Brad Setser

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Cross border flows, with a bit of macroeconomics

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What is the most important price in the world economy?

by Brad Setser
September 27, 2006

  • Dollar/ oil?
  • The ten-year Treasury rate?
  • The S&P 500?
  • European policy rates?
  • The fed funds rate?
  • The RMB/ dollar?

At an on-the-record event at the Council on Foreign Relations this morning, Martin Wolf implicitly voted for the RMB/ dollar.  I can hardly disagree.

China has to purchase an awful lot of dollars — $250b this year and perhaps more next year – to keep the RMB from rising against the dollar in the face of China’s huge trade surplus and ongoing net capital inflows.   Those dollars are invested in US treasuries, agencies and mortgage-backed securities, helping to determine the ten-year Treasury rate.

But Wolf goes further.    He argues that China’s determination to keep its nominal and real exchange rate weak effectively ends up determining US short-term rates, not just shaping US long-term rates …   

His argument potentially applies to the eurozone as well, but to keep things simple, I’ll focus on the US. And rather than starting with the US, I’ll start with China.

Wolf argues that China’s determination to keep the RMB weak in real terms effectively forces China to maintain a savings surplus.   

That is more or less the polar opposite of Stephen Roach’s argument.  

Roach argues the US current account deficit reflects its own savings shortfall, China’s current account surplus reflects China’s own savings rate, and that both the low US savings rate and the high Chinese savings rate is independent of the RMB/ dollar.  

One implication – changing the RMB/ dollar won’t change China’s current account surplus. 

Chinese Premier Wen agrees with Roach.  Ronald McKinnon does too.

Wolf by contrast argues that China has a policy of targeting its real effective exchange rate, not just its nominal exchange rate.   Actually, it effectively has had a policy of targeting its real effective exchange rate against the dollar – which has meant that the RMB has depreciated in real terms against a host of other currencies. 

Keeping the nominal exchange rate constant in the face of strong capital inflows and growing trade surpluses requires a lot of intervention in the foreign exchange market. And keeping the inflation rate low – something that is necessary to keep China’s real exchange rate low – requires that China adopt a set of macroeconomic policies that generate a savings surplus. 

Remember, a stable nominal exchange rate and high inflation leads to a real appreciation – and the striking fact about China is hasn’t experienced either a nominal or a real appreciation, since inflation rates have stayed quite low despite a potentially inflationary surge in reserve growth.

Wolf argues that this reflects government policies.  This morning Wolf noted that about 2/3s of China’s total national savings comes from the government, not from households.   Direct government savings are high.   And the high savings of China’s state-owned enterprises also reflects government policy.   

Investment is also a function of government policies, which determine how much investment the government does directly and how much credit the state-owned banking system makes available to the rest of the economy.

Hence, in Wolf’s view, keeping the real exchange rate weak requires not only that China intervene to keep the nominal exchange rate down, but also that it take a series of steps to keep inflation down even in the face of a huge liquidity injection from growing reserves.  And that means adopting a host of government policies that create a savings surplus.

To sum up, China’s savings surplus is a direct consequence of China’s exchange rate policy.   And if the RMB/ $ changed, the savings and investment balance would also change.

I have a great deal of sympathy for Wolf’s argument.  The surge in Chinese national savings certainly seems correlated with the RMB’s recent real depreciation as the dollar fell v. a range of currencies and China resisted pressure to appreciate v. the dollar.  Louis Kuijs has quite convincingly shown that the recent surge in China’s savings surplus doesn’t stem from a surge in household savings, but rather from government and enterprise savings.  Consumption is falling as a share of Chinese GDP not because of a rise in the household savings but because or a fall in labor compensation of as a share of GDP.

