Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

The IMF on China

by Brad Setser Tuesday, October 31, 2006

The IMF’s Article IV on China.

It suffers from one obvious problem.  It is dated.  The IMF completed this report in early July, and it is now almost November.   China’s current account surplus simply is not going to be $180b.  Q3's trade surplus showed  that.   It will be far bigger.   If the IMF thinks the ability to its analysis to stimulate public debate is central to the impact of its assessment, particularly for countries that are not likely to borrow from the IMF, it needs to shorten the lag between finishing the report and releasing the report.   Yes, Board debate is important – but, well, could this still have come out a bit earlier? 

I am eagerly looking forward to the staff report (mentioned in a footnote) which will explore the reasons why China’s current account surplus exploded in 2005.    Among other things, the IMF Article IV indicates that if you adjust for reserves shifted to ICBC and for swaps with the banking system, China’s 2005 reserve growth was $236b, not $208.   That is useful information for reserve-obsessed people like me – among other things, it implies I actually was slightly underestimating China's 2005 reserve growth (the swaps were larger than I had estimated), and thus slight underestimating global reserve growth.

The IMF also notes that China's July revaluation against the dollar has had virtually no impact on China's real exchange rate: "on a real effective exchange rate bases, the renminbi by May 2006 had returned to roughly its June 2005 level despite the revaluation."   Why?  The change in the RMB/ $ was offset by changes in the $/ euro — and by higher inflation in the US.  Updating the calculation through the end of October wouldn't change much.   The RMB would still be about 15% below its early 2002 levels.

What else jumped out at me as I skimmed the report? 

  • The surge in China’s national savings since 2001.  Savings is estimated to have increased from 34% of GDP in 2001 to 51% of GDP in 2006.  That is extraordinary.   Household savings is high, but the IMF – like the World Bank – says that the real drivers of the surge in savings have been the government and businesses, especially business.    A lot of the debate over China comes down to why folks think business savings surged.    One explanation is rising profits in the export sector linked the RMB’s big real depreciation since 2002 (the IMF, as usual, has great charts).   Another is a set of reforms that allowed state firms to shed their social responsibilities – increasing their profitability — without introducing mechanisms for the distribution of their profits.  And rather than deposit their profits in the banks ay 2% and change (nominal), firms had a strong incentive to invest ….
  • Investment is expected to rise from 34% of GDP in 2001 to 44% of GDP in 2006.  That kind of investment surge usually leads to a current account deficit … the puzzle of China is that it was overwhelmed by an even bigger surge in savings.
  • Consumption has fallen dramatially as a share of China's GDP since 2002 (the Economist should take note)
  • And the chart comparing bank lending growth and m2 growth shows that a ton of liquidity has been bottled up inside the banking system since early 2004.   A ton.   If the banks were ever allowed to lend all their deposits out, investment could soar even higher …  as the banks now have the ability to lend out more than they take in for quite some time.

In Martin Wolf’s analysis, China’s ability to bottle up these funds in the banking system is a key reason why the RMB has depreciated in real terms, not just nominal terms.   Only by constraining bank lending could China hold inflation down.   Turning a nominal depreciation into a sustained real depreciation required that China adopt a set of policies that raised national savings …. Read more »

The UAE still has 98% of its reserves in dollars

by Brad Setser Monday, October 30, 2006

Far me it from me to disagree with the Economonitor, but isn't the real surprise in today's Bloomberg story is that the UAE still has 98% of its reserves in dollars?  And that the UAE is still studying how to shift 10% of its reserves into euros — something that it announced it inteded to do right after the whole Dubai Ports World saga.  

I didn't think anyone (apart from a few small Latin countries) still had 98% of their reserves in dollars.  Moving a couple of billion dollars around isn't that hard.   The Russians have certainly moved a ton of money from short-term US debt securities (mostly short-term agencies) into the international banking system this year, and in the process likely added to their euro and pound holdings.  

In any case the real money in the UAE isn't in its central bank — the UAE's central bank reserves lag those of places like Algeria and Libya.  The various sheikdom who compose the United Emirates tend to keep their money close to home, in the individual sheikdom's oil fund.   I doubt ADIA has 98% of its funds in dollars.

