Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Good thing that there are plenty of Agencies left …

by Brad Setser Wednesday, May 30, 2007

Since it sure seems that there aren't many 3 to 10 year Treasuries still floating around for central banks to buy.  Central banks have already bought up most of the stock!

The US clearly has — thanks to the government sponsored Agencies — a comparative advantage turning mortgages into something that can be sold to foreign central banks.  The increase in central bank Agency holdings so far this year has been breathtaking.  Look at the Fed's custodial data.  There is a lot of money that has to go somewhere.

I personally was pleased by the Bloomberg story for another reason: it confirmed something that Elisa Parisi-Capone and I argued last year, namely that central bank demand isn't limited to the short-end of the Treasury curve.   When the details of the 2006 survey come out, we will have to update our analysis.

The fact that central banks aren't just buying Treasuries — in part because the US isn't, in a sense, issuing enough to meet demand, in part because central banks want a bit more yield — does make it somewhat harder though to estimate how central bank demand is influencing the US interest rates.  Warnock and Warnock used to adjust for custodial bias by looking at total foreign demand for Treasuries, as they argued a lot of bonds were buying bought through London custodians and other intermediaries for central banks.   They were right, but that adjustment alone won't work now that foreign custodians are buying a lot of Agencies and other bonds for official investors.   Looking at all foreign purchases of bonds — and then trying to estimate the share coming from central banks — presumably would still work.   

I don't think central banks are behind every move in the Treasury market.  But I do think that they are one big reason why Treasury yields have consistently been below what most models would predict.

The PBoC – and the Economist – argue that exchange rates don’t matter, but look at this graph …

by Brad Setser Tuesday, May 29, 2007

China's Vice-Premier Wu Yi, the Economist, Stephen Roach,  William Pesek and no doubt a host of others all have argued that the US trade deficit with China has nothing to do with the RMB/ dollar. 

But it sure seems like the US trade deficit is heading down against those parts of the world economy that have – generally speaking – allowed their exchange rates to appreciate, while the US trade deficit with Asia continues to rise.  

Look at the following graph.  It shows the US goods trade deficits with Asia, the US oil balance and the US goods deficit with everyone else. 

To make the numbers jump out, I plotted the change in the goods trade deficit from its end 2002 level of $480b.  It subsequently rose to a high of $850b in q3 2006 (using a rolling four quarter sum to get annual data) before falling a bit.  The graph tries to show what drove the deficit from $480b to $850b.us_trade_deficit_changes_since_02

Tis true, the US deficit with the non-oil exporting world (excluding Asia) did rise in 2003 and 2004 even though the dollar was falling.  But there is that pesky J curve.   Import prices initially rise, offsetting changes in import and export volumes.   Only over time does the overall deficit fall.     And the US dollar was – let’s not forget – very strong in 2001 and 2002.   Some of the lagged impact of the strong dollar was still present in 2003 and 2004.  By 2005 and 2006, though, the lagged impact of the 2003-2004 fall was starting to exert itself. 

And even if the US trade deficit — which depends on both export and import growth — didn't come down when the dollar started to fall, it is clear that the 2003 slide in the dollar had a much more immediate impact on the pace of export growth. 

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Private capital now flows to places that don’t need it

by Brad Setser Tuesday, May 29, 2007

The World Bank’s annual report on capital flows to developing countries highlights two facts that shouldn’t be much of a surprise:

  • Developing economies – the World Bank’s definitions leaves out the rich oil exporting economies in the Middle East – attracted record amounts of private capital in 2006.  They attracted net private inflows of around $650b (see table 2.1).
  • Developing economies also ran a large – over $350b – aggregate current account surplus. 

The logical corollary of a 3% of GDP (aggregate) current account surplus and along with private capital inflows of between 5-6% of GDP is simple: the central banks of the developing world provided a record amount of financing to the US and Europe.  

That is why reports that emphasize how private capital flows now trump official capital flows are incomplete.     (Net) private capital flows to the emerging world are far larger than (net) official capital flows from the rich world to the emerging world.    But (net) official capital outflows from the emerging world to the rich world are even bigger than (net) private capital flows into the emerging world.   

Here, there is no disagreement between the IMF and the World Bank.  Once you adjust for differences in country coverage, the WEO data – see table 1.2 — tells the same story.  Big current account surplus and big (net) inflows of private capital.

