Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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

by Brad Setser
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 …


I consequently think the answer to the question posed in Randy Kroszner’s recent speech, namely why does capital flow (on net) out of emerging economies is actually pretty simple: policy choices in emerging economies.   

I don’t think – unlike some – it has much to do with private demand from savers in emerging economies for “safe” financial assets emerging market financial systems cannot supply.   Rather emerging market governments with large commodity windfalls have opted to save a decent (though falling) chunk of that windfall offshore, and nearly every emerging market central banks is currently resisting pressure for their currencies to appreciate in a massive way.   Right now, demand for “safe” US and European securities comes from governments, not private investors.

I have a second objection to the oft-made argument that private capital flows are now more important than official flows.  The fact that emerging economies are unwilling to rely on private capital markets to finance current account deficit hardly represents a triumph of the market.   Emerging economies – at least those outside the embrace of “Europe’s” institutional structure — seem to have drawn two lessons from the crises of the 1990s. 

  • Massive reserves insure against the humiliation of turning to the IMF for financing – and the corresponding need to adopt the policies the IMF insists are necessary.   
  • And private capital markets cannot be trusted to finance ongoing current account deficits.   Private markets provide tons of money at low cost when a country doesn’t need it (say when commodity prices are high), but very little money at very high costs when an emerging economy really does need it (say commodity prices are low).  The easiest way to protect against “sudden stops” is not to need the money to begin with.

The irony:  outside of South and Eastern Europe — and a new small islands (New Zealand, Iceland) — the big current account deficits in the world are generally financed by official flows, not private flows.   The UK’s current account deficit is largely now financed by the growth of pound reserves.   And the more I look at the data from q1 and April, the more convinced I am that the world’s central banks are now adding to their reserves at a stunning $1.2 trillion annual pace.   Throw in another $100b from oil investment funds.    Pick the fraction you think is going to the US … 

I wonder if the US will eventually conclude that large external deficits financed by official flows are almost as risky – though in a different way – as emerging markets found large  external deficits financed by private flows.   So far, though, it has been almost all good – at least for those who don’t work in manufacturing.

Update: Stephen Roach is well worth reading today.   He believes that China's problems stem in part from expectations associated with the end of the RMB peg that have made the RMB a one-way bet; I would argue that the "excess" domestic liquidity stems at least as much from the rise in China's trade and current account surplus, something that seems to me to be tightly tied to China's decision to basically keep a peg to the dollar with a modest pace of appreciation.   But Roach no doubt is right to emphasize the growing internal challenges associated with rapid reserve growth, the counterpart to "official" financing of the US deficit.


  • Posted by Anonymous

    Rules ‘hiding’ trillions in debt
    Liability $516,348 per U.S. household

  • Posted by Guest

    Private Equity loading US companies with massive Debt Burden

    High leverage ratios could hurt companies with weak businesses, especially if rates rise or the economy weakens. And there are plenty of weak businesses. The percentage of companies at the lower-end of the junk bond market is rising. The percentage of junk bonds that carry a B-minus rating or lower is 49%. That’s up from 30% in 2003, 46% in 2004, 44% in 2005, and 43% in 2006, according to S&P data. “We can see the seeds of the next wave of defaults and distress being sown,” says Vazza.

    That has bankruptcy and restructuring lawyers getting ready for a boom in business. “I agree that default rates are going to rise. They have been kept low, in part, by the use of ‘covenant-light’ debt,” says Jay Goffman, a senior partner at Skadden, Arps, Slate, Meagher & Flom. “That means there are few covenants to default on, short of not making payments. But that holiday often ends after two or three years.”

    Decline in Lending Standards

    Ross argues that the current wave of buyouts will end badly because some private equity firms have stripped too much value from some companies, leaving them ill-equipped to operate their businesses. “Only about 11% of [high-yield offering] proceeds have been for capital expenditures to enlarge the business, with the rest going for sponsor dividends, stock buybacks, refinancing of existing debt or LBOs—not the most exciting uses of proceeds,” Ross says.

    He’s also alarmed by the decline in corporate lending standards, which he compares to the subprime mortgage meltdown. “I believe that credit markets have been recklessly permissive to the point where instead of traditional risk-adjusted rates of return the market is dealing with what I would call risk-ignored rates of return,” Ross said. “The rating agencies recently have begun to revise upward their forecasts for late ’07 and ’08 but are still a bit below mine.”

  • Posted by Guest

    “The biggest and best-managed hedge funds will grow exponentially in coming years… Philip Duff, who headed the $7 billion FrontPoint Partners hedge fund group until it was sold to Morgan Stanley last December, said most corporate and public pension plans still have “significant asset-liability gaps” and will not be able to meet their funding obligations in coming years. Furthermore, given the increasing correlation between domestic and international stock and bond markets, pension plans will be forced to look at hedge funds and other alternative investments as a diversification tool… The funds best positioned to benefit from this trend will be professionally managed with significant risk management controls, said Duff, an industry veteran who has been chief financial officer of Morgan Stanley and a top executive at Tiger Management, a pioneering hedge fund group. “What you are really selling is trust and confidence,” Duff said of hedge funds… “Brand is immensely important.”…”

  • Posted by Guest

    No Darfur genocide, Sino-US conflict over Sudan about Oil production
    By F William Engdahl

    The present concern of the current Washington administration over Darfur in southern Sudan is not, if we look closely, genuine concern over genocide against the peoples in that poorest of poor part of a forsaken section of Africa.

    No. “It’s the oil, stupid.”

    China’s oil demand to fuel its booming growth has led Beijing to embark on an aggressive policy of – ironically – dollar diplomacy. With its more than US$1.2 trillion in mainly US dollar reserves at the Peoples’ National Bank of China, Beijing is engaging in active petroleum geopolitics. Africa is a major focus, and in Africa, the central region between Sudan and Chad is a priority.

    This is defining a major new front in what, since the US invasion of Iraq in 2003, is a new Cold War between Washington and Beijing over control of major oil sources. So far Beijing has played its cards a bit more cleverly than Washington. Darfur is a major battleground in this high-stakes contest for oil control.

    If the US government is able to get popular acceptance of the charge of genocide, it opens the possibility of drastic “regime change” intervention by the North Atlantic Treaty Organization (NATO) – read Washington – in Sudan’s sovereign affairs. The US government repeatedly uses “genocide” to refer to Darfur. It is the only government to do so.

    The Bush administration keeps insisting that genocide has been going on in Darfur since 2003, despite the fact that a five-person UN mission led by Italian Judge Antonio Cassese reported in 2004 that genocide had not been committed in Darfur.