Brad Setser

Brad Setser: Follow the Money

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The world, in a single graph

by Brad Setser
November 17, 2006

Actually, this post should be titled “everything I think I know about the world, in a single graph.”  

The following graph combines various measures of dollar reserve growth with data on the overall increase in the world’s reserves and the US current account deficit.  

uphill_flow_1 

It tries to capture the defining feature of today’s global economy: the flow of funds from governments in the emerging world – and in 2003 and in 2004 the government of Japan —  to the United States.   And it tries to do so in way that highlights the different possible measures of central bank financing of the US.

The 2006 data is an estimate.  I basically doubled the flows from the fist half of the year to produce data comparable to the data from previous years.

The first (white) bar comes from the United States Bureau of Economic (BEA) analysis.   It captures recorded central bank flows to the US.   

The second (blue) bar combines the BEA data with the growth in offshore dollar deposits of central banks (the BIS data reported in table 5c, with additional  ).   And yes, I adjust the two data sets to avoid double counting by subtracting out dollar deposits reported in the US data, which should also appear in the BIS data.   

The third bar tries to adjust for custodial bias – the fact that many official institutions use private custodians to buy US debt – by adding all private treasury purchases by foreigners in the US data to the official inflows data.   This is an adjustment proposed by Warnock and Warnock.  On one hand, it overstates official purchases by attributing all foreign purchases of Treasuries.  On the other hand, it understates official purchases by not counting those Agencies and corporate bonds (including mortgage backed securities) purchased by custodians for central banks.   This is a particular problem in my judgment for the 2006 data.  

I think custodial purchases of US debt other than Treasuries has picked up substantially, as central banks reduced their Treasury purchases.    That would imply more dollar reserve growth than is captured in either the white, blue or green bars in 2006.   

The yellow line is my estimate for global dollar reserve accumulation.  It is based on the IMF's COFER data, with a whole bunch of assumptions that allow me to fill in the gaps in the COFER data.  Those estimates are shaped by my sense of what the countries that don’t report the currency composition of their IMF are doing.   But they are only as good as my estimates.

The red line is my estimate for global reserve accumulation – essentially the COFER total augmented by the increase in Saudi foreign assets and Chinese reserves shifted to the state banks.  

And the black line is the US current account deficit.   2006 is – obviously – a forecast.

If one assumes that offshore dollar deposits are a close substitute for onshore dollar deposits — something I and Lars Pedersen of the IMF (see Box 1.6) believe — and if one assumes that central banks have not bought large sums of th dollar-denominated debt issued by emerging economies (they clearly have bought some, but their total purchases seem small v. the increase in their reserves), the yellow line represents the portion of the US current account deficit that has been financed by foreign central banks.  

The gap between the yellow and the black line is the portion of the US current account deficit that has been financed by the net flow of private funds toward the US

That gap clearly increased in 2005 – and it remains far larger in 2006 than in 2004.   Private flows into the US have picked up.  

But central banks still are financing a bit over 1/2 the US deficit.

It is worth noting that my measure of dollar reserve growth captures central bank flows, not inflows from various state controlled oil funds.   There is a necessary footnote here: the US measure theoretically includes all “official purchases,” including oil fund pruchases.  In practice, though, the only oil fund that seems to appear in the US data is the Norwegian government pension fund.  Recorded inflows from the Middle East are tiny. 

The graph presented abvoe is taken from my most recent (proprietary) paper on central bank reserve growth.   It tries to use the BIS data to help assess how central banks have adjusted the composition of the dollar portfolios as the US yield curve has gotten flatter and flatter.

I cannot resist adding one additional graph.   It sums up the growth in emerging market reserves reported by the IMF in table 1 of Chapter 1 of the WEO with other official flows (outflows from oil funds, repayment of the Paris Club/ IMF). The IMF’s measure of reserve growth here includes all SAMA foreign assets (unlike the COFER data) but it isn’t adjusted for valuation changes (which would tend to lower emerging market reserve growth in 2003, 2004 and 2006 and raise it in 2005).  

It still tells a clear story:  Emerging market governments are a key source of financing of the US current account deficit.   The increase in their (net) foreign assets parallels the growth in the US current account deficit.

uphill_flow_2

There you have it: the world, in a nutshell.   To me, the growing scale of emerging market financing of the US is the dominant international financial story of this decade.   On this, I am in complete agreement with Dooley, Garber and Folkerts-Landau.

