Brad Setser

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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
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:

“The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.”

So I don’t think that there is much risk that too many countries will soon become “too enamored of floating.”   i certainly wouldn’t recommend that China move immediately to a free float.   A bit more controlled appreciation though would be very welcome!

Yes, I do think that intervening to hold down the nominal exchange rate – if sterilized – can have a meaningful impact on the real exchange rate for an extended period of time.  In this week’s big blog debate, I side with Wolf, DeLong and knzn.

That said, I have struggled to reconcile my obvious concern with the imbalances associated with very rapid reserve growth in the emerging world with another of Rodrik’s long-standing arguments – namely that we should allow countries enough policy space to find approaches that work for them, and not insist too strongly on a uniform approach to economic policy.    

Rodrik's argument has long appealed to me.  I believe, for example, there should be room in the global economy for different approaches to health care and labor market regulation.   

What then is wrong with allowing countries enough policy space to maintain undervalued exchange rates and add rapidly to their reserves if the result works for them?

My tentative answer is that there are much stronger global spillovers from targeting an undervalued exchange rate than from different approaches to say labor market regulation.   

China doesn’t just set its own exchange rate when it targets the RMB/ dollar.  It also sets the United States exchange rate with China.   And since many other countries feel forced to intervene to keep from appreciating by too much against China, China’s policy also influences the United States’ exchange rate with many of its other trading partners.

That has one other implication:  I suspect that China’s desire to maintain sufficient “policy space” to keep the RMB at its current level has reduced the policy space effectively available to other emerging economies, not just to the United States.

Josh Bivens wrote back in February:

“the Chinese peg severely restricts the policy space available to the non-Chinese developing world in integrating with the global economy. The monetary authorities in a range of other East Asian nations have expressed the desire to hold fewer dollar reserves, but to keep from losing market share in the U.S. economy, they have to make sure their own exchange rate vs the dollar doesn't stray too far from China's, so, they are essentially forced by the Chinese policy into intervening in the exchange rate market.

Brazil has begun intervening in the real/dollar market as well, as China has started sucking U.S. market share away from essentially all other developing countries, not just those in East Asia.

Indeed, besides the institutions and policies of the Washington Consensus, the single biggest encroachment on the policy-making space of the developing world right now is the Chinese exchange rate policy.”

Bivens goes a bit further than I would in some ways that i would.  I rather suspect that the “institutions” of the “Washington Consensus” — notably the IMF, have a lot less influence on emerging market’s policy choices right now than they had in the past.  But I do think the impact China’s peg is having on a range of countries, not just the US, deserves a bit more attention.


  • Posted by RebelEconomist


    I seem to remember raising this before……an fx swap is hardly intervention, since it involves doing an opposite forward transaction at the same time as a spot transaction. An fx swap should have no effect on reserves holdings recorded on a done basis, but it might if they are recorded on a settled basis. I suspect that Brazil’s use of fx swaps amounts to sterilisation (ie an fx swap is like a collateralised loan using fx as the collateral). It would help to know exactly what is meant by “reverse swaps”… side’s swap is the other’s reverse.

  • Posted by RebelEconomist

    Does anyone know how China operates its monetary policy?

    I am not sure how they can set a deposit rate of 3.06% and a loan rate of 6.57% when they appear to sell sterilisation bonds at a rate somewhere in between. Perhaps they do not use open market operations, but simply instruct the banks what the rates should be?

  • Posted by HZ

    Is the RSS feed stale? My Yahoo is still stuck on two blogs prior.

  • Posted by HZ

    These rates are administrative limits (legalized banking cartel:-). There is a interbank market but PBC doesn’t appear to target the rate there.

  • Posted by bsetser

    RE — certain monetary policy operations are much easier if the government owns the big banks and appoints the chairman of the bank …

    China has a floor on its lending rate and a cap on its deposit rate. sterilization bill rates are theoretically set in an open auction, but lending caps mean the banks generally have had funds with few other places to go (the bills pay more than deposits with the central bank i think). some sterilization bills are also placed directly with the big state commercial banks. But on the technical details here, i would trust stephen green more than myself —

    RE — think of brazil reverse swaps as selling insurance against the risk of further real appreciation. if you get the upside of holding real via the contract, you can be persuaded to hold the contract rather than actually holding real … i think that is more or less right. certainly reverse was true in 03. by selling insurance against real depreciation, Bacen hoped to convince those who worried about depreciation (say firms with $ liabilities) to hold read + the insurance rather than buy $.

    the chinese fx swaps work a bit differently — they are a monetary operation where the banks get $ (plus the protection v. appreciation via the swap) and the central bank gets rmb, taking rmb out of circulation.

