Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

A strange way to go about rebalancing China’s economy…

by Brad Setser Monday, March 19, 2007

China now exports more than it imports – a lot more.   Even most American economist are starting to recognize that the “China runs a surplus with the US but its overall trade is balanced” argument is now a bit dated.

China does import a lot planes.   Aviation is one area where the Chinese concede the US might have a competitive advantage even at current exchange rates. So importing more American and European planes is one way China might chip into its surplus. 

Or maybe not.   The government of China has decided to create a Chinese airbus – a state company to make big planes to compete with Boeing and Europe’s own Airbus.

China's long-term ambitions to produce large planes won’t immediately affect  Boeing's sales, let alone the trade balance.  It will likely take China 15 to 20 years to learn how to make large planes.   

Indeeed, that it what makes the politics of this interesting.   Neither Boeing nor Airbus (or their workers) really wants a third participant in the market, and certainly not one with access to the deep pockets of China's government.  Airbus gets some state aid, but it is currently handicapped by the strong euro. China state firms … well … aren't exactly handicapped by a strong currency. 

At the same time, China is expected to spend a lot of money buying planes over the next 15-20 years.  Richard McGregor

The European group's latest forecast places China second behind only the US in both the number and value of jets needed between 2006 and 2025, with a market for 2929 large aircraft worth $US349 billion ($439 billion).

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Jen v. Setser on exchange rates and global adjustment

by Brad Setser Friday, March 16, 2007

It is fair to say that I see the world very differently than Dr. Jen.  He thinks imbalances are a natural byproduct of globalization.    I think they are a natural byproduct of undervalued exchange ratesin the emerging world and Japan and massive growth in the emerging world’s official assets.

He interprets the fall in the q4 current account deficit as evidence that exchange rates don’t matter, and thus there is little need for the dollar to move more.    A rise in the US savings rate triggered by the housing retrenchment is all that is needed.  He wrote in his weekly note: 

“The sharp drop in the US C/A deficit in 4Q was a validation of the benefits of a world rebalancing through income, rather than through exchange rates.”

I, by contrast, interpret recent data as evidence that exchange rates do matter – not the least the exchange rate between the dollar and a barrel of oil.   

The fall in the dollar cost of oil was the biggest reason for the fall of the q4 current account deficit.   But it wasn’t the only reason.  US export growth has been strong since 2004.   Why?  Probably because of the lagged impact of the dollar’s 2002-04 fall. And when I look at the regional data, I see even more evidence that exchange rates matter.   


Both Asia and Europe grew strongly in 2006 — i agree with Jen on one point, there was a "rebalancing" of the sources of global growth in 2006.   

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Just how big is the yen carry trade?

by Brad Setser Thursday, March 15, 2007

Stephen Jen of Morgan Stanley insists not-so-big.  Or at least that the large size of the carry trade cannot be proved – and that the impact of any recent unwinding has been overstated.   That is his long-standing view. In early February, Jen wrote: “So far, our view is that most of the outflows from Japan are benign and stable in nature.”

John Dizard of the FT seems to agree.  He notes that the Japanese authorities estimate that leveraged short-term bets on the yen only total $20-40b.

Others, though, seem to think the yen carry trade is now rather large.

Tim Lee of Pi Economics recently got some support from Jesper Koll of Merrill Lynch.  He also puts the size of the carry trade at close to $1 trillion – and more importantly, says that various players in the market added about $300b to their position over the past year.  The FT:

Merrill Lynch said on Tuesday that its research in the Tokyo interbank market showed that non-Japanese banks’ funding had surged from Y1,500bn to Y7,500bn since the end of 2005.

“This Y6tn ($51bn) surge in non-Japanese funding is a new development that, in our view, points to the true carry of yen-funded leveraged position build-up in the recent past,” said Jesper Koll, economist at Merrill Lynch, who believes “the absolute size [of this carry trade is] maybe around $1tn, with about a third of the positions built up in the past 12 months”

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Great title –

by Brad Setser Thursday, March 15, 2007

The United States of Petrodollars

One big question is whether the United States of Petrodollars really holds petro-“dollars” or has moved more of its funds into petro-“euros” or other alternatives to the dollar.    My guess is that the Saudis – who keep most of their spare cash on deposit at SAMA – still hold mostly dollars, but that some of the smaller oil sheikdom's investment authorities haven’t been quite as faithful to the dollar.    That is just a guess though.    