Of course, not all those official outflows are inflows into the US.   Dollar-denominated flows to the US would be smaller.    Emerging market governments buy Australian dollar debt, helping to finance Australia’s deficit.   They have increased their pound deposits in the international banking system dramatically, helping to finance the UK deficit.  And their euro deposits and purchases of euro-denominated securities are far larger than what is needed to finance the euro-zone’s deficits.   Some of those inflows, in effect, finance outflows from the Eurozone to the US.   That is the only way the global balance of payments adds up.

I should give credit to Dooley, Garber and Folkerts-Landau here too.   They extended their model to incorporate emerging market flows into Europe in early 2005.  

The role that these large official outflows have played in the financing of the US deficit is rather central to the debate on whether the large US current account deficit is something worth worrying about.   That was the subject of Olivier Blanchard’s recent keynote lecture at the IMF’s research conference.  Like Menzie Chinn,  I do think the large US deficit (and offsetting surpluses) reflect policy choices that have introduced real distortions into the global economy.  Menzie appropriately emphasizes US fiscal and energy policy.  I would put equal emphasis on policies in emerging markets that have led to the “uphill” flow of capital — a flow that reflects official policy choices, not private market decisions …  

25 Comments

  • Posted by Dave Chiang

    At this point in time, no nation can afford a dollar crisis due to mutual economic dependence so the world’s central banks from the Middle East, Asia, and Latin America reactively support US Dollar hegemony (ie. Russia excepted). Of course, the longer the US dollar monetary value remains detached from US Economic fundamentals, the higher the probability exists for a hard landing sometime in the distant future. But political leaders only care about the short term and not the long term future. Eventually the deteriorating US economic fundamentals will overwhelm even coordinated government intervention. The recent rise of Gold and Silver despite lower energy prices is a harbinger of things to come. The Washington Consensus elites benefit short term from this economic arrangement: the budget deficit, trade deficits, and the Iraqi war expenses are financed at low interest rates by the rest of the world especially the Chinese.

  • Posted by ReformerRay

    Causation is a trickey call.

    I look at your second graph and I see the U.S. current account deficit sending money to emerging countries which provides them with the financial assets exipressed as financial outflows.

    In your view, what accounts for the increase in the size of the financial outflows from emerging countries in the last few years.

  • Posted by ReforomerRay

    David Chaing – Dollar hegemony is your complaint.

    The way to eliminate dollar hegemony is the move the U. S. trade deficit towards balanced trade – exports and imports from and to the U.S. equal. The best way to move toward balanced trade – the only option that is in the power of the U.S. government to implement – is to reduce imports into the U.S.

    I assume, therefore, that your would support HR.6050.IH “Balanced Trade Act of 2006″ or S.3899.IS “Balanced Trade Restoration Act of 2006″. Both seek balanced trade by controlling or limiting imports into the U.S.

    The means proposed are not the best option available, in my opinion, but their willingness to restrict imports so as to reduce the trade deficit gets my hardy approval.

  • Posted by abhi

    the second post paints a scary scenario. the recent decrease in chinese imports will increase capital outflow and this would mean the fed wont have any control over liquidity in the u.s. market. i just cant see any possible way of sorting out the trade imbalance without government intervention. even if oil goes to 30$ barrel this would decrease capital outflows from the middle eastern markets but china is the second biggest importer of oil after the u.s. and it would mean their trade surplus would only grow and that money has to end up somewhere..and with the chinese government trying to crack down on excess pollution and over capacity investment opportunities will only decrease. and we are kidding ourselves to believe that free markets will sort out the imbalance since the imbalance was created because of offical policy in the first place, as prof sester has stated.

  • Posted by abhi

    sorry i meant second graph not post

  • Posted by Charly

    Brad and abhi – Can you rush these charts and comments to the G20 officials gathering this week end. They don’t seem to be listening. Hearing but not listening…

  • Posted by Dave Chiang

    To Reformer Ray,

    The best way to eliminate the trade deficit with the world would be to increase exports of high-tech products that the US still enjoys a comparative advantage in manufacturing. Unfortunately, entire categories of high tech products are prohibited from export to China and Russia. For instance, civilian communication satellites, civilian helicopters, computerized machine tools, and advanced semiconductor chips are banned from export to the Chinese. Those high-tech civilian products have at best, minimal indirect military application. Moreover, similar products are available for sale by European and Japanese competitors that don’t implement blanket export restrictions on everything from aerospace components to machine tools. Since the value of one communication satellite is the equilvalent of several million toys at Walmart, Washington should reconsider the economic loss to the US Economy of banning so many high tech exports. The Washington Consensus needs to face reality that the Cold War is really over. The new world order will be a multipolar world order marked by the growing power of a range of new national actors, notably – but by no means only – China, Russia, India and Brazil.