Speaking of the Emirates's assets management companies, Dubai Holdings — is, according to HSBC — in the running to buy Liverpool FC.   What oil magnate doesn't want to watch their team play while in the UK checking up on the house hedge fund?

In a pinch, maybe the US could sell off one of its foreign assets (Man U) to the Saudis to help finance its current account deficit.  I don't think that would require a CFIUS review.

On a more serious note, neither the UAE's central bank nor the Swiss National Bank — which recently joined the Bank of Russia in betting on the yen have a very large reserve portfolio.   The available data suggests that central banks upped the portion of their reserves going into dollars in the first half of the year — at least relative to 2005.   So far, the evidence suggests that central banks have not been destabilizing sellers, but rather the buyer of last resort — Stephen Jen has been right on this.

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Can David Rosenberg out-Roubini Roubini?

by Brad Setser Monday, October 30, 2006

Nouriel “If you are going to be a bear, might as well be a grizzy” Roubini has a bit of competition.  Merrill’s David Rosenberg now puts the odds of a recession at up to 80%

“HSBC, US Bank … now pegs the odds of a recession at 75 percent, and Merrill Lynch … says that recession odds could be as high as 80 percent.” 

(hat tips: Andrew Samwick for the grizzly quip – I love it; and  the Mess than Greenspan Made for Merrill's current US call, which presumably is confirmed behind the Barron’s firewall).

Roubini is still (officially) at 70% and (unofficially) at 100%.  Any doubts — check out the titles of his last ten blogs.   Merrill hedges a bit with “could be” as high as 80%.  But Merrill is still taking a rather bearish view for a company with a bull in its logo that has long branded itself as “bullish on America.”   

I always thought of the Merrill bull as an equity bull.   But maybe the Merrill bull is a bond bull?

Rosenberg – and the rest of the interest rate team at Merrill – aren’t shy about the market implication of their call on the US economy.   Buy Treasuries.   Merrill – via Bill Cara — thinks the 5 year bond will fall to 4% in the fourth quarter of 2007.

I would put Merrill (and apparently) HSBC as the most bearish of all the big economic research shops.   UPDATE: BNP Paribas belongs here too …

Goldman has some bearish tendencies, but right now is a bit less bearish on the US than Merrill and bullish on the BRICs (and on the possibility of global decoupling).

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Goldman economic research v. the Economist (Drivers of Chinese growth)

by Brad Setser Sunday, October 29, 2006

I, obviously, liked this week’s Economist article on China quite a bit. 

So I really shouldn't still be writing about last week’s article on Chinese consumption growth.  That article argued that consumption, not exports is driving Chinese growth — and that China therefore might be able to weather a US slump. But I cannot resist. 

The data in Goldman’s latest China Economic Quarterly helps explain why I wasn't persuaded by the Economist's argument.

There also is no doubt that Chinese consumption is growing faster than US consumption.   Pretty much everything in China is growing faster than in the US.   Moreover, consumption was about the only thing in the US that didn't slow in q3, so we don't yet have a test of the Economist's thesis.   China hasn't (yet) needed to decouple.    

But Goldman's data — specifically the data in the summary indicators on p. 45 — shows pretty clearly that the recent acceleration in Chinese growth hasn't come from an acceleration in consumption growth.   

I used the data in that table to compare the average (real) growth in investment, and private consumption from 1998 through 2004 with the expected growth rates for investment and private consumption during the 2005-2007 period, and I did the same same thing with contribution to growth from net exports.

Oil makes for strange bedfellows

by Brad Setser Sunday, October 29, 2006

I certainly didn't see this coming.   It makes a certain amount of sense. 

Iraq needs investors with a high willingness to take risk …

China doesn't exactly have a low risk portfolio of external assets right now.   It is very exposed to moves in the dollar/ RMB.    But it does have a generally low-yielding external portfolio.  If my estimates are right, it does have a concentrated ($700b) portfolio of dollar-denominated assets that pay around 5%, maybe a bit more.    Diversifying into even-lower-yielding euro assets doesn't offer much additional benefit — the RMB/ euro could move more than the RMB/ dollar. 

