The BEA's current account data contained two surprises.  One that I expected.   Another that I did not.  

The "expected" surprise was that the 2005 and 2006 data looks to have been revised to show much (and I mean MUCH) higher central bank purchases of US assets.   The "unexpected" surprise — at least to me — was that the data on income payments was also revised down quite significantly and a result of the large change in the income balance, both the 2005 and 2006 current account deficit were revised down.  The latest data puts the 2006 deficit at close to $810b, well below the $855 in the last BEA release. 

The q1 income balance was consistent with the revised 2006 income balance.  The ongoing surplus in the income balance offset a portion of the trade deficit, contrary to my expectations.    As a result, the overall q1 current account deficit ($193b) was somewhat lower than I expected. 

My guess is that both changes reflect, at least in part, the data in the most recent "survey" of foreign portfolio investment in the US.   The June 2005 to June 2006 survey showed two things.  One was a much larger increase in "official" holdings of US debt than had been reported in the ongoing "TIC data."  and the other was a much smaller overall increase in foreign holdings of US debt than reported in the TIC data. 

Daniel Gros of the Center for European Policy Studies has argued that the fact that a certain amount of US debt sold to foreigners "disappears" every year after the survey — he calls this "disappearing into a black hole" — is evidence that the US current account deficit is underreported.   Others argue that this "statistical manna from heaven" (See John Kitchen and Bill Cline) shows that the US current account deficit can be sustained for far longer than pessimists think – as ongoing trade deficits simply haven't produced either a significant deterioration in the United States net international investment position (the broadest measure of the US external position — one that includes equity investments as well as debt) or the United States income balance.

That said, the revisions to the income balance seem to come far more from more interest income on US lending than from lower payments on US borrowing — and above all from higher dividend income (counting reinvested earnings) on US direct investment abroad and lower dividend payments (counting reinvested earnings) on foreign investment in the US.   And the changes in the "income" of US direct investment abroad and foreign direct investment in the US do not fall out of the survey. 

There is little doubt that the data on "official purchases" were revised quite significantly.   The last release for 2006 showed "official purchases" of $200b in 2005 and $300b in 2006. (data here)   The revised data puts official purchases at $270b in 2005 and a rather impressive $440b in 2006.  That is a big change, but one that is very consistent with my world view.   I have consistently argued that the US data tends to understate ongoing central bank inflows to the US. 

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Via Felix Salmon and Marginal Revolution comes word that Yegor Gaidar thinks the Saudis — not Star Wars — broke the back of the old Soviet Union in the 1980s.

Russia — as has become very, very clear recently — is a big energy exporter.  Back in the 1980s, the Saudis decided to defend their share of the global oil market even if meant lower prices.  That wasn't good for the old Soviet Union.  It quickly exhausted its commercial credit lines, and, well credit from Western European governments came with political conditions.

"Government-to-government loans were bound to come with a number of rigid conditions.For instance, if the Soviet military crushed Solidarity Party demonstrations in Warsaw, the Soviet Union would not have received the desperately needed $100 billion from the West."

Apparently government-to-government bond purchases don't come with similar conditions.  Either that or China just is far more generous than Europe ever was back in the 1980s.   

After all, Chinese purchases of Treasuries and Agencies currently provides the US with a wee bit more than $100b in credit annually, without either economic or political conditions.   

For that matter, Russia — the heir to most of the Soviet Union — is on track to provide the US with a $100b credit line in 2007 as well.   Its reserve are currently growing at an annualized pace of over $200b a year (they are up $100b in the first five months of 2006), and about half are still in dollars.  

Putin called for a new international economic order last weekend (via Drezner):

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Chinese inflation seems to be picking up.   

That is a good thing.  If China insists on holding the value of the RMB down — and if the RMB's pace of appreciation against the dollar is slow, so the RMB in practice is depreciating against a host of currencies that are appreciating faster than the RMB is against the dollar — the only way China's real exchange rate can adjust is through a rise in inflation. 

Indeed, the biggest surprise coming out of China — and there have been many — is that rapid money growth hasn't, at least until now, generated much inflation.    A DBS report (See Chart 1 on p. 2)shows that China has had Philippine style money growth over the past ten years without experiencing Philippine-style inflation.  Indeed, the average inflation rate in China over the past ten years looks substantially lower than the average inflation rate in the US. 