Incidentally, Wolf’s argument applies with even more force in oil-exporters who are pegging to the dollar.   Keeping the real exchange rate from appreciating in the face of a surge in oil export revenues effectively required that the governments of the oil exporters sequester a large share of the country’s oil export windfall in offshore accounts.    Such “fiscal sterilization” can be done in a lot of ways – by building up reserves, by building up an oil stabilization fund, or by putting most of the oil windfall in other government investment funds.   Injecting it into the local economy would have pushed up prices … 

But Wolf doesn’t stop there. 

If the emerging world is determined to maintain weak real exchange rates and run large current account surplus, the advanced economies have to run deficits.  And if the emerging world’s weak real exchange rates encourage investment and employment in their tradables sector, the advanced economies have to generate employment in the non-tradables sector.  Think housing.

That implies that the Fed – so long as it wants to maintain full employment in the US — has to set US interest rates at levels that generate a large US external deficit.  If the US government doesn’t run a big enough fiscal deficit to make use of the rest of the world’s savings surplus, interest rates have to fall to the point where the household sector runs big deficits … Wynne Goodley has made  similar argument.

In other words, the Fed sets its policy rates to offset the global impact of the RMB/ $ rate set by the PBoC.   And the RMB/ $ is the world’s most important price. 

I suspect Pam Woodall – the author of the Economist’s survey on how emerging economies are influencing the world – would agree.  

Bernanke too.  Wolf though goes further than Bernanke.  Bernanke doesn’t really explain why the emerging world has such a glut of savings, and why so much of that glut has taken the form of an increase in the reserves of emerging economies.   Wolf argues that it is a byproduct of government policies targeting weak real exchange rates in the aftermath of the emerging market cries of the late 1990s.  He emphasizes the impact of Asia’s crisis.  I would also emphasize the impact of $10-15 in 1998 oil on the policies of the world’s oil exporters.


  • Posted by MS

    From economic theory it is impossible to continuosly control the real exchange rate, it is determined endogenously. Either you end up with stronger currency or higher inflation (for countries facing inflows, the opposite for outflows). UNLESS you close your capital account. If I remember correctly this is the holy trinity (cannot have independent monetary policy and fixed rates and open capital acct at the same time). Which is why it makes a lot of sense to invest in weak real exchange rate countries, preferably in inflation-linked local denominated bonds. Either the currency appreciates or inflation ticks up (or a combination of both). Russia, Kazakhstan, Nigeria, Egypt, ARG, China, Ukraine (less certain though),and other Asians as primary examples.
    In my humble opinion people tend to associate competitiveness with weak real exchange rates, when in fact one should associate ‘competitiveness’ with productivity. It’s the other way around. CHina is the one accepting the current FX, not the US being run by CHina’s policies.

  • Posted by bsetser

    Well, the Gulfies and China both have managed a real depreciation over the past few years, with nominal depreciations (v many trading partners) not fully offset by higher inflation rates. Chinese inflation has been below US inflation recently. it may not be possible in theory, but it has happened in practice —

    or put a bit differently, the lag on the inflation pickup in China seems long enough that in practice China has influenced its real exchange rate by targetting the nominal XR.

    Incidentally, productivity differentials suggest China should be appreciating in real terms v. both the US and Europe … and it hasn’t been.

  • Posted by Guest

    What explains this? Only one I can come up with is closed (or highly managed) capital accounts (then it is possible to manage the real ex rate, though extremely inefficient and in the long run doom to fail). As these are starting to open up and liberalize (at least in China and Russia, not sure about the Gulfies), willing to bet won’t be possible to manage a real exchange rate target. we’ll see…
    THanks for your reply

  • Posted by Guest

    1 degree celius.

    That’s what it will take; a real show stopper.

    Time to do the real math.

  • Posted by Anonymous

    The manipulation of the real exchange rate has been even more assertive in the case of Japanese yen. Since 2001 and the beginning of quantitative easing the real yen has depreciated by 30%.
    The tool of choice has been verbal intervention giving Japanese housewives a “safety net” in case of rapid appreciation of the yen.
    As victory over deflation is officially declared it seems almost unavoidable that the yen would better reflect fundamentals by strengthening by 10% to 15%. Carry trades beware.

