth of their export sectors, some countries may end up having to provide even bigger subsidies to the US than they do now just to keep their export sector from shrinking …

34 Comments

  • Posted by Guest

    “America will be the most powerful FDI magnet this decade, whereas emerging markets will be disappointing.”
    http://www.economist.com/agenda/displaystory.cfm?story_id=7927354
    http://www.economist.com/markets/indicators/displaystory.cfm?story_id=7912872

  • Posted by Movie Guy

    FMC:

    Black Friday kicks off at 7 AM (EDT).

    More general news here. And sales information.

    Mexico bound.

    >>

  • Posted by Guest

    U.S. TREASURY EX-CHIEF SUMMERS and a Bank of Korea official told some emerging-nation central bankers to consider more-lucrative investments.

    Asia’s emerging economies will grow 8.3% this year and 8.2% in 2007, faster than forecast earlier, the IMF said.

    China will adjust its tax system to effectively discourage exports of some low-end products such as cigarette lighters and clothing and encourage exports of more sophisticated information-technology goods and heavy machinery.

  • Posted by Guest

    Bad news for the IMF is good for its clients
    http://www.ft.com/cms/s/b0203b1a-4283-11db-8dc3-0000779e2340.html
    “As Frederic Mishkin of Columbia University, now a governor of the Federal Reserve, argues in an important new book, foreign capital can bring big gains at the microeconomic level: more competition, new technology and modern managerial know-how. Inflows of foreign direct investment into the financial system itself are particularly valuable to an emerging country…which are incapable of allocating capital inflows successfully.”

    Do not spend the global dividend
    http://www.ft.com/cms/s/33f0b15a-4350-11db-9574-0000779e2340.html
    “In countries such as the US, strong domestic financial markets have helped finance innovation and reallocate resources to the most productive sectors. New financial products have allowed consumers to borrow against future incomes and consume immediately. These countries have run current account deficits, largely financed by countries whose less sophisticated markets have been less able to translate growth into domestic demand. What could mar this rosy picture? … In the name of national advantage, politicians are once again ensuring collective disadvantage.”

    Calpers to invest in infrastructure
    http://www.ft.com/cms/s/a6d9bf7c-4378-11db-9574-0000779e2340.html
    “The move [...] underlines the growing appetite by public funds for alternative investment strategies as their traditional domains of bonds and equities have struggled to deliver the returns needed to meet expanding pension liabilities. However, in the first detailed outline of their commodity strategy Calpers executives this week stressed the fund would not follow hedge funds and other short-term investors that have been active traders of physical commodities and derivatives.”

  • Posted by Guest

    hedge funds now generate 45% of annual trading volume in emerging market bonds, 47% of annual volume in distressed debt, about one-third in leveraged loans and one-quarter high-yield bonds”

  • Posted by Guest

    GROUP OF SEVEN OFFICIALS are expected to warn China not to overload poor countries in Africa and elsewhere with high-priced loans — to promote purchases of exports — that they can ill afford to repay.

    Ugly face of China in Africa
    http://www.ft.com/cms/s/306bc11e-4350-11db-9574-0000779e2340.html
    “China must remember that delight among African dictators about unconditional Chinese aid is not always shared by ordinary Africans.”

  • Posted by Gcs

    this is for the high concept types

    imagine prc industries inc
    as one firm with many products

    all of which have declining marginal costs

    theory tells us then optimal pricing is below average cost

    maybe the prc is really losing money but thats optimal

    losing money because its carrying a dollar iou
    at twice its real value when fore sight
    shows
    dollar prices are going to soar
    once the rmb is properly valued

    its like loses written in invisible ink
    that will visualize when the ink dries in ten years
    but by then prc industrial base
    will be built and operating at a real profit

    its like a giant start up
    the stockholders invested will reap the benefit
    of the real value of the industrial base
    including the skilled work force
    so time after break even in 10-15 years

  • Posted by touche

    “Black Friday kicks off at 7 AM (EDT).”