But diversifying into oil is another thing altogether.   China is rather clearly is willing to take on a more than a bit more risk to try to profit from the rise in oil demand associated with its development.  In Angola (now China's largest supplier of oil).   In Sudan.  In Nigeria.  In Iran (though more for gas than oil).  In Kazahkstan.

And now in Iraq.   Southern Iraq that is.

China's willingness to put its surplus savings to work by snatching up the world's oil field's is clearly bad news for the world's private oil companies.  It will be harder and harder to find oil fields to buy on the "cheap" — the price oil companies have to pay to develop a country's oil will go up.  But I am not sure it is bad news for the US.  If Iraq's oil flows to China, more oil will be available somewhere else to supply the rest of the world.

Still, I rather doubt those who led the charge to invade Iraq intended to open up Iraq's oil for Chinese investment.  Then again, they don't seem to have anticipated the majority of the consequences of the US invasion of Iraq ….

Is Brazil’s central bank betting on a US slowdown?

by Brad Setser Friday, October 27, 2006

In August, Brazilians – the central bank and private investors – bought $11b of US Treasuries.   That is a lot.   Back in 2002, I would never have thought Brazil would provide (annualized) $120b in credit to the US Treasury in any month …   

Here is one way of thinking about the magnitudes.  Brazil’s 2002 IMF bailout was in the $30b range.  Suppose 1/3 of the IMF’s useable funds come from the US.  Then  Brazil provided as much financing to the US government in the month of August as the US provided Brazil’s government (through the IMF) back during Brazil’s entire crisis.   The times they are a changing.

Actually, Brazilian purchases of US Treasuries are more like a swap than outright financing of the US.  US and European investors looking for yield buy high-yielding Brazilian debt, and Brazil’s central bank, which is intervening to keep the real from appreciating, uses the funds to buy US debt.     That is a trade that – at least so far – has generated big profits (dark matter, in other words) for American and European investors. 

Back to August.   How did Brazil manage to afford $11b in US treasuries in a month?

First, Brazil’s reserves increased by a bit less than $5b in August.   Second, Brazilian central bank/ banks reduced their short-term claims on the US by $2.7b or so.   So even Brazil's central bank accounted for all the fall in short-term claims, it would have only been able to generate $7.5b or so of $11b in purchases ….  Yet even if Brazil's central bank didn’t do all the buying, it rather clearly invested a decent chunk of growing reserves in Treasuries and shifted a significant sum from short-term investments to longer-term investments. 

That is the sort of thing you do if you think US rates are about to fall.    In other words, it was the sort of bet that makes sense if you think Mr. Recession in 2007 is going to be at least ½ right, and not just about the third quarter.

I rather suspect Brazil was not the only central bank making this kind of bet in August and September.  There were big inflows to the US fixed income market in August, and given who has spare cash these days, that usually means big central bank and oil fund purchases.

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Trillionaires R Us

by Brad Setser Thursday, October 26, 2006

The rewards for guestimating the currency composition of China’s reserves pale relative to the rewards for lending your credibility to China’s effort to clean up and recapitalize its banking system.    

But my estimates of the currency composition of China’s reserves have been widely cited.  So I feel rather exposed to the risk that they may prove to be way off.  Kind of like Goldman should ICBC go belly up when China’s current boom ends …

So here is the due diligence behind my estimate.

It is primarily based on data that is now a bit dated – the Treasury’s survey of portfolio investment in the US at the end of June 2005.   That survey revealed far higher Chinese holdings of US debt than could be inferred from the monthly flow data.  Total Chinese holdings of US debt were $524b at the end of June 2005, and China added $184b to its portfolio between the end of June 2004 and the end of June 2005. (See table 5)     

The $184b increase made sense to me, given China’s reserve growth– Chinese inflows in the monthly data had long seemed too small relative to China’s reserve growth.   The flow data is now picking up a higher fraction of Chinese reserve growth, for reasons that I don’t fully understand.   But until the next survey comes out, we won’t know quite how well the TIC data from July 2005 on has tracked Chinese purchases.    My guess is that the monthly flow data still somewhat understates total Chinese purchases. 