Even with inflation above 3%, China isn't appreciating all that rapidly in real terms.  US and European inflation isn't that much lower.  

If China only could experience a bit of Qatari-style inflation.  Or a burst of Russian-style import growth.  (see Danske Bank)

I am kidding.  I generally don't think negative real rates are healthy, especially in rapidly-growing economies. I would rather see more nominal appreciation across the emerging world.   But in countries whose real exchange rate is undervalued, rapid inflation is a logical consequence of resisting nominal appreciation.  

The Wall Street Journal reports that the pace of Asian reserve growth fell in May.   They look at the change in the reported reserves (in dollars) of twelve Asian economies, including Japan.  But they don't adjust for valuation.

That matters.  The dollar rose against the euro (going from 1.36 to roughly 1.345) and pound in may, reducing the dollar value of Asia's existing euros and pounds.

After adjusting for valuation changes, I didn't see any fall-off in the pace of Asian reserve growth in May. 

Japan doesn't have large fraction of its reserves in euros or pounds, but with $900b or so in reserves, it still has a decent chunk of euros and pounds.  More importantly, Japan reports the market value of its long-term bond portfolio — so its reported reserves tend to rise when US rates are falling and fall when US rates are rising.  Japan isn't actively intervening in the market right now, so all changes in its reserve reflect valuation changes (along with ongoing interest payments).   The underlying pace of Japan's reserve growth didn't change in May.   The swing from $6-7b in reserve growth in April to -4.5b in May reflects the impact of valuation changes.

Most other Asian central banks — to the best of my knowledge — value their bonds at face, so changes in US rates don't have an impact on their reported reserves.  But they do value their euros and pounds at the market rate, and some Asian central banks (India above all, but also Malaysia, Thailand and Singapore) have substantial euro and pound shares in their reserves.    Korea has — again, as best I can tell — substantially more dollars than euros and pounds.  But it has enough euros and pounds for a valuation changes to matter.

After adjusting for valuation changes, emerging Asia's reserve growth actually looks stronger in May than in April.   India, Malaysia and Korea all increased their intervention.   Korea has been talking tough (and intervening) for some time now.  And India jumped back into the market in a big way in the last week of May.   

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That quote doesn't come from me — but from someone with a bit more authority: Jim Caron, co-head of global interest rate strategy at Morgan Stanley (quoted by Michael MacKenzie in Monday's Financial Times).    Interestingly enough Caron's estimate of the impact of Asian [read central bank] demand on yields is lower than some other academic and market estimates – he puts the impact at around 60 bp.

Caron's quote ranks up their with one of my other favorite quotes from the past few weeks — Kevin Giddis of Morgan Keegan and Co argued that, for the bond market, China's investment in Blackstone was like "kind of like the butcher finding out his best customer…is now a vegetarian." (as reported by Michael Hudson on May 29th)

I actually don't think China is close to becoming a bond market vegan.   Not with a $22.4b monthly trade surplus and close to 30% y/y export growth in May.   China's trade surplus, current account surplus and reserves are all rising strongly this year.  Fan Gang — who is in a position to know – is now predicting China's reserves could hit $1.6 trillion in 2007, and top $2 trillion in 2008.   

 The $3b China invested in the Blackstone is roughly equal to my estimate of China's average bond purchases over any two working days: Think $40b a month in reserve growth, $30b in a month in dollar purchases, 20 working days  a month …   

The pace of China's reserve growth has essentially doubled over the past year, rising from $20b a month to around $40b a month this year.  Justin Lahart's take on Blackstone — "if you are paying for the fuel, you might as well get some of the heat " — was perfect.   Right now, China can buy a "Blackstone stake" a month AND still buy far more bonds every month than it did in 2005 or 2006. 

I don't see many other Asian economies adopting bond-free all vegetable diets either.   All indicators suggest Asian economies are still adding to their reserves quite actively.  India added $3.5b to its reserves in the last week of May.   Korea has been buying dollars steadily over the past month.  Malaysia has intervened all year long — at least until the past week or so, when private inflows turned to outflows.      

