Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Wrong about 2006. Right about 2007? Or 2008?

by Brad Setser Thursday, November 16, 2006

I don’t think that Nouriel Roubini and I ever argued Bretton Woods 2 – an international monetary system based on central bank financing of the US deficit — would absolutely collapse by the end of 2006.  But we did say that there was a “meaningful risk” that the Bretton Woods 2 system would “unravel before the end of 2006.”   It is quite fair to say that our tone suggested far bigger risks than have been realized, and that Bretton Woods 2 has been far more stable than we expected.   

The dollar has not fallen significantly against most currencies since we wrote our paper warning that Bretton Woods two might prove to be unstable: the dollar rallied against the euro in 2005 before falling in 2006, rallied v. the yen and stayed basically stable v. most emerging markets.  All signs indicate that central bank reserve accumulation has remained quite strong, and that the lion’s share of those funds are still lent to the US.  

Simon Derrick of the Bank of New York – in his note yesterday — rather graciously decided not to dwell on the fact that my timing was off.   He instead opted to highlight that the various forces that Nouriel and I argued might make Bretton Woods unstable are still in play.   They just may have a longer fuse than we thought at the time.

Derrick writes

Back in February of last year the Federal Reserve Bank of San Francisco hosted a seminar entitled “Revised Bretton Woods System: A New Paradigm for Asian development?” Among the speakers at the event were Nouriel Roubini from the Stern School of Business at New York University and Brad Setser from University College, Oxford who together presented their paper “Will The Bretton Woods 2 Regime Unravel Soon?” In the paper they highlighted the fundamental reasons why they believed the  “Bretton Woods 2 international monetary system” is unstable and would unravel “before the end of 2006.” What are particularly interesting to note now (as the end of 2006 approaches) are the potential sources of instability they identified nearly two years ago that they believed would feed through into the systems potential break-up. These were:

1. “The intrinsic tension between the United States’ growing need for financing to cover its current account and fiscal deficits and the large losses that those lending to the US in USDs are almost certain to incur as part of the adjustment needed to reduce the US trade deficit.”

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I am big in Denmark …

by Brad Setser Thursday, November 16, 2006

OK, not really.  I suspect my entire Danish readership either has already heard my interview with Peter Harmsen of the DBC on Chinese reserves, or knows about as much about the topic as I do (the folks at Danske Bank are good).   The DBC story is mostly in Danish, but there are a few English snippets from Harmsen's interview with me here and there … 

Bill Gross, eat your heart out … Norway is the new bond king (The SeptemberTIC data)

by Brad Setser Thursday, November 16, 2006

No one seems to have timed the US Treasury market better that the Norwegian Government pension fund.    

In the first half of the year, Norway shortened the maturity of its dollar portfolio – adding $33.5b to its short-term claims and selling $23.7b of long-term claims (including $18.2b of Treasuries).     That was back when yields were rising/ the value of long-term bonds were falling. 

In the third quarter, it shifted back into long-term bonds … likely catching part of their rally.  Norway purchased $17.5b of long-term debt in the third quarter, in part by cutting its short-term claims by $3.7b.

Brazil did something similar, buying $14.3b of long-term debt, in part by reducing its short-term claims by $2.4b.  Indeed, my own proprietary work suggests that central banks collectively shortened the maturity of their portfolios in the first half of the year by building up dollar deposits even as they reached for a bit more yield in the Agency/ MBS market.

Those kinds of details are a lot easier to see with the Treasury’s new format for presenting the TIC data.    I love the new quarterly totals by regions.

But the big story, of course, if that no matter how you cut it, recorded flows in September (and indeed the third quarter) were too small to finance the US current account deficit.    The Q3 current account deficit looks set to approach $230b.      And if current trends continue, the US actually needs to raise a bit more than $250b a quarter to finance net FDI outflows.

Net foreign purchases of long-term securities – without adjusting for principal payments on agencies – were $212b.  Recorded inflows from official institutions provided $69b of that total.  Those are the numbers that we are used to seeing; they are the only numbers the Treasury used to report in its headline release.

But the new format provides a bunch of additional data.

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Rising private Chinese purchases of US debt …

by Brad Setser Wednesday, November 15, 2006

Yes, that is a new topic.

But private Chinese demand for US debt seem to be rising.   The World Bank Quarterly Update reported – drawing on Chinese data — that “Chinese individuals and institutions bought $45 billion in foreign notes and bonds in the first half of 2006.”  

Chinese foreign direct investment – particularly in oil and gas – has gotten a lot of attention.   But the total outward flow of foreign direct investment in the first half of 2006 ($6 billion) pales relative to private Chinese purchases ($45b) of the world’s debt, let alone official purchases of debt ($122b, assuming all reserves were invested in debt).