    Regards,

  • Posted by Guest

    Isnt one of the problems incentives? If I am Brazil, Mexico, Argentina, or Russia I am happy to accumulate reserves by keeping my currency weaker than it otherwise would be. I am maintaining trade surpluses, and using those reserves to lower the stock of dollar debt and increasing creditworthiness. Ultimately, wont the day come when those reserves will be “monetized” to some extent by buying commodities, buiilding infrastructure, or otherwise investing in non-market assets to increase country wealth, all thanks to the US trade imbalance?

  • Posted by Guest

    Systemic Risk to US Banking System from Derivatives “Insurance” to protect against a dollar decline
    http://www.prudentbear.com/creditbubblebulletin.asp

    The unfolding risks associated with the proliferation of strategies and the explosion of Credit derivatives trading have characteristics that contrast materially to recent experience in currency and interest-rate markets. Let me attempt an explanation, first with respect to the currency derivatives marketplace. Importantly, currency markets have benefited incalculably from the foreign central bank liquidity backstop. This has ensured that, despite the ongoing dollar bear market, Derivatives “Insurance” to protect against a dollar decline has remained inexpensive and readily available.

    Those writing/selling this “Insurance” have enjoyed the extraordinary luxury of a captive audience demonstrating insatiable dollar demand – buyers willing to take the other side of the dollar (“dynamic hedging”) selling (risk transfer) required to hedge/”reinsure” protection written. And, amazingly, the more acute underlying dollar weakness the more willing they are to accumulate ever greater quantities of U.S. securities. In history’s greatest market intervention, foreign central bank (chiefly dollar) reserve holdings have since 2001 ballooned from about $2 Trillion to today’s $4.7 Trillion. On the back of virtually limitless central bank dollar support, market players – especially speculators writing Derivative protection – have operated both with the confidence that markets would remain highly liquid and without the fear of abrupt marketplace dislocations (that cause bloody havoc for derivatives hedging strategies). The resulting cheap and readily available “Insurance” has created a perception that fear of further dollar weakness is no cause to liquidate U.S. securities or assets. Instead, simply hedge with Derivatives!

    Today, the unfolding Derivatives “Insurance” Bubble is creating one additional troubling facet to what has developed into a full-fledged global Credit Bubble comprising U.S. household, government, financial sector and corporate finance, along with Credit systems and asset markets around the world. Global imbalances and associated liquidity excess are unprecedented, and the dollar vulnerable. Despite the recent energy price decline, the domestic and global backdrop remains inflationary as opposed to dis-inflationary. Here at home, productivity is waning and wage pressures are rising.

    - Doug Noland

  • Posted by Guest

    It is currently happening throughout all the United States and constitutes a catalyst of the impact phase of the global systemic crisis. The US consumer, i.e. the US middle class, basically becomes insolvent[11], victim of overwhelming debt, a negative rate of saving, the bursting of the real estate bubble, the rise of interest rates and the collapse of US growth. All these elements are dependent, and mutually reinforcing, to plunge the United States, starting from the end 2006, into an economic, social and political crisis without precedent[13].

    http://www.newropeans-magazine.org/index.php?option=com_content&task=view&id=4906&Itemid=110

  • Posted by bsetser

    technically, those reserves are “monetized” the moment the central bank sells local currency to buy dollars — but in most cases, the central bank then partially withdraws the money it issues from circulation by selling bonds/ including sterilization bonds and “buying” local currency cash. The “monetization” can be avoided if say an oil exporter’s state oil co holds its export proceeds offshore and never exchanges them for local currency.

    the issue is what are the constraints on this process … and one of them would be a desire to stop building up external assets (i.e. buying fx) and to start building more domestic assets (infrastructure) … but that doesn’t per say “monetize” the reserves so much as increase domestic investment (infrastructure) v. savings and thus reduce the need to build up reserves.

    Ray — causation is tricky thing. There is a self reinforcing cycle here, but I would argue that two policy choices — many country’s de facto peg to the dollar and the oil exporters decision to save most of the recent oil windfall — lie behind the surge in official asset accumulation in the periphery. tho so long as those funds are lent back to the us, they help sustain the process that generates the dollar outflows needed to buildup offshore dollar balances (i.e. help the US consume more than its produces, leading to a trade deficit).

  • Posted by ReformerRay

    To David Chaing

    Edmon Fingerton believes that Japan has been able to avoid a trade deficit with China by limiting its sales to China to products that do not involve technology transfer – and that the Chinese object to this practice.

    I realize that the Chinese will ultimately win the competive game – they have the best tools, including a habit of using the central government to defend the long term interests of China.

    The U.S. has made a lot of mistakes in foreign trade. We have not done enough to hold on to any techonological advantage that the U.S. has.