  • Posted by DOR

    RE nominal vs. real Rmb change:

    (1) China has experienced a lot more inflation in the past decade than is recorded in the official statistics.

    (2) Exports prices of China-made goods are kept artificially low – and import prices of components artificially high – in order to ensure that profits are recorded (and taxed) in a less onerous location.

    If either or both of these are correct, the entire argument changes, dramatically.

    * * *

    Surplus, good. Deficit, bad.
    Savings, good. Debt, bad.

    Shouldn’t we be talking about the investment deficit, rather than the savings surplus? The terminology just works better, even though the two mean the same thing.


  • Posted by HK

    Brad–I think Martin Wolf has made a very important point that the saving ratio is not independent from the exchange rate. China has an undervalued currency, which produces its huge currenct account surplus (excess savings), but necessitates the PBoC to continuously purchase the dollar in a massive way. Usually, such currency intervention results in excess liquidity and inflation. But China has successfully avoided inflation and real appreciation through increasingly tight fiscal policy and various control measures including the price control on agricultural products.

    Anonymous–It is simply impossible for Japan to manipulate the real exchange rate, since it has not been intervening in the currency market two and half years, has maintained very loose fiscal policy, and has no control measures like China.

  • Posted by bsetser

    Given how much China is investing (absolutely and as a percent of GDP) I find it hard to talk of an investment deficit in China’s case … investment is way, way up. savings is just up more. that truly fits my defintion of a glut …

    the rest of asia — well, the story is different.

  • Posted by MrBill

    If you would have said the REAL price of oil, as measured in a basket of currencies, I would have argued that is the most important price of those listed.

  • Posted by Steve Waldman

    Re: MS’ point above, suppose China opened its capital account entirely, no capital controls whatsoever. What would cause its real exchange rate to rise? Would it be that “hot money” inflows force too much Yuan printing, forcing China to sell more sterilization bonds, driving up sterilization bond yields, forcing PBoC to choose between a nominal reval or inflation? I’m skeptical, though, as with China’s reserves, it can bear some negative spread on sterilizing for a very long time without much hurting its balance sheet. PBoC’s credibility is very high. I don’t think many “Soroi” would step up to fight this way, particularly since PBoC can always choose to stiff the speculators by taking the inflation route. Alternatively, speculators might short PBoC bonds as a carry trade. Arbitrageurs could suck up the sterilization spread currently earned by PBoC this way, sure, but the worst they can do is drive away PBoC’s sterilization gains, not impose costs, which PBoC would anyway have the wherewithal to bear. Chinese depositors might seek higher yields outside the Chinese banking system, forcing domestic interest rates to rise and putting pressure on sterilization, but an outflow of RMB only eases pressure to inflate or sterilize (and a tremendous outflow would break the peg in the opposite direction). Any other ideas?

    I have a little ditty here that argues that a real exchange rate peg amounts to a synthetic tariff. As a general proposition, one might argue that any trade account intervention can be simulated by a capital account intervention, and that therefore a free trade regime that condemns one sort of intervention but permits the other is fatally flawed. If deficit countries were to restrict net capital inflows, that would have much the same effect as a tariff, stifling imports as the cost of financing them skyrockets, and transfering wealth to mostly domestic long-duration debtors.

  • Posted by a

    “Anonymous–It is simply impossible for Japan to manipulate the real exchange rate, since it has not been intervening in the currency market two and half years, has maintained very loose fiscal policy, and has no control measures like China.”

    Nonsense. The market remembers the BOJ’s massive interventions three or four years back. And so the market believes the BOJ will intervene should the Yen ever take a tumble – thus hedge funds and others enter the carry trade, which bolsters the yen. I’ll make a (theoretical) bet with you. The yen/dollar is at 117.5. I’d wager that if the BOJ comes out and says it will let the market set the forex rate and it will no longer intervene, then the yen/dollar will fall below 100 in less than three months.