Indeed, lots of countries are now attracting more money from abroad than they want.   Colombia just joined Thailand in imposing capital controls.   India and others are quietly making it a lot harder for banks to borrow from abroad …


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$100b in five months gets my attention …

by Brad Setser Monday, May 28, 2007

Russia’s reserves just topped $394b – and that is for the middle of May.    On current trends, Russia’s reserves will top $400b by the end of the month.   That is an increase of almost $100b from the $304b Russia had in the bank at the end of 2006.


No wonder Russia now talks of a Russian Davos.    And thinks about an investment fund.   If your reserves are growing almost as fast as China’s reserves – OK, $20b used to the pace of China’s reserve growth, but China raised by the bar in the first quarter — you want a bit of respect. 



Russia started the year with a lot of euros and pounds in the bank – at least 50% of its reserve are in euros and pounds.   But valuation gains only explain $3-4b of Russia’s reserve growth this year.  Most of the increase is real.     

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Chastened prophets of doom

by Brad Setser Friday, May 25, 2007

In a recent talk at the Council on Foreign Relations, former US Treasury Secretary Larry Summers described himself as a “chastened prophet”– a description that former Chairman of the Fed Paul Volcker also embraced.  Both warned about the risks associated with large US current account deficits several years ago.


I lack the stature of Summers and Volcker, but I too often feel like a “chastened prophet of doom.”   Along with Dr. Roubini, I publicly worried in 2004 that a $600b US current account deficit financed in large part by demand for US debt from the world’s central bank carried grave risks.     It is hard to be less worried by a $800-900b current account deficit if anything now financed in even larger measure by demand for US debt from the world’s central banks.    


Especially a deficit that doesn’t seem to be falling when global conditions are about as good – setting aside the dollar’s inability to fall v. many in Asia and high oil prices – for a benign adjustment as is likely to be case for some time.   


Yet, as Summers noted in his talk, the “balance of terror” generated a relatively stable state system during the cold war, as – at least– so far, has the “balance of financial terror”.


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I am not sure there is much risk that emerging economies will become too enamored with floating any time soon.

by Brad Setser Wednesday, May 23, 2007

Dani Rodrik poses an important question on his blog:

“If forced to choose between a world in which developing countries are growing rapidly but there are global macro imbalances associated with it, and one in which current account imbalances are smaller but there is less growth in poor nations–which one would you pick? I would go for the first.

Of course, the essential point is that we have to get the right mix between these two objectives. Arguably, we have sacrificed macro balances too much in the last few years. But as we go about redressing this, we better not forget the role that the level of the real exchange rate plays in developing nations, and not become too enamored of floating.”

I do believe, as I think Dr. Rodrik does, that we have sacrificed global macro balances too much over the past few years.  And, like Dr. Roubini, I also worry that rapid reserve growth is creating a ever-larger internal imbalances in many countries.  Two examples: China’s stock market and dangerously low (negative actually) real interest rates in most oil exporters.

I am not sure that countries like Russia and Brazil who attract very large capital inflows (in part because of interest rates than are higher than US rates) but just use the resulting inflow to add to their reserves are really doing much for their growth either.  In effect, they are borrowing from abroad at a loss to build reserves they no longer need.  Funds parked in central bank reserves are not invested in the local economy; they instead are lent back to the US and Europe.   

Russia’s reserves increased an incredible $14b in the first week of May. Brazil’s reserves are rumored to have increased – counting off balance sheet intervention through the sale of reverse swaps – by something like $15b in the first two weeks of May and Brazil is still in the market.   Those are big numbers.   Reserve growth in the emerging world now seems to running at a $100b a month pace, if not slightly higher.

As Martin Wolf notes, it is hard to square that kind of reserve growth with the argument that the emerging world currently floats.  

Wolf writes:

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No one covers the debate on China’s macroeconomic policy better than Richard McGregor

by Brad Setser Tuesday, May 22, 2007

McGregor’s long analysis piece in today's Financial Times (free link here) shows why.  It is the best summary of China’s macroeconomic policy challenges – and the contractions associated with China’s current policies – that I have read in a long time.   

If the discussion of macroeconomic policy in the today’s US-China Strategic Economic Dialogue is half as sophisticated, I would be surprised.    

