Brad Setser

Brad Setser: Follow the Money

Roach on globalization and China

by Brad Setser Wednesday, January 31, 2007

Stephen Roach made three arguments last Friday.

I disagree with two of them, but agree with the third.  And the third is by far the most important.   

But before getting to the point of agreement, the points of disagreement. 

The US saves less than it invests.   Roach thinks the US would do so no matter what China does.  So rather than criticizing China for subsidizing its exports (and US consumption), the US ought to be writing China thank you notes.  

This is one of those arguments that I strongly disagree with. It is an example, I think, of what Brad DeLong calls one-equation economics.   I personally don’t think the US deficit can be divorced from the willingness of China (and others) to finance it.   Like Morris Goldstein, I don't think savings and investment balances are entirely independent of exchange rate policies, even if finding the connection takes a bit of work.

It is pretty easy to explain why the depreciation in the real value of the RMB (in the face of strong Chinese productivity growth) led – with a lag to the rise in China’s current account surplus.    It is even easy to link the depreciation in the RMB and growing profits in the export sector to the surge in Chinese business savings.   And, as Martin Wolf has shown, China has had to adopt restrictive macroeconomic policies to prevent inflation from eating away at the real depreciation.  In order to avoid real appreciation through rising inflation, China basically had to clamp down on bank lending and increase government savings … pushing the current account surplus up.

That is the core of my disagreement with Dr. Jen.  He argues large Chinese current account surpluses are a natural byproduct of globalization.  I think they are a natural byproduct of an undervalued RMB. 

By contrast, if you start from the savings and investment side, is seems — at least to me – pretty hard to explain why the 10% of GDP increase in China’s investment to GDP ratio over the past few years should be associated with a rise (not a fall) in China’s current account surplus.   Clearly, Chinese savings has grown even faster than Chinese investment – but unless it is pretty hard to explain what shock triggered a 15% of GDP increase in China's propensity to save.

A surplus in one part of the world has to be offset by a deficit elsewhere. So it isn't surprising that I think that there is a link between China’s savings surplus and the US savings deficit.  China's large current account surplus and the associated growth in Chinese reserves, basically subsidizes US external borrowing.  Without that subsidy, the US would borrow less from abroad.   It would either save more or invest less.  

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Hey big spender (or why conservation is perhaps a bit more than just a personal virtue) ….

by Brad Setser Tuesday, January 30, 2007

In the past, I have noted that oil exporters saved rather than spent the windfall from the surge in oil prices.    The IMF calculated that the average oil producer in the Middle East “spent” 30% and “saved” 70% of the increase in their oil revenues between 2002 and 2005.   I think the IMF is using spending in a broad sense – counting an increase in domestic investment as well as an increase in domestic consumption.     The reason for this restraint wasn’t hard to find.   Lots of oil states were budgeting for $20 a barrel oil in 2004, and oil was well above $20 then.   Budgets inched up in 2005, but not as fast as oil prices. 

But that seems to be changing.  In 2006, both Russia and Saudi Arabia seem to have only saved about ¼ of the increase in their oil revenues.   That is a bit misleading – part of the increase in spending in 2006 reflects the impact of higher oil prices in 2004 and 2005 and so on.   Still, at the margins, ratios changed.  In 2007, the Russian and Saudi budgets balance is their oil is a bit above $40 a barrel – which works out to balancing if WTI is north of $45 or so.      That is a big change from balancing at $20 a barrel (local blend) or WTI in the low twenties.

Then again, the Saudis and the Russians aren’t the big spenders.    Iran, Venezuela (at least when it comes to fiscal policy), Bahrain, Subsaharan Africa and (believe it or not) Kazakhstan are.

That shows up in the following chart – one of many I have been working on for a paper on oil and global adjustment.  It shows the oil price (roughly) needed to cover the import bill of various oil states through 2006.    Imports here are used in a loose sense to refer to imports net of non-oil exports, income payments and transfers – the definition the IMF generally uses for these kinds of calculations.   It is a bit rough.  Some data is still lacking (especially for many of the GCC countries).    I am not sure that Rachel Ziemba and I have adjusted for gas correctly.    But it still gives some idea of the basic trends.

Crude oil price that covers oil exporters import bill; 2007 = forecast  


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Capital freedom, not exchange rate freedom …

by Brad Setser Monday, January 29, 2007

That, more or less, is the conclusion of today’s Wall Street Journal oped on China.    

I loved the title – talking of the People’s Investment Company is far more catchy than talking of a sovereign wealth fund or a government investment fund.    But I didn’t love the content, as my regular readers know (this oped ran on Friday in the Asian edition of the Journal).    It would be nice, for example, if the Journal recognized that foreign exchange reserves are an asset – not a liability – on a central bank’s balance sheet.    The FT consistently gets these kinds of things right in its leaders.