The Asian oil exporters  — TICspeak for the Gulf — really did put a lot of funds in the US in January (around $11b, counting both short and long-term flows), but that big influx came after several sub-par months.   And generally speaking, the Gulf uses London custodians and private fund managers and offshore accounts so very little of its surplus tends to show up in the US data.

Other than that, I don’t have much to add to Serhan Cevik’s analysis. I share his doubts about the wisdom of the GCC’s plans to continue to peg to the dollar in the run-up to their monetary union (link here, RGE subscription required).    Pegging to the dollar over the next few years seems to be sure recipe for a lot of inflation, as the dollar’s slide drives up import prices even as the oil states are spending more of the surplus.  Some are spending more on domestic social programs and salaries, others  on mega-investment projects.    No matter.  Both imply less fiscal sterilization and more inflation.   

And I agree with Cevik's argument for more exchange rate flexibility: “a more flexible exchange-rate regime would allow these economies to manage the volatility of oil prices better.” Put a bit differently, I don’t think dollar pegs make any more sense for a group of oil exporting economies than for an individual oil exporting economy.    

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Capital inflows to the US resumed in January …

by Brad Setser Thursday, March 15, 2007

That shouldn't be a total surprise.  You cannot run a $850-860b current account deficit for long if you cannot borrow from the world.   December's roughly $15b net outflows simply wasn't sustainable.    In January, net inflows totalled aroudn $75b, with a bit under $50b in recorded net private inflows and a bit over $25b in net official inflows.  

Foreign private demand for US bonds — recognizing that the line between private and official demand is blurred by the use of custodians and private managers for a portion of the world's reserves — returned in January.  Perhaps as importantly, US demand for foreign bonds fell.   The big upturn in US demand for foreign bonds explains, in part, the weak December data.    Foreign demand for US equities also exceeded US demand for foreign equities in January.   Let's see if that continues.

Official buyers liked Agencies but not Treasuries.  China bought Agencies,  Brazil bought both Treasuries and Agencies and the Norwegian government fund sold Treasuries, big time.  China, Brazil and the Asian oil exporters combined to buy over $20b of long-term US securities, but their purchases were offset by Norway's $10b sale.  

Moreover, since a lot of the reported overall increase in official assets doesn't show up in the specific line items for either long-term or short-term securities, it looks like the world's central banks built up their dollar bank accounts.   The disaggregated data indicates that both China and the Asian oil exporters increased their short-term claims on the US.  Norway did too, but the increase in its short-term claims was smaller than the fall in its long-term claims.  Russia, by contrast, continued to move its assets offshore — total Russian short-term claims continued their fall.

Brazil and India also increased their short-term claims on the US — and the growth in individual line items scream "central bank."  But the increase from Brazil was more noticeable.   The Tokyo (or Zurich) to Rio (or Sao Paolo) to US treasuries channel is becoming a rather important mechanism for financing the US: the Brazilians, unlike the Indians, seem to hold most of their reserves in dollars.

To be honest though, I am more interested in the February number than the January number.  Every indicator I check suggests (private) capital flowed toward the emerging economies in a big way in February and, in turn, global reserve growth absolutely soared.   Monthly reserve growth of something like $80b (an annualized total of over one trillion dollars) isn't out of the question.   And I want to know how much of that flowed into dollars — and how much of that dollar flow was captured in the US data.

The q4 current account deficit

by Brad Setser Wednesday, March 14, 2007

Count me among those who were surprised by the size of the fall in the q4 current account deficit.  I was expecting a fall, but not as big a fall as the BEA reported this morning.

The q4 deficit came in at $195.8b, down from $229.4b in q3.  Add in a $213.8b deficit in q1 and $217.7b deficit in q2, and the annual deficit came in at $856.7b.   That is about $200b more than the 2004 deficit.