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The trade deficit fell back under $60b in April — see Jeremy Peters' coverage in the New York Times.  The fall in the overal deficit stemming more from a fall in non-oil imports rather than from a rise in exports.  That doesn't suggest a strong underlying economy, but it did help the trade balance.   The overall balance was also helped by a fall in the volume of imported oil, which offset a rise in the oil price.   

The overall trade deficit has stayed close to its q4 2006 levels so far this year — and thus stayed below its level for most of 2006.  As importantly, the Fed's flow of funds data didn't show much deterioration in the US income balance. The flow of funds coomes out before the balance of payments data, and covers much of the same ground — though in slightly different way.  

The absence of much deterioration is a bit of a surprise, at least to me.   The basic logic behind a deterioration in the overall income balance is simple: US rates are rising, and the US should have well over $11 trillion in gross external debt by the end of the year.  

Stronger growth outside the US than inside the US should help the income balance, at least the portion of the income balance that stems from dividend payments on direct investment.  US FDI abroad should be more profitable while foreign direct investment in the US will be less profitable.   On the other hand, if higher growth abroad pushes up US interest rates, that will hurt more than stronger profits on US FDI helps.  US gross external debt is far larger than US direct investment abroad.

The US adjustment optimists break into two camps.   Some, like Calculated Risk, are optimistic about the prospects for adjustment in large part because they are pessmistic about the US economy.  Calculated Risk argues that the rise in mortgage equity withdrawal led to a surge in consumption and imports, and that the fall in mortgage equity will trigger a slowdown in consumption growth — lowering imports and thus the trade deficit. 

Others, like Stephen Jen, are optimistic about both the US economy and prospects for global adjustment.  They expect the US to pull out of its housing-induced growth slump — but don't expect a reacceleration in US growth to drive up the trade deficit.   Strong global demand growth will help the US for once.

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•  Total “official” (central bank) holdings of Agencies at the end of q1 2007 according to the Federal Reserve’s flow of funds: $537.4b (table L107)
• Agencies held by the Federal Reserve Bank of New York (FRBNY) on behalf of foreign central banks at the end of March:  $668.9b (H.4.1). The Fed knows these data series don’t line up – there is a nice explanation for the sources of the difference on the Treasury’s web site (see point 4 in particular).

True official holdings of agencies:  Somewhere north of $669b.    Not all central banks use the New York Fed as a custodian. 

• The change in official Agency holdings in the flow of funds in q1: $73b
• The change in the FRNBY’s custodial holdings in q1: $51.5b
• The change in official Treasury holdings in the flow of funds in q1: $26b
• The change in FRNBY’s custodial accounts: $55b.

It is likely that some of the $65b rise in “private” holdings of Treasuries outside the US reported in the flow of funds come from central banks.   Several central banks right now buy their bonds in London and then have FRBNY serve as their custodian. 

Caroline Baum really doesn’t like the TIC data.   She argues that there is no correlation between official demand – as measured in the TIC – and anything that matters.   

I also don’t like the TIC data, but for a different reason.  It clearly understates official purchases of US debt, and thus no longer provides much useful information about how central banks are influencing US markets.   The gap between the FRBNY's custodial accounts and other data sources provides one clue.   Another clue comes from the last survey, which showed $140b more in official purchases than showed up in the TIC data.    That gap likely has increased in the past few months.  

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A standard argument is that China’s export success is overstated.   Sure, a lot of goods, especially electronics, are assembled in China.  But those goods are composed of imported parts.     Chinese labor just puts the imported components together.   China is the master of processing, not exporting.

The IMF has argued (see box 1.2) – and I agree — that things are changing.  More and more electronic components are now made in China.   Until about 2004 the growth in China’s surplus with the US and Europe was accompanied by a rise China’s deficit with Asia.  In 2005 and 2006 though, China’s surplus with Europe and the US kept on rising but its deficit with Asia fell.    The obvious explanation: fewer imported components and more Chinese value-added. 

China’s role in the global automobile trade though isn’t going to resemble its initial role in the global electronics trade.    Rather than being a location for the final assembly of imported parts, China is becoming a major supplier of parts to the global automobile industry.

I really liked Keith Bradsher’s article in the New York Times today.    He got – in my view – almost everything right.   Not the least the impact of the shift of automobile parts production toward China on small town Ohio.   

