Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Waiting for the Plenum

by Brad Setser Saturday, September 29, 2007

Michael Pettis

It is hard to overestimate the importance to China's near-term and longer-term prospects of the 17th Plenum in two weeks.  These meetings, held every five years, are the main events of China’s political cycles and it is during these meetings that the big promotions to senior positions within the Party and, juiciest of all, membership in the Standing Committee of the Politburo are made.  The Standing Committee consists of the nine men (previously seven, and there are not completely credible rumors that it may be reduced to seven again – the decision has everything to do with factional fighting) who are the ultimate source of power in China today, and is headed by President Hu Jintao and Prime Minister Wen Jiabao. 

Although the deliberations are secret, the months leading to the congress are rife with factional infighting, sweetheart deals, attacks on frontrunners, corruption scandals, and the all-important maneuvering for promotion.  Unfortunately, on the assumption that that any serious contender must at all costs avoid doing anything that may give rise to criticism before the promotions are decided, the period before the meetings tends to be a time in which very little, no matter how urgent, gets done.  For this reason, although the government is watching with terror China's rising inflation, after the last interest rate move little has been done except to freeze a number of prices, and this latter is rumored to have been done almost solely to prevent rising prices from ruining the feel-good ambience that is always required to permeate the national congress meetings.

Once the congress is over – we expect that to occur around October 22 or shortly thereafter. – the financial authorities have some very serious problems to deal with.  Logan Wright, a Beijing-based analyst who regularly writes excellent reports on China’s financial system for Stone & McCarthy, puts it this way in a September 27 report called “China's Perfect Storm? Food Price Inflation and a Possible PBOC Policy Shock:” 

First, at the same time that pork prices have driven August CPI growth to 6.5%, China has also been ravaged by unusually harsh floods in the south and droughts in the north. As a result, the autumn harvest, which comprises around 70% of total annual grain output, could produce a significant negative surprise, accelerating the rapid rise in food prices. At the same time, global food prices and futures continue to trend higher based on a series of bad harvests around the world, just as China may need to increase imports to supplement its own supplies. Secondly, signs of weakness in the housing sector spilling over into U.S. consumption are developing, and this could have consequences for China's exports, which have been a critical engine of China's growth and a safety valve for domestic overcapacity in several industries. Third, and perhaps most significantly, inflation is more salient politically in China than in other nations, because of its tendency to produce social unrest that challenges the legitimacy of the Chinese Communist Party's rule. Support for the CCP depends heavily upon improving standards of living for Chinese citizens. This means that the Chinese government is very likely to react quickly and strongly in response to a potential threat of escalating inflation. 

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Is the US trade deficit declining?

by Brad Setser Thursday, September 27, 2007

Michael Pettis

In an article in yesterday's Financial Times, Jim O'Neill, who heads global economic research at Goldman Sachs, asks if the US trade deficit is about to disappear.  According to him the latest monthly data show that the US trade deficit, at $59 billion, has declined from 7% of GDP to 5%.  Exports have been growing nearly 15% year-on-year whereas imports have been growing at just over 5%.  If a subprime-crisis-related economic slowdown keeps import growth at this level, and a weak dollar also keeps export growth at this level, the trade deficit would drop to 3% of GDP within one or two years. 


I am not smart enough to say whether O'Neill's speculations are loony or sound, and I am not sure what is driving this shift, but O'Neill points out that retail sales are growing in all the BRIC countries at double-digit levels (China recorded over 17% growth in July).  They only account for half the global share of GDP that the US does, but their spending growth is double the US rate.  

This satisfies the savings-glut model by suggesting that a slowing down of the growth rate of developing-country savings is having the expected effect on the US balance of payments.  The weaker dollar and the consumer fears arising from the sub-prime crisis, I guess, satisfy the excess-US-consumption model.  Either way, if things continue at this rate and the US trade deficit declines sharply – a big if, I know, I know – we could see a major shift in the world economy, and it might not necessarily be a very pleasant one. 