A significant fall in the q4 deficit was expected.  The big fall in oil prices in q4 — together with decent export growth and relatively subdued non-oil import growth — brought down the trade balance.   But the size of the fall was bigger than I expected.  I thought the income balance would continue to deteriorate.  Instead, it improved — a q3 deficit of $5.3b turned into a q4 surplus of $3.0b.  I was expecting something more like a deficit of $8b — or was until the flow of funds data came out (it also showed an improvement in the income balance in q4, see table F107)

The q4 income balance likely will be revised downward over time.   That has been the pattern this year (note the rise in the estimated current account deficit for q1 and q2).  And some of the details of the q4 data seem a bit strange.   The earnings of foreign direct investors in the US fell by over $5b in q4.  Sure, the US slowed, but I thought Toyota still was doing rather well.   The microdata indicates the fall comes entirely from a huge fall in reinvested earnings, which more than offset a rise in distributed earnings. 

Seven other things jumped out at me.

1.  The US borrows to consume, not to invest.  That at least is the story of the flow data.   US equity investment abroad exceeded foreign equity investment in the US (counting portfolio equity as well as FDI) by about $80b.   The current account deficit by contrast was around $860b.   Think of it this way: the ratio between borrowing to invest ($80b) and borrowing to consume ($860b) was about 1: 10.   The true global financial intermediaries of today's world are found in Europe, as London and a host of eurozone financial capitals take in large sums from Asian central banks and oil exporters looking for alternatives to the dollar and use those inflows predominantly to finance their external investment.  So long as Euroepeans didn't use central bank inflows to buy too many CDOs backed by subprime US mortgages, that presumably is a good business.

2. The rise in the US oil import bill accounted for most of the deterioration in the US current account deficit in 2006.   As Menzie Chinn has highlighted, the non-oil trade deficit has stabilized on the back of strong export growth and slowing non-oil import growth.   The transfers deficit fell in 2006, as US government grants fell by about $10b (from $30b to $20b) — think a fall off in budgeted economic aid to Iraq.  And the deterioration in the income balance — $20b — was smaller than might be expected.  The US afterall needed to take on $850b of debt at say 5% to cover its current account deficit, which implies a roughly $40b increase in its interest bill …

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Forget multilateral coordination; let China do it

by Brad Setser Tuesday, March 13, 2007

Fred Bergsten has long advocated in favor of a bit more exchange rate coordination – both to limit volatility and to try to avoid large misalignments among the major currencies.   Right now, the most misaligned major currency is the yen.  Even after today's move, the yen remains quite weak, especially v. the euro.  Yet Japan’s economy is now relatively strong and its current account surplus is growing.

But the G-7 hasn’t shown much interest in Bergsten’s proposals.   The major central banks don’t like exchange rate coordination very much.   Not all the finance ministries are on board either. 

The G-1 (G-7 slang for the US) has traditionally led the opposition to multilateral exchange rate management.  The Fed doesn’t want to subordinate domestic monetary policy to an external target.  All those lending to the US take note: that means the Fed feels no obligation to defend the dollar should the dollar start to fall.   And there is broad skepticism within the US about the effectiveness of intervention.   At least small scale intervention.  Right now, it is pretty hard to deny impact of large scale intervention –

But the G-1 isn’t what it is used to be, at least in foreign exchange and bond market.   When it comes to those markets, China is the new superpower.  

Scratch China.     Per Niall Ferguson, call its east Chimerica.   Or perhaps “new” Chimerica.   The government of “new” Chimerica (headquartered in Beijing, with a regional financial capital in Shanghai) subsidizes low-end consumers and high-end financiers in “old” Chimerica (headquartered in Washington DC, with a regional financial capital in New York), at a growing – but still hidden — cost to itself.  

Bergsten thinks the government of "new" Chimerica doesn’t just set the RMB/ dollar exchange rate.   The allocation  of its reserve portfolio also sets – or at least heavily influences – the euro/ dollar, the dollar/ yen and the yen/ euro.    

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The $10b a month club

by Brad Setser Tuesday, March 13, 2007

Forget nukes.  To be in the top-rung of emerging powers – a true brick in the new global financial order – you need to prove yourself by financing the US.    With growing (economic) power comes responsibility …. And specifically the responsibility to do your part to prop up the beleaguered dollar, and finance a US current account deficit that is now far larger than the private markets want to finance.