But the bigger issue is would “capital freedom” – lifting China’s capital controls – reduce the pressures facing China’s central bank in the absence of “exchange rate freedom” – letting the RMB  appreciate a bit. 

My answer is an unequivocal no. There just isn’t much evidence private Chinese savers want dollars.  At least not at current interest rates and exchange rates.  The dollar share of domestic deposits is falling.    Chinese savers aren’t shying away from the cleaned up domestic banking system (nor, for that matter, are foreign investors).  There hasn’t been much interest in the Qualified Domestic Investor Initiative, as the Journal notes.   And given how well Chinese stocks have done recently, it isn’t obvious that letting Chinese domestic investors buy equities would dramatically change the dynamics. Controls on outflows are being tightened, controls on inflows are loosened.   The money that is flowing out of China seems to be coming from state institutions – whether state banks, state insurance companies or state pension funds.  

If anyone has good evidence to the contrary – do tell.  I would be most interested. 

The basic problem China faces – highlighted by Dr. Jen among others – is that at current exchange rates both Chinese goods and Chinese financial assets are cheap.  At least for foreigners.   Conversely, both foreign goods and foreign financial assets are expensive for Chinese investors.   At least for those who cannot borrow the PBoC’s dollars at a fixed rate in the swaps market …  

As a result, my guess is that if China truly lifted all controls on capital at the current exchange rate, far more money would flow into China than would flow out of China.   Rather than reducing pressure on China’s balance of payments, capital account liberalization would add to it.    That is why I am fairly sure Chinese policy makers won’t be embracing “capital freedom” any time soon.

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The Davos lie

by Brad Setser Sunday, January 28, 2007

I am intrigued by a comment the often provacative Larry Summers made at a Davos seminar:

Lawrence Summers, the former U.S. Treasury Secretary and Harvard University president, delivered some harsh criticism of the way globalization has been pitched to the public. Making the intellectual case for free trade and then simply “paying off” some of the losers in globalization, Mr. Summers said, will not work for world leaders trying to sell the current round of global trade talks to a skeptical polity.

“That’s the Davos lie,” Mr. Summers said during a dinner Friday night.

I wonder what Summers thinks would work?

One of the things that has struck me about the current politics of trade is that the losers aren't really paid off — either formally or informally.  The various government programs that help displaced workers are small.  The heads of private equity firms don't, for example, don't tend to raise funds for charities to help workers displaced by booming US imports of auto parts, even though private equity firms clearly have been among those who have benefited heavily from the United States ability to import China's savings surplus. 

In some areas, paying people off the losers is rather hard.  Compensating US farmers for the loss in market value of their land should the US ever really give up its agricultural subsidies would be quite expensive – as, for that matter, would compensating US homeowners for their losses should the US every stop subsidizing mortgage interest.   Once a subsidy gets capitalized into asset values, watch out …

I suspect Summers believes that the integration of China and India into the world economy have such profound implications – including such profound implications for who wins and who loses from trade — that old policies for managing trade-related dislocation aren't enough.   But I don't really know … 

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Davos nights

by Brad Setser Sunday, January 28, 2007

Gideon Rachman seems to be having far more fun at Davos than the far more earnest Nouriel “still doom and gloom in an ever more complacent world” Roubini.    Just guessing.  I don’t know what Nouriel has been up to.   But Gideon Rachman seems to be spending more time with pliffered Bordeaux and Ms. Invest in Germany than, you know, actually attending conference sessions.     

Not that I wouldn’t do the same.  Me, I have been spending my time updating various calculations on oil exporters’ propensity to consume.   Ms. Invest in Germany might want to take notice.   The oil exporters are big fans of German goods …

The latest sign the apocalypse is upon us … CNY funded carry trades

by Brad Setser Friday, January 26, 2007

If what rational world does it make sense for the currency of a high-investment, fast growing, still quite poor country to be the funding currency for a carry trade?

The Japanese yen and Swiss franc as funding currencies I get, even if it is hard to pin down the size of yen-funded carry trades using the balance of payments data.    Japan and Switzerland are wealthy slow growing economies with lots more capital than people.  China not so much. 

Though – picking up on something HK raised in the comments on a previous post, the notion that CNY appreciation would push up the currencies of all of Asia, including Japan, doesn’t necessarily seem to be holding.   Most of emerging Asia has been appreciating along with or faster than China.   But Japan hasn’t been.  And still isn’t.   Japan hasn’t been a good proxy – at least in the fx sense – for China.  Now the weak yen seems to emerging along side the weak RMB as a constraint on the willingness of a country like Korea to allow further appreciation.