I say this not because I am one of those apparent crazies who are not terribly worried about the US trade deficit, and even believe it is a necessary pre-condition for the very difficult demographic adjustment needed by Europe, Japan, Russia and especially China in the coming decades.  I am, but my concern is different. 

As I said in an earlier post I believe that the recycling of the US trade deficit has been the main factor underpinning the recent globalization cycle.  If so, and when the current cycle ends, if history is any indication the adjustment from the insanely happy days of too much liquidity (with its attendant surge in risk appetite) to a more “normal” level of liquidity will be a very difficult one and can result in significantly reduced global growth lasting many years – especially for those countries that begin the slowdown with the weakest and most rigid financial systems.   

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My blog is on the blink

by Brad Setser Wednesday, September 26, 2007

Michael Pettis

Apropos of nothing in particular, I thought I might mention that if anyone is checking my own blog and wondering why I have stopped posting, it is not because I am guest blogging here.  People in China are no longer able to log onto my site, although people outside of China don't seem to have that problem.  I can't get on to post.

This could be just a minor and temporary glitch (although an email to the host came back saying that they could find nothing wrong) or if could be part of the clean-up process taking place before the 17th National People's Congress, to be opened on October 15.  Of course I will never know.  You might have thought that rather technical discussions on problems with managing domestic repo rates had no chance of inflaming the masses, but it seems that you would have been wrong.

Global savings growth?

by Brad Setser Wednesday, September 26, 2007

michael pettis

One of the comments on one of my earlier posts had me search out a quote from Steven Roach about there being no growth in global savings to support the global-savings-glut thesis.  There were also several interesting comments on the topic following the initial comment.  But rather than keep the discussion buried in the comments section, I thought I might pull out the Roach piece and discuss my reaction a little more fully.   

I have no doubt that this subject will elicit a flurry of comments – some brilliant and some cantankerous – but even though many of Brad’s readers may disagree, I do not think the savings-glut hypothesis has been fully demolished.  I, for one, still find it very illuminating (and no, I am not trying to shift the blame to the damned foreigners – as I said in another post, I don’t think there is any blame to apportion out).

There is no glut of global saving. Yes, global saving has risen steadily over the past several decades, but contrary to widespread belief, the rise in recent years has been no faster than the expansion of world GDP. In fact, the overall global saving rate stood at 22.8% of world GDP in 2006 – basically unchanged from the 23.0% reading in 1990. At the same time, there has been an important shift in the mix of global saving – away from the rich countries of the developed world toward the poor countries of the developing world. This development, rather than overall trends in global saving, is likely to remain a critical issue for the world economy and financial markets in the years ahead. 

So says Steven Roach, Morgan Stanley’s Chief Economist, in a very interesting piece last year about the shift in global savings that has taken place over the past ten years.  Basically Roach points out that the advanced countries of the world, which accounted for 80% of global GDP in 1996, have seen their share of global savings drop from 78% in 1996 to 65% in 2006.  Part of this decline can be explained by their declining share of world GDP – the US share has remained fairly constant, but the rise of China and India has been accompanied by the relative decline of Europe and Japan.   

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China’s Sovereign Wealth Fund

by Brad Setser Monday, September 24, 2007

michael pettis

The Chinese sovereign wealth fund (which, following convention I will call the CIC) is expected to be approved later this month or early October, before the October 15 meeting of the 17th National People’s Congress.  Much of its expected structure, however, is known and it has already made one very big and visible investment, the $3 billion it invested in the Blackstone Group IPO, which value began falling almost as soon as the deal was launched.  As of last week the market value of the investment had declined by $600 million, causing a great deal of complaints and criticism in China, not all of it rational.  

The CIC has already been approved to purchase $200 billion from China’s central bank, the People’s Bank of China (PBoC).  The purchase will be funded by a RMB 1.55 trillion bond offering by the Ministry of Finance (MoF) with maturities of ten years or more.  Already about one-third of the money (RMB600 billion) has been raised, with all of the rest expected to come before the end of the year.  Given that China is accumulating reserves at the rate of $100-120 billion a quarter, it is probably safe to assume that if it is perceived as being successful (from the point of view of domestic political considerations, not investment performance) a lot more money will eventually be transferred into the CIC.