    Your solution is a short-term fix. My solution is also a short-term fix. The difference is my solution will leave the U.S. in a better position to survive in a global economy, where international trade will determine the national pecking order.

  • Posted by Guest

    re: “the Chinese will ultimately win the competive game”

    not sure what you mean by this, but could only guess it would end in implosion and there would be no game left to play. The world – and technology sector – is far too interdependent to think that way.

  • Posted by abhi

    “Ultimately, wont the day come when those reserves will be “monetized” to some extent by buying commodities, buiilding infrastructure, or otherwise investing in non-market assets to increase country wealth”

    In most bric countries the private sector has taken the lead in infrastructure improvement and they are funded by private sector banks. for e.g. in india most airports are being privatised and new ones being built are mainly by the private sector infrastructure companies.

  • Posted by abhi

    though i should point out capital outflows from india are insignifcant compared to china’s.
    prof sester, what do you think of the statements coming out of the pboc about diversifying their reserves to add more euros? was it just rhetoric or do you think they will go through with it? wouldnt this be a big problem for the euro zone as their exports would bemuch pricier and how do you think this would affect their growth as contrary to the US their main growth driver has been exports?

  • Posted by Guest

    Not sure what Brad et al think about Kaletsky, but as Felix did a short post on this recent piece:

    “…These simultaneous fiscal blunders in Italy, Germany and Eastern Europe will almost mean another “lost year” for the euro zone, with economic performance falling far behind America, Britain and Japan. But the long-term consequences could be more far-reaching…” http://www.timesonline.co.uk/article/0,,1061-2421880,00.html

    I have to ask if anyone believes there are good reasons to place any greater confidence in the euro – or the yen – or the CCP’s capacity to safely clear any number of hurdles that seem to be rising up in its path.

    When Volcker refers to, if I understand, the strong possibility of a “crisis” forcing some sort of resolution of an unsustainable arrangement, it would be very helpful to know just exactly, or even vaguely, what he has in mind and how he sees it playing out.

  • Posted by Guest

    Prof. Setser:
    As you say in 11-18 10:13:46, ‘reserves are ‘monetized’ the moment the central bank sells local currency to buy dollars’. The central bank may then withdraw all or part of this newly created fiat money by issuing ‘sterilization’ bonds.

    The issuance of the sterilization bonds is a form of governmen deficit financing, which allows the central bank to buy dollar assets on credit, like a gigantic hedge fund, but one with infinite borrowing capability. Instead of the usual practice of monetizing a government deficit after issuing government bonds, the sterilization bonds are issued after the monetization has occurred, when the dollars were purchased with local currency issued by the central bank.
    Central bank purcheses of dollars result in inflationary credit expansion whether they are ‘sterilized’ of not. They force down global interest rates and stimulated a global credit booms, and leveraged finance bubbles.
    .

  • Posted by BH

    I rather wonder if there’s not something of a doomsday clock parallel here. I grew up with the number of bombs rising by hundreds or thousands each year, knowing the world hung in a slender balance, that any misstep could send us to our dooms. Sanity prevailed, although I don’t wish to understate the danger.

    This and other sites have been moving the doomsday clock on a dollar meltdown/US consumer collapse closer to midnight for some time, and I must acknowledge the danger is real, and it scares me, for I cannot know what anything I own shall be worth when the unwinding occurs.

    But I wonder, is it at possible that this might happen: that the dollar holds around where it is; that the Asian dollar holdings somehow find their way into asset purchases in Africa and other resource-rich places; that wages go up fairly quickly and harhazardly across SE and South Asia as manufacturing spreads out of China to gobble up more liquidity; that Latin American fixed capital, through new elections, policies and good management, simply becomes more valuable; that the wealthy Arabian princes oblige us all with absolutely ridiculous levels of infrastructure spending that will make their current gems in the desert pale by comparison; that America lets in enough entrepreneurial immigrants to recreate its domestic economy; that Europe just continues being Europe….

    …in short, that things turn out OK. Of course, there’s a round of global inflation, billions of dollars end up in private bank accounts of corrupt officials, and a fair bit of cash is frivolously spent on stuff nobody really needs, but midnight never comes? Is is plausible, or am I dreaming in technicolor?

  • Posted by Guest

    one word

    TRADE

    PS many feel uncomfortable about this but it does not have to be neg as long as everyone is happy

  • Posted by Guest

    Plus you know what the other option is and it can be very costly

  • Posted by HZ

    BH,
    What you described is a lot closer to reality than doomsday. One should also follow the physicla economy — not just financials.