Indeed, there is no particularly strong reason why one would expect the TIC flow data to track Chinese purchases perfectly.  If China buys a Treasury bond from a European pension fund, that transaction would never register in the TIC data.   And if a custodian bought on behalf of SAFE, it wouldn’t show up as a Chinese purchase either. 

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James Dorn leaves me confused –

by Brad Setser Wednesday, October 25, 2006

CATO’s Dorn attacks a coordinated policy response to global imbalances on the grounds that it presumes that governments have a better sense of the “right” exchange rate than the markets:

A negotiated approach to resolving trade imbalances presumes that “experts” know the relevant market-clearing exchange rates and that governments can agree to enforce them – neither of which has proved to be true. Any exchange rate that was fundamentally misaligned would eventually be attacked and governments would be ill-equipped to prevent it. Moreover, the longer that adjustment was delayed, the higher the cost would be in terms of resource misallocation.

But doesn’t the current system hinge on “experts” rather than markets setting key exchange rates?   In this case, the key experts are China’s State Council (which seems to make Chinese exchange rate policy), the central banks of the GCC countries and the heads of all the other emerging market economies intervening in the fx market at an unprecedented rate.  And hasn’t a key lesson of the past few years been that governments are a bit more able to ward off attacks if they are defending an undervalued exchange rate than if they are defending an overvalued exchange rate?   Particularly if they have somewhat effective capital controls in place …  

And, viewed, from Dorn’s perspective, doesn’t delaying the end of the current system  only increase the misallocation of resources created by central banks massive intervention in markets and the resulting deviation of key exchange rates from market levels?

It seems to me that a big part case for policy coordination is precisely that current emerging market exchange rates are so far from market clearing exchange rates – look at the current scale of reserve accumulation in the emerging world – that any changes needs to be both gradual and coordinated.   Ending the United States bond markets dependence on its central bank fix by going cold turkey wouldn’t be fun.   

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Why would a rise in Japan’s trade surplus be “unexpected”?

by Brad Setser Wednesday, October 25, 2006

Call me old fashioned, but isn't a rising trade surplus — driven by strong exports — a rather natural result of a weak currency?    The yen is super-weak v the euro and weak v. the dollar.   And it has been rather clear than Japanese car companies are gaining market share here in the US ….

Strong September export growth from both Japan and China suggests that the US continued to snap up a lot of imports in September.  And continued strong export growth, rising interest income on Japanese and Chinese holdings of US debt and — eventually — a somewhat lower oil import bill — all suggest a rise in East Asia's current account surplus.

Not so big worries for big oil — even at $60 a barrel, oil is rather expensive

by Brad Setser Tuesday, October 24, 2006

I would be the first to concede that $60 isn't $80.  Or even $70, the average price for oil (at least the good sweet light easy to refine stuff) in the second and third quarter.   US consumers – at least those in those parts of the income distribution that haven't seen big rises in their nominal-let-alone real wages — were starting to feel really squeezed with oil at $80.  Now, they can afford to fill up their tank and still buy at least a few things at the local Walmart.

But the premise behind Chip Cummins' A2 Wall Street Journal article still seemed a bit off.  If you invested in a lot of oil fields that were expected to be profitable if oil averaged $20 a barrel, you will certainly make more money if oil is at $80 — or even $70 — than if oil is at $60.   But I am pretty sure that you will be making money even if oil is hovering around $60 a barrel.

Equity markets are not my thing.  But given the change in the trajectory of oil prices, I cannot imagine that anyone holding an oil companies' stock would expect oil companies to be able to sustain the kind of revenue growth they enjoyed when oil was steadily climbing up now that oil is falling.   So, unlike Cummins, I would hardly define a slowdown in oil profits as a "big problem":

"With crude prices falling and oil-field costs on the rise, major oil companies have a big problem: sustaining their phenomenal profit growth." 

Oil companies should make less money in q4 than in q3.  So what?  They will still be making a ton of money.

The same basic logic applies to most oil exporting countries.  They aren't going to be quite as flush with cash as they were in q2 or q3.  But they will still be very flush.  

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