  • Posted by Guest

    Some might say U.S. residential real estate prices. I’m going from notes taken at a recent presentation, and just realized that hard copies were not provided, so if anyone with more expertise can correct or fill in the blanks – but goes like this:

    7 – 10% growth averaged out over 2 years required to limit CDO losses to zero

    -4% – 7% price decline over 2 years = 100% CDO losses and a journey deep into uncharted territory

    Didn’t get into issues of affordability if house prices continue to increase at the rate deemed necessary to limit CDO losses to zero.

  • Posted by Guest

    Entschuldigung – the number is probably growth in home sales – although price has to be factor in there somewhere.

  • Posted by bsetser

    I think Wolf would argue that US real estate prices are a function of China’s exchange rate policies and the resulting US interest rate policies …

    I didn’t realize tho that CDOs had such real estate exposure.

    I am interested in learning more about that aspect of finance, and particular how various long the risky bit of real estate loans that have been securities positions are hedged. If anyone knows more — do tell — or email (brad dot setser at rgemonitor dot com)

  • Posted by Anonymous

    a – I think you have misread my post or else.

    The MoF is responsible for significant moral hazard. Japanese retail investors have piled into uridashis in NZD AUD etc on the basis that the yield pick would be underwritten by the MoF through verbal or physical intervention.
    I posit the yen will strengthen as the magnitude of its depreciation in real terms will be recognised more broadly. To wit Japan’s ex-oil current account surplus at 8% of GDP is back where it used to be in 1985.

  • Posted by HK

    a–It is not that any authorities, including the Japanese, cannot control the nominal excahnge rate (actually they can, if they are prepared to make indefinitely large intervention), but that most of them cannot control the real exchange rate (which is realy relevant), except the Chinese. So, what you said was nonsense, not mine.

  • Posted by Guest

    CDS on subprime mezzanine tranches; already seeing some signs of cracking… first loss pieces supposedly are still on the books.

    default probabilities on ‘exotic’ mortgage products can’t be accurately modeled since they’re so new, esp given low documentation and i’m not sure fair-isaac is any guide… on top of that you had them being shopped around to get rated.

    provided they behave as they should, they probably won’t…

  • Posted by bsetser

    guest — thx. more details would be great. understand why first loss pieces would still be on the books of the lenders since, well, that protects the buyer given the difficulty modeling new kinds of structures w/o historical experience.

    but are mortgages bundled with corporates in a CDO, or are these mortgage only structures that are sliced and diced (sorry about my ignorance — i just really have no idea how these markets are working)

  • Posted by Guest

    One other concern at that conference being more fallout from what seems to have been a meltdown in natural gas prices – especially if low prices persist in that sector.

    any one care to comment on gold prices – or might copper, nickel and aluminum have taken on greater importance?

  • Posted by Guest

    from what i’ve seen, and i haven’t followed that closely (just talked to some ppl that do), it’s mortgage only; i’m guessing it’s easier to market (don’t want to confuse the salesforce)…

  • Posted by Guest

    “Wolf argues that it is a byproduct of government policies targeting weak real exchange rates in the aftermath of the emerging market cries of the late 1990s.”

    mcculley would argue mercantilism is a phenomenon that occurs from a mismatch between the mobility of global capital and global labor becasue ‘there is no free market in passports’.

  • Posted by bsetser

    I am a bit suspicious of the mismatch betweeen mobile capital and immobile labor explanation for asian neo-mercantilism. that mismatch was present in the mid-90s as well — global capital flows to ems were comparable to current levels in 96/ first part of 97 (and more broadly during the 92-97 period) and labor mobility was if anything less (fewer illegals in us/ less mobility inside europe). but there wasn’t the same kind of neo-mercantilist reserve accumulation.

    i.e. the mismatch in mobility precedes the shift in policy

  • Posted by Butch

    The MOST important price in the world?