And, judging from the q3 balance of payments data – which shows a huge surge in private capital outflows from China, enough to hold China’s reserve growth below its current account surplus for the first time in a long-time – those private outflows have continued.   See Richard McGregor in the Financial Times.

So what is going on?  

Stephen Green of Standard Chartered (quoted here) has done great work on the topic, but it is behind their firewall.  Sorry. 

He thinks most of the outflow comes from the banking system.    

Some of it clearly reflects the investment of the funds Chinese banks raised through their IPOs in international markets.   The Bank of China raised $11b in the first half of this year (ICBC raised more, but not until the third quarter).   But even if all of the IPO proceeds were invested in bonds, that wouldn’t explain a $45b outflow. 

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Still not rebalancing …

by Brad Setser Tuesday, November 14, 2006

The Economist cover jinx strikes.  After the Economist’s cover story extolling how Chinese growth no longer depends heavily on exports, the contribution of (net) exports to Chinese growth has done nothing but increase.

The always excellent World Bank China Quarterly Update delivers the goods. 

“The contribution of net trade to GDP growth increased to almost 3 percentage points, after 1.2 percentage points in Q1 and 2.4 percentage points in Q2”

Given China’s October trade data (exports up 30% y/y, imports up 15% y/y) , it seems quite likely that net trade’s contribution to q4 growth will even higher still – though perhaps as high as in Q2 2005. Update: for more on China's ongoing dependence on external demand, see Denise Yam in Morgan Stanley's (redesigned) Global Economic Forum.

In one sense, though, China is rebalancing.   The dollar peg has increased China’s competitiveness relative to other regions more than its competitiveness in the US.   As a result, China is less dependent on exports to the US – as Goldman’s Hong Liang and the World Bank both note. Chinese exports to Europe (West and East), Latin America and Africa have all been rising faster than Chinese exports to the US. 

But in a broader sense, China isn’t rebalancing the basis of its growth away from investment and exports.  Every time China tries to cool investment growth, it ends up increasing its dependence (net) exports.   To be clear, consumption continues to increase, but not as fast as China’s productive capacity.

Nor is the world economy rebalancing.    At least not really.   The US trade deficit is at best stable in real terms (see the graph of NX to GDP in Menzie Chinn’s most recent post).  My personal view is that, abstracting from fluctuations due to fluctuations in the price of oil, the trade balance is still growing in nominal terms.  That implies that the current account balance will continue to rise on the back of higher interest payments. 

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“Exceedingly unlikely to be indefinitely sustained”

by Brad Setser Monday, November 13, 2006

Those are – best I can tell – the words former Treasury Secretary Robert Rubin used to describe the current pattern of global capital flows, one which has allowed the US to finance a current account deficit that Rubin considers “almost unimaginable” in size.

Rubin is the consummate diplomat.    He always chooses his words carefully.   He uses phrases like “the already difficult politics of trade have gotten substantially more difficult.”  But there is an underlying tone of deep concern in his speech at a recent Brooking event.

About the US external deficit and the current pattern of capital flows.  About the elevated (in Rubin’s view) risks to the US outlook.   About low risk premium in almost all financial markets (oil is the exception), when in Rubin’s judgment future risks are likely to be “at least as great” as past risks.   About stagnant real wages for many Americans.  And about the political difficulties combining a domestic policy agenda that helps mitigate some of the insecurities created by increased global competition with political support for continued openness to that competition.  

Are most petrodollars already in sovereign wealth funds?

by Brad Setser Monday, November 13, 2006

Stephen Jen thinks so.

“Most of the petrodollars are already in ‘sovereign wealth funds’, with good exposure to emerging markets and equity markets, including the Nikkei” 

Alas, Jen is wrong.   At least when it comes to the flows.   Most of the Gulf’s oil money is in oil investment funds (sovereign wealth funds) – though Saudi Arabia is a big exception.  But the overall flow of oil money into in the foreign exchange reserves still trumps the flow of oil money into oil investment funds.   At least that is what my work suggests.

Jen isn’t the only one who has a tendency to understate the reserve growth of oil exporters.   At the Euromoney fx conference last week, estimates of reserve growth by oil exporters were all over the map.  The only consistent pattern is that they are generally too low.  

Let’s go through the key countries.

Three important oil exporters clearly have given most of their oil windfall over to their respective oil investment fund to manage: Kuwait (KIA), Abu Dhabi (ADIA) and Norway (the government pension fund).     