    I don’t want to miss it. I’ll set the alarm.

  • Posted by MrBill

    We were clever
    Inward investment
    And foreign technology
    Begged, borrowed or stolen

    Learning from the land of the rising sun
    Starting from humble beginnings
    Climbing the value added ladder
    Like Rod Stewart, ignoring all the rules

    Kept our currency undervalued
    Undercut with Everyday Low Prices
    Closed down their manufacturing base
    Banked the export receipts

    Now we are number one
    Export more than they can afford
    Margins are zero and falling
    Environment spoiled, our people old

    We were too clever for our own good

  • Posted by Guest

    “…aside from Beijing court politics, the scandal has broader implications. As well as raising questions about the country’s pension system and nascent financial markets, it has become a symbol of the often questionable relationships between government officials and a new generation of millionaire entrepreneurs whose rapid wealth is based on impeccable connections… The scandal has also created doubts about the transparency of China’s commercial paper market, which only began last year…” http://www.ft.com/cms/s/9c3616e4-4380-11db-9574-0000779e2340.html

  • Posted by Guest

    “…In credit derivatives, hedge funds accounted for more than 55 per cent of all trading volume, including 60 per cent of the standard and most liquid derivatives contracts and one-third of volume in more complex structured derivatives products…. Overall, US fixed income trading was up about 25 per cent in the year. The importance of hedge funds as clients to the large investment banks has led some to drastically cut back on published research, instead seating desk analysts alongside traders to feed ideas to top hedge fund clients…” http://www.ft.com/cms/s/c5105816-4431-11db-8965-0000779e2340.html

    “…Mr Geithner echoed the position taken by Alan Greenspan… that the growth of private equity and hedge funds had helped to strengthen the efficiency and resilience of the financial system. But their ability to take on risk was constrained only by the returns required by their investors… The effectiveness of this market discipline may be compromised by “market failures” such as lack of information, incentive conflicts and moral hazard….” http://www.ft.com/cms/s/818c42c4-4456-11db-8965-0000779e2340.html

    “…Goldstein contends that his stock holdings are “trade secrets,” much like the protected formula used to make Coke. His application states that complying with the 13F rule “constitute(s) a ‘taking’ of (the fund’s) property without just compensation in violation of the Fifth Amendment to the Constitution.”…” http://news.yahoo.com/s/bw/20060913/bs_bw/pi20060913356291

  • Posted by Dave Chiang

    China Rejects U.S. Criticism on Currency
    http://www.chron.com/disp/story.mpl/ap/fn/4188995.html

    Beijing warned Washington on Friday that linking a dispute over its currency to the U.S. trade deficit would hurt both sides.

  • Posted by Movie Guy

    Ford Motor Company: Black Friday, 14 September 2006

    7 AM detailed news release: FORD ACCELERATES ‘WAY FORWARD’

    Supporting presentation: Slide show (36 page pdf)

    Next: 9-11 AM Webcast

    Webcast event link

    9:00 – 9:45 a.m. (EDT) Way Forward Acceleration Webcast: Members of Ford Motor Company’s executive management team announce details of the accelerated Way Forward plan.

    Approximately 9:55 – 10:55 a.m. (EDT) Media/Analyst Q&A: Approximately ten minutes after the conclusion of the presentation, members of the news media and investment community will ask questions of Alan Mulally, Mark Fields, Don Leclair and Mark Schulz.

    Note that approximately 14,000 salaried employees will also bite the dust, along with whatever number of Ford’s 75,000 UAW employees accept the buyout package. Perhaps 35,000 to 45,000 UAW employees max will exit, or something along those lines.

    Nine facilities will be idled and cease production through 2008, including seven already announced.

    Ford has announced plans to cease production at 16 North American manufacturing facilities by the end of 2012, including seven assembly plants.

    Automotive Components Holdings (ACH) will be sold or terminated by 2008. All employees are offered buyout packages.