    That’s easy: The price of GOLD!!!

    But not for the reasons you might think.

    No, my friends, the price of gold determines how much of it men can afford to buy to adorn their women with the shiny yellow stuff.

    And let’s face it, if the women are unhappy because they don’t feel their men appreciate them enough, then the men will DEFINITELY be very, very, unhappy!!!

    Now, moving on to the esoteric discussion of the dollar/RMB, please allow me to offer my two cents (or .1658 RMB!).

    These little discussions, where everyone shows how smart they are by citing obscure macro-economic theories and insightful ratios miss the main point:

    That the U.S. is beholden, via massive indebtedness, to its ideological hated enemy–China. Yes, China, a Communist country that practices virtual slavery to the state, offers virtually no human rights to free speech, votes, travel, assembly–THAT China.

    And BOTH the supposedly “free-enterprise” U.S. and the assuredly Communist” China happen to share at least ONE common trait:

    They BOTH practice anything-but-free monetary and banking policies. In fact, one would be hard-pressed to differentiate between the two systems (save for slightly more restrictive capital controls in Communist China, but that is also subject to change at any time!).

    Trust me when I state the BOTH countries will rue the day that they traveled down this path of mutually-parasitic growth–China will be stuck with a trillion or more dollars of defaulted (or rendered worthless in a true “Weimar” fashion) U.S. treasuries and agencies, and the U.S. will be stuck scrambling for a new “debt-enabler” to keep the consumer-as-mouth-of-the-world scam going for another few years.

    Yes, we are indeed looking at the whirlwind to be reaped by the fifty-year progression of Keynsian/Monetarist subjugation of the world’s economy. By the time this is all played out, the world as we know it today will be barely recognizable.

    Best you should buy a nice gold necklace for the woman in your life and enjoy what little time we have left.


  • Posted by John123

    Brad, I am a little confused about what you say is the needed U.S. policy response to the Chinese currency policy,
    “If the US government doesn’t run a big enough fiscal deficit to make use of the rest of the world’s savings surplus, interest rates have to fall to the point where the household sector runs big deficits…”

    How does the household sector run a big deficit? Are you saying that if the U.S. Government didn’t run a large deficit, the economy would go into recession?

    Basically the U.S. Government is borrowing funds from the Chinese Government(or State, including state-owned banks and such). The U.S. Govt pays interest to the Chinese over the next ten years or so, but eventually must repay the principal.

    At some point, U.S. taxpayers will have to carry the burden of this debt shifting. Obviously inflation reduces the impact of the repayment, but repaying the $3 trillion in U.S. debt, plus interest, is going to put a significant hurt to somebody, and not that long down the road, given that 10-year bonds are the maximum term.

  • Posted by bsetser

    John123 — the US will refinance that debt as it comes due; otherwise, it doesn’t just have to reduce its trade deficit; it would need to run a current account surplus. not likely.

    I am not sure that i fully believe martin wolf, but his argument is more or less that so long as the US wants full employment and China successfully targets its real exchange rate and runs surpluses, some portion of the US economy has to be in a deficit. If not the goverment, households or firms. The mechanism generating a household deficit is as follows:

    if there is no governmetn defiict and net exports are not contributing to US growth (b/c of China’s weak real exchange rate), the US economy will be weak — at under full employment. The fed will lower rates. Then all the dynamics associated with low US rates kick in — higher home prices, capital gains on homes to support spending, mortgage equity withdrawal via home equity lines to support consumption, and so on. so households end up borrowing on net, and specifically borrowing on net from the world (i.e. China/ the oil exporters).

    that is one extreme view. i don’t think it works 100%. but it does describe (in my view) some recent dynamics.