  • Posted by Anonymous ibid.

    Does anyone think that the exchange rate regime could exist without the agreement of the US and Europe?
    * China gets factories into which to dump persons displaced from agriculture.
    * Europe gets appreciating living standards, and

    … best of all,

    * the US gets its splendid little war.

    We’ll be picking up the pieces for decades to come.

  • Posted by psh

    ‘allow countries enough policy space to find approaches that work for them’

    All the more because micro factors vary by country and change over time. Seems market structure affects the macro response to exchange rates when imports have domestic content. Transnational vertical integration can boost price elasticities, so with more multinational FDI you’d expect surpluses to be more sensitive to exchange rates. But when we inhibit technology transfer, with raw deals on IP or with ‘dual-use’ export restrictions, we obstruct China’s efforts to diversify their value-added. Exchange-rate policy matters less. That gives them one more reason to blow us off when we pester them for yuan appreciation.

  • Posted by bsetser

    doesn’t a smaller response to any given XR move potentially imply a bigger move is needed generate balance?

    I guess you could take the view that it implies other channels of adjustment are more effective, but then you have to explain why those channels aren’t currently having more of an impact on the overall us trade balance … i.e. relative growth is working against the us and in favor of adjustment, fiscal policy in the us is no longer wildly expansionary, etc. It feels to me like the “policy space” accorded to the emerging world to set their own XRs (and the us XR) is having an impact on how the US economy responds to various shifts …

  • Posted by Guest

    Just a few thoughts. In the Asian crisis, it was overvalued exchange rates that saw governments trying to defend the pegs leading to a collapse in reserves. Now we have undervalued exchange rates and a growth of reserves. Clearly the latter can go on for longer than the former as the latter is unbounded. For the former case once you run out of reserves it is the end. The latter system will only go bust if the source of the reserves, in this case, the US dollar becomes worthless.

    With everyone pegging their currency to the US, these countries will generally be driven by US monetary policy. I think the mistake was that rates were taken too low after the tech bubble. That led to overconsumption in the US. With the undervalued exchange rates in Asia , it was natural for those in the US to overconsume Asian products especially Chinese ones. This led to the macro imbalances we have seen today.

  • Posted by ryyjjyyr

    Just a few thoughts. In the Asian crisis, it was overvalued exchange rates that saw governments trying to defend the pegs leading to a collapse in reserves. Now we have undervalued exchange rates and a growth of reserves. Clearly the latter can go on for longer than the former as the latter is unbounded. For the former case once you run out of reserves it is the end. The latter system will only go bust if the source of the reserves, in this case, the US dollar becomes worthless.

    With everyone pegging their currency to the US, these countries will generally be driven by US monetary policy. I think the mistake was that rates were taken too low after the tech bubble. That led to overconsumption in the US. With the undervalued exchange rates in Asia , it was natural for those in the US to overconsume Asian products especially Chinese ones. This led to the macro imbalances we have seen today.

  • Posted by Guest

    greenspan’s still got it! but he _is_ working for PIMCO now 😛

  • Posted by bsetser

    If US over-consumption was a by product of low us policy rates after the tech bubble, why hasn’t the us deficit come down now that policy rates have increased back to above 5%? And why didn’t the policy tightening have more impact on the long-end of the curve?

    In any case, what do you all think of Rodrik’s argument about policy space? what should states be allowed to do (economically wise) and what should be considered anti-social behavior that works against living harmoniously in a world of other states? Is China’s undervalued XR now infrining on the policy space of other emerging economies?

  • Posted by charlie

    If US over-consumption was a by product of low us policy rates after the tech bubble, why hasn’t the us deficit come down now that policy rates have increased back to above 5%? And why didn’t the policy tightening have more impact on the long-end of the curve?

    You obviously know the answer, but I’ll give it anyway. Low long term interest rates in the US had little to do with the Fed’s overnight lending rate. They were artificially low because of the willingness of foreign central banks to loan the US money at low interest rates. Central banks were flush with USD and they had two options. Hold the money and get nothing or loan it to the US and get whatever interest they could get. They chose the latter.