  • Posted by Movie Guy

    That should read:

    Ford Motor Company: Black Friday, 15 September 2006

  • Posted by Movie Guy

    Nice post, MrBill.

  • Posted by Gcs

    mr bill

    china harvest moon
    have two sides

    nice picture dark side
    but
    what about bright side

    less fun to talk about maybe eh ??

    but still there

    in two words :

    human capital

    yes china will have
    a modern workforce
    reproducing itself
    that is treasure chest

    ——————

    ps:
    we not all old even then

    and btw
    to return from charlie chanese a mo

    pops dig it
    kids love pollution
    it be sexy

  • Posted by MrBill

    “Members of Ford Motor Company’s executive management team announce details of the accelerated Way Forward Plan.” The Final Solution? or Found On Road Dead?

  • Posted by MrBill

    “pops dig it
    kids love pollution
    it be sexy”

    investment bankers be sexy
    not because they be math nerds
    but multi billion dollar pollution problems
    deserve billion dollar solutions
    and all those bonuses too

  • Posted by Dave Chiang

    G7 Group led by Bush Administration blames China for Global Economic Imbalances
    http://www.businessweek.com/investor/content/sep2006/pi20060914_522985.htm?chan=globalbiz_asia_more+of+today%27s+top+stories

    My comment: While it has become politically correct for the Bush Administration to blame the Chinese for every economic problem on the planet, a devaluation of the US dollar versus the China yuan won’t address the fundamental economic deficiencies of the US Economy which include massive budget deficits, soaring health care costs, low saving rates, asset bubbles in Housing, foreign energy dependence, Wall Street fixation on short term profits, and low capital investment. In reality, the Chinese and American economies are held together in a Gordian Knot of interdependency that few appreciate. The virtuous cycle — the US buys goods from China while China lends the US the money to buy Chinese goods and imports raw materials from third countries, which it uses to make goods that it exports to the US — turns vicious with the US being unable to buy Chinese goods because they do not have the money to lend the US as the US cannot afford to buy Chinese goods. And China cannot buy raw materials from third countries because there is no demand for goods from the US. Due to disfunctional economic policies in Washington, there will be a global recession.

    Regards,

  • Posted by Guest

    “The decisions by Russia and Venezuela to direct more of their oil production towards the Chinese market reflects the strategic importance of Asia. Therefore, the current decline in commodity prices may be a correction of the imbalances that accumulated between real demand and speculation over the last few years, but it is not a reversal of the trend.

    “On the contrary, some of the problems in the global economy are attributed to the reluctance of the Chinese to float their currency. The dollar is a proxy for the yuan, given the quasi-fixed relationship between the two currencies. The slump in the value of the dollar is causing the value of real assets, such as real estate and commodities, to rise. In an effort to maintain a competitive exchange rate against the dollar, central banks are actively intervening in their currency markets. However, this is fueling inflationary pressures and creating a glut of dollars in the marketplace.

    “The floatation of the yuan would remove these imbalances, allowing the dollar to plunge, and commodity prices to stabilize. Given the collapse of the dollar, the yuan would probably become one of the main reserve currencies of the world, as well as the denominator for most commodity transactions. The flotation of the yuan would eliminate most of the imbalances in the global marketplace—thus completing the transition process. Of course, this would thrust the Chinese into the global leadership position, forcing them to reinvent the multilateral institutions that are now irrelevant—such as the IMF, World Bank, WTO and the U.N. China is reluctant to assume the global leadership role, but it has to. Otherwise, the global imbalances are going to get worse, and the transition process is going to become trickier.” — Walter Molano, BCP Securities, “The Latin American Adviser” 9/15/06

  • Posted by Guest

    Brad – this could be a very dumb question, but given the IFC estimates of the size of the informal economy in emerging markets – looks significant to me – and reading the wikipedia definition of informal economy: “the term informal economy refers to the general market income category (or sector) wherin certain types of income and the means of their generation are “unregulated by the institutions of society, in a legal and social environment in which similar activities are regulated.” (Portes et al.)” – and thinking about questions of hedge fund regulations, might hedge fund activity be part of the emerging markets and the ‘developed’ world’s, also sizeable, informal economies? Might hedge funds in some way be changing the meaning of ‘official’?