McGregor highlights a series of points that I think deserve a bit more attention. 

One: China’s current development strategy actually hasn’t created many jobs.  At least not given how fast China is growing. 

For all the talk about how China cannot change its exchange rate until its surplus agricultural labor has been absorbed in the export sector, the available data doesn’t suggest that China's export machine has been a job creating machine.   Far from it.   Brazil (that’s right, Brazil) has done better.

“A focus on capital-intensive industry also runs counter to the economic task Beijing often professes to be its most pressing: creating enough jobs for the 15m workers who enter the labour force every year. China created fewer jobs (as a percentage of the workforce) between 1982 and 2006 than Brazil, even though it grew by an annual average of more than 10 per cent compared with Brazil’s 3-4 per cent, the IMF found.”

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Meanwhile, over in the (Arabian) Gulf …

by Brad Setser Monday, May 21, 2007

Kuwait decided to shift (back) to a basket peg, and in the process it allowed the Kuwait dinar to appreciate (though not by much) against the dollar.   Its central bank presumably bought a substantial quantity of dollars today to keep the Kuwaiti dinar from appreciating by more.  

Kuwait’s move isn’t a total surprise.  It always has been the GCC country least committed to the dollar peg.  Its investment fund already holds a relatively diverse portfolio.  It presumably thought all the GCC countries should have adopted a Kuwaiti-style basket peg rather than a Saudi-style dollar peg in the run-up to the GCC’s planned (but increasingly uncertain) monetary union.

Moreover, Kuwait’s initial move was rather modest.    Shifting to a euro/ dollar basket after the dollar has already depreciated substantially against the euro doesn’t accomplish much.     It protects the dinar from following the dollar down even further. But, if it is a true basket, it also means the Kuwait dinar wouldn’t appreciate along with the dollar if the dollar rebounds against the euro.   That isn't enough. 

Most of the oil-exporters need to appreciate against a euro/dollar basket – not just against the dollar.   After all, oil has appreciated substantially in real terms, and that usually implies over time a real appreciation in the currencies of the oil exporters.  If that appreciation doesn’t come from a nominal appreciation, it has to come from higher levels of inflation. 

It consequently shouldn’t be a surprise that inflation has picked up substantially in the Gulf – and in a lot of other oil exporters – as these countries started to use more of the oil surplus domestically, whether to finance more spending or more property investment.   

I don’t think Kuwait’s move goes far enough.   Kuwait would benefit from an exchange rate regime that allowed its currency to appreciate against a basket, not just a basket peg.   For more – a lot more – see my paper for the Peterson institute/ Bruegel institute/ KIIEP conference.    Or read something by Serhan Cevik

Still, not following the dollar down is a start.

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What, if anything, has China decided to do differently?

by Brad Setser Sunday, May 20, 2007

China widened the band around the RMB and raised (slightly) interest rates, with the rate on deposits going up more than the rate on lending.     It hardly seemed like a major policy shift to me – but it attracted a lot of attention.


Widening the band in particular didn't strike me (or some others) as much of change.   After all, China hasn’t made much use of its existing band.   An anonymous Shanghai trader in the Wall Street Journal:


“It "means nothing" for yuan appreciation, said a Shanghai-based trader with foreign bank. "We don't even use half of the current band. This is just to impress [U.S. Treasury Secretary] Henry Paulson."


If a wider band doesn't lead to faster appreciation, I doubt Paulson — and more importantly the Congress — will be all that impressed.   I liked the way Keith Bradsher of the New York Times reported the limited scale of RMB appreciation over the past two years:  an initial 2.1%, and then another 5% over nearly two years. 


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Exchange rates don’t matter. At not least not the RMB/ dollar …

by Brad Setser Friday, May 18, 2007

Sometimes it seems that the larger China’s current account surplus – and the bigger the share of the US current account deficit financed by China’s government – the more insistent the Economist becomes that the RMB’s current value has nothing to do with the United States current account deficit.   Its special report on US/ China trade argues:


“The biggest myth of all is that a revaluation of the yuan would greatly reduce America's trade deficit.” 


Its leader goes further, arguing that neither China's surplus nor the US deficit is tied closely to the RMB/ dollar: 


China's overall surplus and America's overall deficit have less to do with the value of the yuan than with Chinese saving and American profligacy.


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