    People who point the finger at the US fed and blame them for the large amount of liquidity causing bubbles around the world, don’t understand what’s going on or refuse to see the facts in front of them. The Japanese and Chinese are the ones who are providing massive amounts of liquidity. They’re the ones who are providing liquidity to the world at artificially low interest rates. Look at the growth in money supply in these countries over the last few years. It dwarfs the growth rate in the US.

    I’m glad you pointed out how China’s pegging is forcing other’s to peg. I’ve realized this (As I’m sure you have too) for a long time. China’s pegging to the USD is the key to the rapid growth of foreign central banks reserves worldwide. If China moved their peg at a non-glacial pace, the rest of the world would follow suit.

  • Posted by Macro Man

    I am going to agree with Dave Chiang (there’s a run on parkas in Hell) that it isn’t China’s problem if other Asian countries feel like they have to peg to some USD and RMB hybrid, and they don’t like the level of the RMB. Now, if CIC starts buying those currencies like it’s going out of style, then it does become China’s problem/responsibility.

    The real beef I and many other have is what Charlie alluded to…that China, formerly Japan, and others disrupted the normal monetary policy mechanism in the US by executing price insentive purchases of Treasuries and Agencies.

    Europe is coming close to having a beef with China (and, if justice is served, Russia) for driving the euro exchange rate higher.

    I guess it all comes down to the level of the domestic exchange rate is entirely within the policy purview of a soverign nation. But if executing the exchange rate regime introduces significant distortions into the financial markets of other countries, well, there’s a problem.

  • Posted by Dave Chiang


    Unless you are accusing the China PBoC of counterfeiting US currency, how can the Chinese be responsible for excess US dollar liquidity everywhere around the world. Every US dollar in legal circulation originated from the Federal Reserve. The Federal Reserve and only the Federal Reserve has the authority to print unlimited number of fiat US dollars. In recent years, the broad M-3 money supply in the US Economy has simply exploded with the Federal Reserve printing an inflationary excess of US dollars, purchasing of US Treasury securities to fund the budget decifit, and lowering banking reserve requirements to almost zero. Despite the Federal Reserve discontinuing reporting of an important statistic to the general public, estimated broad M-3 money supply has expanded by 12 percent over the past fiscal year. It is disingenuous for the irresponsible Bernanke Federal Reserve to scapegoat the Chinese PBoC for the numerous asset bubbles littering the US Economy, which are reponsible for massively misallocating capital into non-productive McMansions from coast to coast. US monetary policy requires an immediate return to “sound and hard” money.

  • Posted by Guest

    well it’s not just foreign central banks, per se, driving long-term interest rates lower, altho as berner sez, “two of the factors that I think are important drivers of US real yields originate abroad, and they are right now making the difference,” but as others have noted, it’s not just US long-term rates that are lower; it’s pretty much across the board. berner attributes this to lower term premiums around the world, which may be interrelated w/ central bank interventions, but i still think it is a separate issue…

    fwiw, i think bill gross came up with a nice formulation/argument for explaining lower term premiums (and long-term interest rates 🙂

    (1) globalization.
    (2) technology.
    (3) freer markets/financial innovation.
    (4) favorable public policy


  • Posted by RebelEconomist

    Thanks for the information about Chinese monetary policy operations. The reason I ask is because I am trying to understand whether low Chinese interest rates and inflation respresent a market response to strong savings preferences, or are artificially held down by state control. It seems the latter, which is presumably one reason why the Chinese property and stock markets have boomed.

    It seems to me that this is a vital question, because the answer is needed to decide Chinese intervention is driven by saving or currency considerations. The balance of payments should be the indicator of whether a currency is undervalued, rather than the trade balance. In China’s case, however, the capital account is restricted (why so is another interesting question), so to some extent, intervention could be taking the place of a voluntary capital account surplus.

    I must say that, the more I learn about how Chinese economic policy works, the less sympathy I have for their position. That said, it takes two to tango, and do I think America could do a lot more to reduce its own preference for borrowing.

  • Posted by RebelEconomist

    Brad, you have confused me even more about Brazilian reverse swaps… seem to be implying that they involve some optionality (ie “insurance”)?

    Are these not just fx swaps? If so, does the spot leg involve Brazil receiving or supplying US dollars?