  • Posted by Dave Chiang

    Why The Gap Won’t Stop Growing
    U.S. consumers can’t get enough of Chinese goods.
    http://www.businessweek.com/magazine/content/06_39/b4002072.htm

    Can anything stop the Chinese export machine? In August the mainland’s trade surplus hit $18.8 billion — the fourth straight month with a record-setting gap. For the year to date, the surplus stands at $94.7 billion, 57% ahead of a year ago. Although China’s imports jumped to a record $72 billion, exports surged nearly a third to — yes, another record — $90.8 billion. And much of that gap can be attributed to the vast quantities of goods shipped to eager American consumers. For the year, China’s exports to the U.S. look set to approach $300 billion, up from $243 billion in 2005.

    Just what are Americans buying? Numbers won’t be available until 2007, but it’s a safe bet that gizmos such as TVs and iPods were popular. U.S. Commerce Dept. data show that electronic gear was the largest category of imports from China last year. That’s a big change from a decade ago, when low-tech manufactured goods dominated. Below, the true scope of America’s imports from China.

  • Posted by Dave Chiang

    China’s Economy can withstand a short US Recession – Andy Xie
    http://www.bloomberg.com/apps/news?pid=20601087&sid=a22PJ040r.TE&refer=home

    “Asia may be insulated from a U.S. recession at first, as China’s high savings rate could keep investment flowing in the world’s fourth-largest economy.”

    “But if the U.S. stays down for several years then China will also slow down, because in the end Chinese liquidity is based on exports,” Xie said.

    “The U.S. housing bubble is bursting. The economy will slow down just due to the housing-sector slowdown,” Xie said.

  • Posted by Guest

    “The United States, the European Union and Canada filed complaints Friday with the World Trade Organization over China’s tariffs on the import of foreign auto parts…” http://www.globeinvestor.com/servlet/story/RTGAM.20060915.wchina-autoparts0915/GIStory/

  • Posted by Gcs

    you got that right mr bill

    mess it up makin money
    then make money cleaning up the mess

  • Posted by Guest

    “There is a blind spot in the US State Department and academia regarding China. They think China equals the Chinese Communist Party (CCP), but it does not…”

    http://www.taipeitimes.com/News/editorials/archives/2006/09/10/2003327000

  • Posted by Guest
  • Posted by Guest

    “Germany is considering a plan for a free-trade zone between Europe and the US… the notion has struck a chord with Ms Merkel, who has often called for “a global framework of rules” – minimum social, environmental and ethical standards – to prevent competition from sophisticated yet authoritarian low-wage economies eroding western achievements in these domains…” http://www.ft.com/cms/s/621106a0-44e7-11db-b804-0000779e2340.html

  • Posted by Dave Chiang

    The mounting U.S. Current Account Deficits are a consequence of the U.S. Financial Sphere creating excessive Credit/”purchasing power” and then directing resultant abundant financial flows to securities and asset markets (with attendant Financial and Economic Spheres maladjustment). These Monetary Processes are only reinforced by the Bernanke Fed’s abhorrence of popping Bubbles.

    - Doug Noland
    http://www.prudentbear.com/creditbubblebulletin.asp

  • Posted by Guest

    “…CCP’s Global Chinese-language Media Dominance and Anti-America Propaganda…In the meantime, the CCP has been making aggressive efforts to infiltrate into the Chinese-language media outside China since mid-1980, as waves of Chinese immigration have changed the profile of overseas Chinese communities… CCP’s Main Tactics to Silence NTDTV and Other Free Media…” http://wwwa.house.gov/international_relations/109/zho072105.pdf