In general, setting Saudi Arabia aside, the Gulf countries make use of oil investment funds to manage their oil wealth.    And those investment funds generally do have exposure to both emerging markets and equities, unlike (most) central banks.

However, Saudi Arabia is an important exception.    It doesn’t report a large increase in its formal reserves.   But it also uses a very narrow definition of its reserves.   The Saudi Monetary Agency’s foreign assets have been growing very rapidly: See the lines “deposits with banks abroad” and “investment with foreign securities” in this data release; the data is in riyal, but the conversion is easy.   

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“Convenient to the point of being self-serving … but it seems right”

by Brad Setser Sunday, November 12, 2006

Those are the words Charles Dumas and Diana Choyleva of Lombard Street Research use to describe Bernanke's savings glut hypothesis in their book "The Bill from the China Shop."  They write:

In March 2005, Ben Bernanke, successor to Alan Greenspan as chairman of the Federal Reserve, followed the same logic, attributing US financial deficits to an "Asian savings glut."   For the Fed, his argment is convenient almost to the point of being self-serving.  But it seems right.

I basically agree.  That is a bit of a change.  Back in early 2005, there seemed to be as much of an investment dearth as a savings glut.   And some of the world's excess savings seemed to stem from an excess of fiscal stimulus in the US.  But since then, the amount of policy stimulus in the US has been scaled back while the savings surplus of China and the oil exporters has soared.   

There remains one key point of difference.  I still think Bernanke downplayed the role government policies — whether exchange rate pegs that have led to a surge in reserve growth, bank policies that have restrained credit growth to help sustain a real undervaluation or fiscal policies that have saved a very large fraction of the oil surplus — have played in generating the savings glut.   Combine the savings of China's state-owned business sector with the savings of oil-exporting government and it sure seems that the global savings glut is really a government savings glut. 

China right now clearly has savings glut, not an investment dearth — at least is a glut means more than you know what to do with.   China's surging current account surplus (its savings surplus) has come in the face of surging investment.  And China's surging surplus has come in the face of a surging bill for imported oil — indeed, for imported commodities of all kinds. 

Indeed, the fact that China's "savings" surplus has soared — keeping Asia's overall "savings" surplus growing — even as higher oil prices increased the "surplus" savings of the oil exporters goes a long way to explaining the "glut."   Higher oil prices — and higher oil state savings — could have been offset by lower savings in all oil importing regions.   But the savings surplus of one oil importing region (Asia) has increased along side the oil surplus.   That has left plenty of funds to finance deficits in the US and elsewhere at fairly low rates.

While I am marking my views to market, so to speak, I should formally recognize that the Michael Dooley, Peter Garber and David Folkerts-Landau have gotten an awful lot of things right over the past two years.   They missed the impact of the oil exporters' dollar peg, but it fits neatly into their overall hypothesis.    The set of countries adding to their reserves has changed, but all available evidence indicates that the surge in emerging market reserve accumulation that started in 2002 has been sustained.  2006 reserve growth looks likely to at least match its 2005 levels.   

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Neither monetary policy nor half a billion dollars is what it used to be …

by Brad Setser Friday, November 10, 2006

Michael Mandel’s Business Week cover story poses an intriguing thesis in a provocative way: 

“No matter which party you belong to, or which Big Idea or school of economic policy you subscribe to, one thing is clear: Globalization has overwhelmed Washington's ability to control the economy.”

Mandel hints at an equally bold solution – global institutions for macroeconomic management that replace national institutions.

a Big Big Idea–probably too big to even consider right now–would be the creation of global institutions for governing the world economy. History tells us that market economies are prone to financial crises, to which the only solution is a strong central bank.  ….  But with the explosive growth of China and India, that sort of [crisis management] role for the Fed is no longer feasible, and no new institution has arisen to take its place. …. The best solution would be some sort of global central bank with real powers–but that's not going to happen until there's a big enough financial crisis to truly scare people.

Mandel's right.   Replacing the Fed with a super-sized and super-powerful IMF – one that that acts like a central bank, not a (moderately-sized) global credit union — is a big step, one that is not likely to happen soon.  [Note: I edited this section in response to Mandel's comment]

I liked the article — and think it raises an important set of issues.   So I feel somewhat bad highlighting a couple of points of potential disagreement.   But only somewhat.

Globalization does potentially alter the effectiveness of certain macroeconomic tools.   Higher policy (short-term) rates do not always lead higher long-term rates any more.  Europe now has its own bond yield conundrum.     

But I am not sure if Mandel’s broad analytical point that globalization has reduced the effectiveness of all macroeconomic tools holds.  It seems true for monetary policy.   But not necessarily for fiscal policy.

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