  • Posted by Guest

    i think productivity is driving lower inflation, at least on the manufacturing goods side, but as food and (hidden) environmental costs rise, it’ll take up more of their CPI… there’s pressure building at the bottlenecks and (it looks like to me) some cracks are starting to appear…

  • Posted by Macro Man

    RE, I believe the BRL swaps are more like an interest rate swap than a simple buy/sell FX swap. To wit, I believe Bacen ‘receives’ USD Fx move + interest rate, and “pays” BRL fx move plus inteerst rate. As far as I am aware, there is not any maturity set on these swaps, so they’re open ended.

  • Posted by RebelEconomist

    Macro Man,

    Thanks…….very interesting indeed! So Brazilian “reverse swaps” are a kind of perpetual total return swap. They should be no less effective than intervention in terms of market impact, but the custody of the currencies is not transferred. It awdabe illegal!

    As you say, you aren’t as dumb as you look!

  • Posted by psh

    A bigger xrate move is needed for balance, true. But reduced effectiveness of exchange-rate moves supports whiny rhetorical points like, ‘If you want adjustment, don’t hamstring our economy.’ More micro horse-trading can come into play – at least until negotiation gives way to coercive sanctions. I do think there’s lots of additional scope for the other channel, slower US relative growth. We’ve hardly begun to try that yet.

  • Posted by Alejandro

    Hi Brad,

    I think Rodrick’s argument is right. We are starting to see evidence that keeping a STABLE and COMPETITIVE real exchange rate is crucial for developing nations. Argentina is a clear example. Check not only the growth figures but also the rapid pace of job creations.
    Your point about Brazil in terms of growth is not that accurate because indeed the real keeps appreciating and that is hurting tradables.
    Central banks should think about an explicit real exchange policy along with the obvious mandates.
    For a good empirical evidence towards the relevance of this types of policies in developing countries, you can check “Foreign capital and economig growth” by Prasad, Rajan and Subramanian from the IMF. They find a positive and significant relationship between growth, current account surpluses and undervalued real exchange rates.
    So what the interest could be for countries to do their part in the global rebalancing when they would sacrifice their development strategy? I just don’t see it and that’s why I think the debate should be around Inflation targeting versus a balance between stable and competitive real exchange rates and growth. Unfortunately, we don’t see that hapenning and we are taking the mainstream argument as given.

  • Posted by Macro Man

    Re Argentina, it obviously helps to run a weak currency policy when you can just make up CPI numbers to say what you want them to…

  • Posted by charlie

    Bubbles are occurring world wide in various assets. Equities, real estate commodities. To infer that the US fed is causing this is ignoring this fact. The US fed doesn’t lend money outside the US. How can they possbily be causing such an increase in world liquidity? The fed argument in which the fed is causing world wide bubbles makes as much sense as the moon being made of cheese. The dots don’t connect. Not even close. The real source of world liquidity is central banks, primarily China and Japan loaning money at extremely low interest rates. Anyone who follows the market can clearly see that the Yen carry trade and china’s massive accumulation of foreign debt are the primary drivers of world liquidity.

    The monetary growth in the US over the past few years has been high, but nowhere near as high as that in China and Japan. How else can you explain that when the fed raised interest rates from 1% to 5.25%, it had relatively little effect on long term rates. If the fed were funding the world, this would have had a huge impact on long term rates. I guess some suppose that Japan raising their interest rates by 4.25% or the chinese not bidding on debt unless coupon rates were 4.25% higher wouldn’t have much more effect on world markets. Those who believe this are completely out of touch with reality.

  • Posted by Alejandro

    Macro Man, I agree with your comment about the pathetic CPI manipulation in Argentina. I think that some flexibility with the exchange rate management is needed but it is not obvious (at least to me) that there is currently a transmission mechanism from the monetary policy to prices. As long as the inflows do not become outrageous, there is always room for sterilization. If they become unmanageable, I wouldn’t sacrifice the development argument and I would impose some sort of capital controls.
    Btw, I read your blog on a daily basis (I work for a hedge fund) and I find it interesting and useful, keep the good work.

  • Posted by Dave Chiang


    Legal trading of the Chinese yuan is only permitted in mainland China and Hong Kong, which is closely administered by the PBoC. Chinese yuan and Japanese yen aren’t global reserve currencies flooding the world with liquidity. It’s dollars, dollars, and dollars everywhere. The record reserve accumulation in the BRICs during Q1 2007 is denominated in fiat US Dollars printed exclusively by the Federal Reserve. So the next time you manage to pull a rapidly devalued US dollar bill with the Bernanke seal of approval, don’t go complaining that the Chinese PBoC somehow printed it. People will think that you have serious mental issues.