In February, for the first time, it looks like four different countries joined the $10b a month club. 

India’s reserves were up $14.6b in February.   A bit of that came from valuation gains, but on a flow basis, India no doubted added substantially more than $10b.

Russia’s reserves were up $10.7b between February 2 and March 2 … 

Brazil’s reserves increased by $9.985b – $10b in my book– in February.  They rose another $2.2b in the first week of March.

All three added on average over $2b a week to their reserves in February.  For the sake of comparison, SAMBA calculates that Saudi Arabia – which can almost mint dollars by pumping oil – only added on average $1.4b a week to its reserves (SAMA foreign assets) in 2006.  

China hasn’t reported its reserve growth, but with a $24b (gulp) February trade surplus it is hard to see how China’s reserves didn’t increase by significantly more than $10b.  $30b seems likely, unless China did something to hide its reserve growth.  China’s current account surplus is bigger than its trade surplus, it still is attracting net inflow of FDI and private Chinese savers don’t seem so keen on the dollar.

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What rebalancing?

by Brad Setser Monday, March 12, 2007

It has been pretty clear for some time that the oil states’ current account surplus was set to fall significantly in 2007 – oil has stabilized (at a high level, to be sure) and oil state spending and investment has picked up.

The interesting global question was whether the fall in the oil state surplus would lead to a fall in the deficits of the big deficit countries (like the US), or a rise in the surplus of the oil-importing surplus countries (like China).   Judging from China’s January-February trade data – which shows exports up 41.5% y/y and imports up 20.6% y/y – the answer is a rise in China’s trade surplus.  Japan’s surplus also seems to be growing. 

Global rebalancing requires that a fall in the surplus of one surplus region (the oil exporters) be offset by a fall in the deficits of the deficit regions, not rise in the surplus of another big surplus region.

January and February are typically the months when China runs a small not a big surplus.  Jonathan Anderson of UBS thinks that the January-February data indicates that China’s seasonally adjusted monthly trade surplus is now around $30b.    That is big.    It implies China’s 2007 trade surplus will easily top $300b.If I project out China’s export and import growth rates over the past three months (36% and 17%), China’s (customs) trade surplus would reach $340b in 2007.


China is bringing in foreign exchange faster than China’s government can think of new ways of investing all its burgeoning foreign assets.    My earlier estimate that China, inc would need to add $400b to its foreign assets in 2007 to sustain the status quo may be an underestimate. 

Interestingly enough, the US isn’t obviously driving the expansion of China’s exports.  US imports from China are up nicely – they were up 20% y/y in January.  But they have been lagging China’s overall export growth.  

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Just what is in China’s portfolio? And do foreign central banks think Agencies are Treasuries?

by Brad Setser Monday, March 12, 2007

China's decision to set up a new investment authority with a mandate to invest in a range of assets — not just traditional reserve assets — has attracted a lot of attention.  But as the Bank of New York notes, China hasn't yet revealed a lot of the key details about the new authority, including how it will raise the money to finance the purchase of its foreign assets and how quickly it will build-up its assets. 

The announcement of the new investment authority though has had one useful byproduct: it has produced a flurry of information about the content of China's existing portfolio.

Keith Bradsher of the New York Times – reporting out of China – notes that China has roughly $100b in U.S. mortgage backed securities.   That seems right to me.     

People close to the State Administration of Foreign Exchange, which is controlled by the People's Bank of China and manages the country's reserves, estimated that the agency already held about $100 billion worth of American mortgage- backed securities. That may seem to be an unusual place to invest foreign-exchange reserves, but it was selected in the hope of achieving better yields than those on U.S. Treasury securities.  None of these mortgage-backed securities is said to be tainted by the subprime loan portfolios that have recently fallen sharply in value.

Bradsher also notes that China holds $600b in Treasuries.    

Experts estimate that it holds another $600 billion or so worth of U.S. Treasury securities that it lends actively to generate extra profit, as well as at least $200 billion worth of euro-denominated bonds. The remainder is thought to be held in bonds denominated in yen and other currencies.

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