  • Posted by Guest

    “If the US sneezes, will the rest of the world catch a cold? The question relates most immediately to the broader economy, but with housing markets, consumer spending and economic outlooks potentially so intertwined, it is relevant to the markets for bonds backed by residential mortgages outside the US…”

  • Posted by Guest

    “…rumors that the Hong Kong Monetary Authority might shift the Hong Kong dollar to a yuan peg when the two currencies reach parity have periodically roiled currency markets. As the yuan approaches the same value as the Hong Kong dollar, “that might invite a lot of speculation for the Hong Kong dollar peg…”

  • Posted by Cassandra

    Dollar/ oil? Just a tax albeit one that can drive needed substitution & conservation in the direction of long-term convergence of supply & demand;

    The ten-year Treasury rate? Rates are like a water balloon where they’re not coordinated. Squeezing only one end just forces water to the other end. Could reach primacy beyond a threshold perhaps…

    The S&P 500? Hmmm. Though there is reflexivity in markets and wealth effects, but this seems a symptom of other things and in itself is just a weathervane.

    European policy rates? Both production and consumption seem less sensitive to Euro interest rates either up or down. Europe reminds me of an national economic “Zelig”.

    The fed funds rate? No.

    The RMB/ dollar? A rise in the RMB while necessary, won’t change anything for a while least of all US demand; Unless it was a shattering and cataclysmic re-alignment

    I think the “big-3 are:

    3. Credit Spreads
    2. Real US Interest Rates
    1. US PCE

    To my mind, the immediate economic well-being of the world is tethered to US PCE since I do not believe anyone else can or will immediately step up to the plate once we vacate . And while any single variable – be it house prices, S&P, unemployment, hourly earnings, both shorter & longer term interest rates – may not be sufficient in themselves to tank PCE, the interplay of all is what crucially matters for this most important of numbers.

  • Posted by HZ

    I agree with DOR on the inflation stats. I’ve written about it before: Chinese economy has been evolving very fast- when purchase pattern changes fast enough you can create a non-inflationary picture.

    For non-prime MBS, first loss is too toxic to sell. Plus it’s where the profit is. Suppose you get 500 bp spread on the whole loan and hold onto 10% first loss tranche, the nominal rate is 50% on your investment; for real rate subtract loan loss and other cost. Leverage up with preferreds you get a real profit engine indeed, at least while the going is good. Alas, there is not much to prevent anyone who wants to try this game from trying, which inevitable drive down the spread. And who knows what the foreclosure rate will be — we only know that it has been very very low recently.

  • Posted by df

    great great post.

    I would also add on the causes of china policies the fact that it basically applies the washington consensus : export led growth, low inflation, budget surpluses.

    China indeed is only doing what Chile and japan showed a long time ago, remain a constant exporter and rely on someoneelse to generate demand.

    I d like to point out that may be in 1929 the most important price was not the sterling-gold price, but the dollar-sterling price.
    THe US helped the sterling to stay high thus kept rates too low for too long worldwide.

  • Posted by HK

    Guest–If the Hong Kong Monetary Authority pegs the Hong Kong dollar to the renminbi at this stage, it would be a disaster. True, Hong Kong’s ecoonmy is fast integrating with the mainland Chinese economy through trade and labor movement. However, its financial sector is much more integrated with the global market rather than the strictly controled Chinese market. Possible strains coming from future US dollar-renminbi fluctuation will be quite damaging to the Hong Kong economy.

    Therefore, Hong Kong should aim at pegging its currency to (or better, unify it with) the Chinese currency only after the renminbi undervaluation is eliminated and the Chinese financial system is liberalized.

  • Posted by DOR

    Prices: 10 barrels of oil . . . 1 ounce of gold. OK, 8-12 barrels, but it is pretty consistent over the decades.


    Labor immobility? Isn’t that the opposite of urbanization? Best guess I’ve see for China in the 1990s was on the order of 100 million (and, wildly up from there, but harder to swallow).


    HZ beat me to it on the HK$:Rmb. Not a chance in this decade, and probably not in the next.