  • Posted by FTX

    It was a surprise to see Richard Fisher doing a selling job on the virtues of CBs holding their reserves in dollars in the Bloomberg report below. I can remember a time when Fed officials would have considered it beneath themselves to have to defend the integrity of the greenback. While reading the article I certainly got the impression Fisher was on the back foot.

    Fed’s Fisher Says Dollar Likely to Stay Main Currency

    “United Arab Emirates Central Bank Governor Sultan Bin Nasser al-Suwaidi, who last month said he planned to increase his country’s reserves of euro, said the dollar would be eclipsed by the European single currency within the next decade.”

    If that really were to happen, I’d be interested in a quick back-of-an-envelope assessment from Brad of what it would mean for the US trade deficit. Also, if these sorts of statements are just hot air, what are the motives of those who are making them? What are they trying to achieve?

  • Posted by Guest

    It is interesting that those outside the EU seem to be more frequently quoted in the press as having greater confidence (although they rarely say why) about the Euro’s sustainability and path to being the world’s reserve currency than those within the EU.

    Might this graph is from a 7/25/2006 post on a GaveKal forum, showing the increase in ‘US Wealth’ 1970 to 2006, add any perspective? http://gavekal.com/forum3/attach.aspx/70/us%20wealth.bmp

    “…The rise in real estate does not even register on this graph, because it was financed by debt, and the wealth in the US is computed NET of ALL DEBT. The correct title for that series should be not wealth but EQUITY owned net of all debt by the US citizens… Of course, if we has a collapse in economic growth accompanied by a collapse in the housing market and a rise in interest rates, then all bets would be off. But then US imports would collapse, and so would the US dollar. Shorting the dollar is in fact believing that this last scenario will happen…” http://gavekal.com/forum3/default.aspx?f=2&m=373

    These could be very dumb questions, but is it possible US imports could ‘collapse’ without also dragging down many economies? Doesn’t the doomsday scenario require some explanation of what the dollar is falling against – and how that adjustment may in turn affect the nations most exposed to a violent increase in any one currency against the USD? – and how much of this ‘US wealth’ may already be ‘invested’ in the currencies most likely to rise in the event of a declining USD. Might it be at all relevant to look at how the ownership and distribution of the wealth represented on this graph has changed over the past 36 years? Is it possible that many emerging and developed economies have a direct interest in facilitating an on-going improvement in this situation – i.e. that a great deal of this wealth represents assets both internal to and outside the physical boundaries of the US – or at least with subsidiaries outside the US – which also generate returns for ‘foreign’ participants, whether in Euro or yen or whatever – and may actually represent real wealth creation with potential for further growth in the foreseeable future?

  • Posted by Rueff

    There is stealth currency diversification.
    As ECB vice president Lucas Papademos explained the Euro Area is the greatest trader in the world and more than 50% of its international trade is now in euros. Surely heading towards higher levels testament of the coming of age of the euro.

  • Posted by bsetser

    re: the Euro. eurozone growth has actually been stronger than US growth in 2006 (at least q2 and q3 — see the FT), even without adjusting for slower population growth (US growth should be about 1% higher than europe’s for that reason) and it has been domestic demand led growth …

    I don’t want to minimize the eurozone’s problems — the deficits, the difficulties financing pension/ health care promises with an aging population, demographics. but its balance of payments fundamentals (a small deficit, solid export growth with a rising currency) strike me as stronger than the united states.

    re: sterilization as a backdoor form of government deficit financing … alas, this is not true. if it were China woudl be running huge deficits. If the Central bank buys government debt for cash, that is monetization/ backdoor financing. But when the central bank sells sterilizatoin bonds to take cash out of circulation isn’t financing a fiscal deficit …

    think of it this way — buying the debt of your government = monetizing your own fiscal deficit. buying the debt of the US government (reserves) = monetizing the US deficit (in a sense — as US treasuries are the asset backing local currency issuance). And then withdrawing the money issued by sterilzation bonds turns the monetization of the US deficits into simple financing of the US — with the central bank selling its own debt (sterilization bonds) to raise funds that it uses to buy US debt and other reserve assets.

    FTX — UAE governor’s comments were interesting. I think we should be paying a lot more attention to the strains the $ peg is starting to place on the Gulf. but I agree with your baseline assumption — shifting in that big a way into the euro poses some problems for a smooth adjustment for the US. My baseline scenario for a soft landing assumes $400-500b ongoing central bank financing of ongoing US current account deficits as the US slowly adjusts, as the overall current account deficit stays very large (due to rising itnerest payments) even as the US trade deficit falls. Tis hard to see how that is consistent with a shift into euros on a massive scale.