  • Posted by Macro Man

    Alejandro, what’s interesting is that Lula and co. appear to be getting jealous of Argentina’s growth. What’s interesting is that they are, to a degree, using the capital inflow in their favour to spur growth, taking advantage of the dramatically lower borrowing costs to fund a huge fiscal stimulus package. It will be interesting to see if it works…

  • Posted by Guest

    “that we should allow countries enough policy space to find approaches that work for them”

    sorry if I’ve missed it, but it sounds like readers are to assume “we” means the “U.S.” – anything or anyone more specific? – and isn’t part of the problem in the difficulty of adopting the ‘right’, or even feasible? means for ‘disallowing’ countries the policy space to find approaches that work for them, with some consideration for the broader impact of ‘not working?’ – not only to the nation at hand, but any number of possibilities for different types of obvious and not so obvious blowback.

  • Posted by gillies

    the blame game – mr. nixon went off the gold standard and opened up to trade with china. if you are looking for where the buck stops for starting the dollar tsunami why not try there ?
    a flaw has developed now in the logic of labour arbitrage, or a flaw that was there all the time is becoming apparent – you cannot cobble together an alliance of the american casino-capitalist elite and the chinese communist working class, to squeeze the life out of the american middle class, who are supposed to be the consumer engine of both.
    the logic is flawed – or has logic anything to do with it ?

  • Posted by Guest

    it’s just the idea of a bunch of wonks sitting around a boardroom table and someone saying “we should allow countries enough policy space to find approaches that work for them” as if that’s a new or debatable concept. But it does raise the question of who it works for now and how that’s enforced.

  • Posted by Cassandra

    gillies has parsimonioulsy distilled a Britannica’s volume of detailed facts and verbiage into a most-concise political-economic observation worthy of BW2’s epitaph. Bravo!

  • Posted by Eddy

    Russia’s reserves increased once again 8bln (11-18May)

  • Posted by bsetser

    we economists, we Americans (tho that may imply more power than we have now, tho the implication is that we shouldn’t protest too much about undervalued RERs), we who have worked in international financial institutions … i was trying to wrap a lot of possibilities in, but i can see how it came across in a way that i didn’t really intent (patronizing).

    there are some very concrete cases i have in mind — for example, the US China FTA had a provision that outlawed inflow controls more or less. that reduced Chile’s policy space — and it came b/c of a request from the US policy makers (early Bush 43), not b/c of any strong us lobby that wanted it.

  • Posted by RebelEconomist

    Regarding policy space:

    Commentators – probably including me – often talk about “the exchange rate”, but of course any currency area actually has about two hundred exchange rates with other currency areas. Big as it is as a US trade partner, China can only affect the US exchange rate in a, say effective, sense to a minor degree.

    No country with an open capital account can peg to another currency area without the acquiescent of that area, because if the reserves inflow is not welcome, they can effectively send it back. This would be interesting (and perhaps not as fruitless an exercise as it might initially seem).

    As I have said before, it seems to me that any exchange rate constraint unilaterally imposed by another country does not need to be disadvantageous to the object of the peg (“pegee”?) – ie a geeky “constrained optimum cannot be superior to an unconstrained optimum” argument. This must be right, no? If so, then the problem for America is how to deal with other countries’ intervention to its own advantage.

  • Posted by Guest

    Yes – but with income disparities rising everywhere, along with foreign born populations of all income classes and the ongoing integration of firms and institutions, the definition of any nation’s best interests is debatable. So if America or any other nation is “to deal with other countries’ intervention to its own advantage” the question of who and what is best served gets very interesting, along with the strategies and tactics used to achieve specific outcomes.

  • Posted by Guest

    May 24, 2007 – “Iran’s financial system suffered a fresh jolt yesterday with panic selling on the stock market after the president, Mahmoud Ahmadinejad, abruptly ordered banks to cut interest rates sharply, despite surging inflation. The order, which Ahmadinejad issued by telephone during a visit to Belarus and which flew in the face of expert advice – has triggered warnings of a financial crisis and spiralling corruption amid fears of a capital flight from the country’s lending institutions…”