He notes that Chinese domestic parts producers who raised their standards to supply GM’s Chinese operations (which primarily are geared toward producing for the Chinese market) found themselves in a position where they could also supply GM’s global operations.  

"Multinational automakers set virtually the same quality standards for their operations all over the world. They are working closely with Chinese parts companies to help them meet these standards; once they do, they are allowed to submit bids for supplying factories elsewhere. “They get put on the global list and then can quote for anything worldwide,” said Nick Reilly, the president of Asian and Pacific operations for General Motors.

There is a reason why GM and the US auto makers complain about the yen but not the yuan.

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Justin Lahart’s column today noted – quite correctly – that a slew of emerging Asian economies have allowed their exchange rates to appreciate against the dollar this year.  

The verb “allow” is important.  Their central banks previously had been intervening to defend a given exchange rate – so in effect, appreciation means that the central bank decided to stop actively holding the value of its currency down. 

India is the best example.  It intervened massively in February, but then scaled back its intervention and let the rupee appreciate.  It is now taking heat for a “strong rupee.”    And after several weeks without intervention, the RBI seems to have stepped back into the market two weeks ago (reserves went up).

Other central banks though never really stopped intervening.  They just stopped defending a specific level.  Asian reserve growth outside China has been quite strong this year.  Malaysia is still intervening – look at its reserves (click on the chart option if you follow the link).  Bank Negara Malaysia’s non-reserve foreign currency assets also seem to rising – if anyone knows what is going there, do tell!  

Korea has – over the past few years – allowed the won to appreciate significantly.  But it has gotten worried that a "strong won" risks becoming a "too-strong won."  It seems to be intervening in the markets again.  The May increase in Korea’s reserves is higher than can be explained by the interest income on Korea’s $250b.

Thailand let the baht appreciate in 2006.  And then it got scared by the baht’s strength and imposed capital controls.    That hurt the baht for a while, but only for a while.   The central bank has been intervening again this year. 

Look at the following chart.    One legacy of Thailand’s crisis is that it reports both its actual foreign exchange reserves and the forward position of the central bank.  I have summed up Thailand's cash reserves and its forward purchases (you can debate whether this is the right measure, or whether the forward position should be marked to market, but that is another issue).    Thailand’s near bankruptcy in 1997 (the first year in the chart) shows up clearly, as does the ongoing increase its reserves now.

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The official sector – at least the IMF – thinks the world has started to rebalance, and the US external deficit is safely heading down.    Stephen Jen agrees, strongly.   He recently declared himself a “Global Re-Balancing Optimist.” 

While we are unsure if the US C/A deficit will decline substantially (i.e., below 4% of GDP) in the coming two years, we believe that, in the current cycle, the US C/A deficit (as a percentage of GDP) will continue to shrink, both due to the deceleration in US DD and, more importantly, DD growth in the rest of the world.  Even when the US economy recovers toward trend growth by end-2007 — a process that may have just begun — the US C/A deficit will be lower (as a percentage of GDP) than that in 2006.

I see the case.  A weak(er) dollar should boost US exports.   Appreciating homes can no longer substitute for savings, or provide as good an asset to borrow against.   That should prompt Americans to scale back consumption, and start to save more out of their current income.   Slower consumption growth means slower import growth.   Higher savings would reduce the savings and investment gap.

Sounds good.    But three reasons keep me among the pessimists.

First, I don’t yet see strong evidence that the trade deficit is set to fall.  Q1 wasn’t exactly encouraging.   Exports should bounce back – strong global growth and the dollar’s weakness against the euro and the Canadian dollar is hard to square with no export growth, even if China seems to be benefiting far more than the US from dollar (read RMB) weakness.  But if consumption growth stays strong — as Jim Hamilton notes "Whatever problems the economy had in the first quarter, they weren't a lack of consumer spending" — non-oil imports should also grow.  

The stabilization of the United States non-oil trade balance in 2006 hinged on two things – an acceleration in export growth and a slowdown in import growth, particularly imports from Canada and Europe.   If the US pulls out of its growth slump on the back of consumption growth, the second pillar of the adjustment will dissipate.   

I can make the same argument from a savings and investment point of view as well: Consumption growth was far faster than income growth in q1.   That means less savings – and a wider current account deficit in the absence of a fall in investment. 

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