    “…The word “hegemon” usually used alongside other terms such as “imperialist,” unilateralist and “self-appointed world policeman” is precisely how official Chinese media characterize the United States. Such characterization communicates to the Chinese people that the United States, from the point of view of its foreign policies toward China, is a power with which China has a competitive, if not antagonistic, relationship…. By this logic, even the U.S. policy of engagement with China itself is a new form of “containment” and U.S. support for peaceful evolution toward democracy is no more than a sinister ploy to destroy the Chinese Communist Party…. China’s leaders have been predicting the relative decline of American economic, political and military influence relative to other powers, for decades…” http://www.uscc.gov/researchpapers/2000_2003/reports/ch1_02.htm

  • Posted by Dave Chiang

    Three related facts combine to make the global market not free. The first fact is that global trade is carried out under an international finance architecture based on US dollar hegemony, which is a peculiar arrangement in which the dollar, a fiat paper currency backed by nothing of intrinsic value, can be printed at will by the US, and only the US, thus making export for dollars a game of shipping real wealth overseas for paper that is only usable in the dollar economy and useless domestically in all other non-dollar countries. Key commodities, such as oil, are denominated in dollars primarily because of US geopolitical prowess.

    Since Neo-liberal capitalism does not recognize any ceiling for fair profit, it must by implication oppose any floor for fair wages. The terms of global trade then are based on seeking the lowest wages for the highest profit, rather than fair wages for fair profit. This is the linkage between neo-liberal capitalistic globalization and wage arbitrage, both in the domestic labor market and across national borders. Yet in a consumer-based global market economy, low wages lead directly into overcapacity because consumer demand depends on high wages. The adverse effect on consumer demand from the quest for maximum profit is the critical internal contradiction of the deregulated capitalistic market economy.

    The third fact that makes the global market not free is that while financial globalization facilitates unrestricted cross-border mobility of capital around the globe, obdurate immobility of workers across national borders continues to be maintained through government restrictions on immigration. Labor immobility deprives labor of pricing power in a global market by preventing workers to go to where they are needed most and where market wages are highest, while capital is free to go where it is need most and where return on investment is highest. This econ-political regime against labor mobility, coupled with unrestrained cross-border mobility of capital, maintains a location-bound wage disparity that has created profit opportunities for cross-border wage arbitrage, in a downward spiral for all wages everywhere.

    - Henry Liu
    Asia Times Online

  • Posted by bsetser

    You know, Dave, if China doesn’t like US dollar hegemony, it might want to stop pegging to the dollar and stop holding so much of its national wealth in dollars at the PBoC. The ironic thing right now is that dollar hegemony isn’t sustained by the US — it is sustained by the world’s emerging markets, who are currently making a series of soveriegn choices that support dollar hegemony.

    And when I criticize those choices — i don’t think it is in the long-run interest of either China (or the Saudis) or the US for China to peg to the dollar — you criticize me as the voice of neo-liberal imperialism …

  • Posted by Guest

    My first post here. This discussion touches on an issue I’ve been trying to understand for several months:

    To what extent has the run-up in dollar reserves over the last few years been driven by policies of emerging economies (in fact, most economies) to maintain sufficient (dollar) resources to buy, say, twelve months of oil? To the extent this is the case, overseas dollar holdings can be expected to unwind with a drop in the price of oil (or, to a lesser extent, a drop in the volatility of oil prices). Similarly, once oil prices have stabilized at a new, higher plateau, the demand for dollars due to this effect is over.

  • Posted by bsetser

    Guest — China had enough reserves to buy 12 months of oil at $70 a barrel even before oil rose to $70 a barrel. It already had the needed funds in the bank.

    And in all probability, as oil prices fall, China’s reserve growth will increase — China exports more than it imports with oil at $70, and if oil falls to $50, its surplus will get even bigger.

    The need to hold dollars v. an oil shock is real, but i don’t think it explains much of what we are seeing now. most reserve growth isn’t coming from oil importers with realtively small reserves, but rather from oil exporters with more funds coming in than they can spend, and from countries that already have lots of reserves (i..e China).

    make sense?