The yuan carry trade is apparently financed with offshore yuan – which are a lot cheaper than onshore yuan.   Philip Bowring in the Asian Sentinel

The latest throw of the dice proffered as an “investment idea” is to take advantage of the low cost of borrowing in yuan in the offshore market. The implied cost of 12-month money is just 0.7 percent, which makes it about as cheap a funding currency as the yen.

But if banks can lend offshore yuan at 0.7%, someone else must be willing to hold yuan denominated accounts that pay even less in the hope of currency appreciation.   There are two sides to this trade.   And, well, funding a carry trade in the currency of a country facing enormous appreciation pressures is kind of risky.  But it is increasingly hard to make a buck.  Borrowing short-term in dollars and lending long-term in dollars doesn't cut it any more.

While I am on the topic, the WSJ’s oped on the “People’s Investment Corporatation”  wasn’t totally off the wall.  Which is a little unusual. But it wasn’t totally unobjectionable either.

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Sometimes I agree with Dr. Jen

by Brad Setser Thursday, January 25, 2007

I rather suspect I favor a bigger and faster appreciation of the RMB over time than does Dr. Jen, but I very much agree with his argument for a bit more RMB appreciation in the near term.   Stephen Jen of Morgan Stanley, in his most recent note:

I do believe that, relative to the trends in China’s external account, the pace of crawl of USD/CNY is too slow.  First, the argument that China’s exporters are sensitive to a modestly stronger CNY is no longer compelling.  Second, a stronger CNY has merits, from the capital account perspective.  Third, the rapid growth in China’s official reserves is becoming a problem.  Fourth, the real effective exchange rate of the CNY has not changed since 2003, despite the move in USD/CNY.  The bottom line is that the cost-benefit proposition no longer justifies China confronting the US Congress over the USD/CNY parity.

(Update: the internet version of Jen's note is here.  I should add that while I agree with much of what Jen wrote, I never have found the argument that China's financial sector wasn't ready for a bit more RMB appreciation compelling.  China's financial sector never had a currency mismatch.  What China needed to do was to clean up the banks bad domestic loans.  And in lots of ways, the slow pace of RMB appreciation and the associated need for lending curbs has slowed banking reform.  I also don't quite see how selling off small stakes in banks that are still majority owned by the state constitutes "privatization.") 

I also agree with another point Dr. Jen makes in his most recent note: the enormous growth of state investment funds is leading to a shift in the balance of financial power, one where the "financial" power of the public sector is growing relative to the financial power of the private sector.    And specifically one where the financial power of the public sector in emerging economies is growing relative to the private sector in  advanced economies.  

So far though, the enormous influx of funds from the public sector in emerging economies into US and European markets has been nothing but a boon to most players in the private market.   They may not be as powerful as they once were (who is now afraid of the bond market?) but they are a lot richer than they used to be.   And Wall Street and the City have always cared more about money than any thing else …

"Liquidity" is a nebulous concept.  Everyone thinks that there is a lot of it out there.  Financial assets (including complex ones) are easy to sell, making it easy to raise money for new lending or new investment.  But if you look at classic measures of money growth, the US doesn't seem to be creating quite as much of it as it once did — at least according to the measures the Fed uses (M1 and M2, see the graphs here; M3 may tell a different story).  Central banks have tightened short-term rates even if long rates haven't followed.   Credit Suisse notes that the gap between policy rates and nominal GDP growth — one of its measures of excess liquidity — has shrunk.

As Jon Anderson of UBS points out, emerging market central banks cannot create dollars — only their own currency.   They have to buy (or borrow) their dollars on the open market.  They aren't the ultimate source of dollar liquidity, at least as it is classically defined.

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Et tu, Argentina?

by Brad Setser Thursday, January 25, 2007

Argentina apparently bought $2.1b in the foreign exchange market over the past three weeks.  Brazil – if you are keeping tabs – bought around 3.65b.   The southern cone seems to have joined Bretton Woods 2 …

I spent most of 2001 working on Argentina in one way or another, and I never thought I would see the day when Argentina added $2b to its reserves in a month, let alone is on track to add well over $2b.   Just to put this kind of inflow in perspective, in 2001, Argentina lost $20b of reserves (net of IMF lending) through the course of the year.  That works out to an average monthly reserve loss of well under $2b.

Some of Argentina’s reserve growth comes from its trade surplus – this is the time of the wheat harvest in the southern hemisphere, and wheat is kind of high right now.  The country that Paul O’Neil famously said couldn’t export ran a $12.5b trade surplus in 2006   But some presumably comes from capital inflows.  Investors may be worried that Ecuador is about to "pull an Argentina," but they don’t have similar worries about Argentina.   At least not now.

Incidentally, it is a bit unfair to attribute Argentina’s default to Kirchner.  He wasn’t the President back in 2001.  He is, by contrast, the one responsible for Argentina’s decision to stay in default for an extended period of time and to demand a deep haircut from Argentina’s creditors.  He put the government of Argentina on a course where it had little need to borrow from global markets to finance ongoing fiscal deficits.

One of the things that has most surprised me over the past few years is just how willing countries that don’t exactly see eye to eye with the United States have been to finance the US by building up their dollar reserves.   

That applies to countries liek Argentina that have a somewhat different view of economic policy than the US and countries like Venezuela that have a very different view of economic policy than the US.  Venezuela apparently still has 80% of its reserves in dollars, even they aren’t held onshore in the US for political reasons.  That applies to countries like China and Russia, which seem a bit more keen on "bureaucratic" capitalism and state control than US, aren’t so keen on little things like democracy and presumably have a slightly different conception than the US of the world’s future geopolitical order.  And it applies to the various sheikdoms in the Middle East, which presumably have a very different vision of the “new Middle East” than the Bush Administration.

Corporate profits likely up by more in China than in the US …

by Brad Setser Wednesday, January 24, 2007

OK, we don’t know how much corporate profits increased  But 29% increase in China’s corporate tax revenues in 2006 tops the 22.2% y/y increase in US corporate tax revenues so far FY 2007  …

I think the tax data rather reinforces the argument that Louis Kuijs and Bert Hofman of the World Bank’s Beijing office have been making about how rising corporate savings have been the key driver of the overall rise in China's national savings.     Martin Wolf – citing Jon Anderson of UBS – has made a similar point.

Overall tax revenues grew by something like 20% y/y — so spending also needed to grow by 20% y/y to keep China’s fiscal balance constant.  I rather suspect that spending didn’t grow at that rate, which implies that a falling fiscal deficit and rising government savings contributed to China’s rapid savings growth as well.

The FT article notes that investment growth slowed in the second half of 2006.  That also wasn’t an accident: the government clamped down on lending growth.

It all seems quite with another of Dr. Wolf’s key arguments – China has had to take policy actions to raise savings and reduce investment in order to keep its economy from overheating, given the strong stimulus provided by the rapid growth of its exports.   And in the process, Chinese policy has in effect created is savings surplus.   The causality though goes from the fall in China’s nominal exchange rate to a surge in exports to a policy-induced rise in savings relative to investment – with the rise in savings relative to investment necessary to prevent inflation from leading to a real appreciation.

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Yet more evidence that emerging markets cannot create the financial assets their citizens want to hold …

by Brad Setser Tuesday, January 23, 2007

If I am doing my math right, Chinese citizens added RMB 4.83 trillion (around US$ 620b at 7.8 RMB to the dollar) to their RMB-denominated bank accounts over the course of 2006.   It seems like more and more Chinese are putting their savings in the bank (rather than holding onto cash) at a time when the PBoC is injecting a lot of "liquidity" into the local economy.  During that same time Chinese citizens reduced their holdings of domestic dollar deposits by RMB 0.033 trillion (around US$4b) even though dollar interest rates exceed RMB interest rates.   Not exactly strong evidence that Chinese private savers are desperate for dollars …

China is trying to restrain domestic Chinese investment in its frothy domestic stock market even as it loosens restrictions on capital outflows and tightens restrictions on capital inflows.  

Domestic Chinese savers just don’t seem that keen on keeping the dollar share of their portfolio constant.   Come on guys, trendy modern economic theory says that a falling dollar is a reason to increase your dollar holdings – and the out-performance of the Chinese stock markets is a reason to increase your holdings of US stocks.  Get with the program!

China’s banks haven’t been able to match their surge in deposits with a surge in lending.  If my math is right, Chinese bank loans increased by RMB 3.18 trillion (around US$ $405-410b) in 2006.   But don’t blame the banks.  They were more than willing to lend out their surging deposit base.  The central bank just wouldn’t let them. 

And if any one can provide a detailed accounting of what China’s banks did with the RMB 1.65 trillion (around US $210b) that they didn’t lend out, I am all ears … 

Some of it is on deposit with the central bank as a result of rising reserve requirements, and some has been used to increase the banks holdings of PBoC sterilization bills.  I also wouldn’t be surprised if some RMB has been swapped with the central bank for dollars … but that is just a hunch.

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