One bit of good news is that the PBoC plans to use these MoF bonds as part of its open market operations to control the expansion of the domestic money supply.  This is good news to me because I think the use of central bank bills, which is what the PBoC mainly has used in its ineffective sterilization attempts, has been pretty much a waste of time.  They are too similar to money and way too liquid to have much impact in draining China’s ocean of liquidity.  The less liquid MoF bonds should do a better job.  

Interestingly enough, the loss on the Blackstone IPO and the recent turmoil in the markets seems to have affected the CIC's investment strategy, as has the international outcry against non-transparent SWF's purchasing major strategic assets around the world.  During their meeting with German Chancellor Merkel's during her visit to China at the end of August, Chinese officials promised that the CIC had no intention of buying strategic stakes in big western companies.  In fact it seems that the original goal of the CIC – to maximize investment returns – has been put on hold.  This is probably a good thing because, it seems to me, the most valuable use of excess reserves is as a sort of stabilization fund that minimizes the changes in creditworthiness of the sovereign borrower.  Instead of maximizing returns – which is likely to be pro-cyclical and so will only increase volatility – the funds should be invested in ways that hedge Chinese risk, for example, by buying assets that perform best when conditions in China are likely to be at their worst, and vice versa.  

Unfortunately that doesn't seem to be the alternative strategy.  It looks like the management of the CIC's investments, perhaps not surprisingly given the size of the honey pot, is going to be the result of a hodgepodge of competing ministries and claims.  This is what Xinxin Li has to say about it (see the September 20 entry for my blog at for a more complete excerpt):  

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Sovereign wealth funds

by Brad Setser Sunday, September 23, 2007

michael pettis

One of my tricks when I want to look smart on the topic of global financial flows and monetary conditions is to check out the latest entries in Brad’s blog, which is the only blog I read nearly every day.  Now that I am guest blogger, of course, this trick isn’t going to work nearly as well, although some of the comments from some of Brad’s regular readers should help somewhat. My background is in emerging markets, which until 2002 generally meant Latin America but since then, when I moved to Beijing, has largely meant China.  I will try as much as possible to discuss global conditions, like Brad does, but I suspect I will be spending far more time on China and emerging markets in general than he normally does. 

So with that caveat, let me post my first blog on – what else? – China, and more specifically what we know or think we know about the soon-to-be-established but already operational sovereign wealth fund.  I will use as my crib sheet a very interesting report prepared by Xinxin Li, chief China analyst for the G7 Group, a New-York-based consulting and research firm. I have been spending a lot of time thinking about the impact of these funds. 

In early August, just as the sub-prime crisis was really getting going, I wrote an op ed piece for the Wall Street Journal that argued that, in spite of the problems we were facing, not only was this not going to be the end of the world – I expected spreads to be back by October – but that the crazy party we have been living through would go on at least a few years longer.  A lot of my friends on Wall Street (I am a former emerging markets bond trader) wrote me very patient emails explaining that I had finally lost all my market sense – it was obvious that this time around the crisis was so severe that it was going to derail the whole liquidity boom.  This, according to them, really was going to be the big one.  I still disagree. An important part of the reason for my believing this has to do with the reserve management strategies of China, Japan, the OPEC countries, and other, mostly Asian, central banks. 

It is a basic assumption on my part that globalization cycles, of which by my count there have been six in the past two hundred years, are driven largely by new developments or structural changes in the financial system that cause a significant increase in global liquidity and a concomitant increase in risk appetite.   Because of rising risk appetite this newly-abundant capital flows into a variety of risky countries or ventures – financing canals in the 1820s, railroads in the 1860, long-distance communication media in the 1920, the internet in the 1990s – and sets off the growth in international trade, capital flows, technological development (and, for some reason, the rebirth of liberal economic theory) that we associate with globalization. 

I write about this history extensively in my book, The Volatility Machine, which Brad was nice enough to plug, and in articles in various journals. These liquidity cycles were never smooth sailing but were often interrupted by sometimes shockingly severe crises in the form of temporary liquidity panics which, after scaring the hell out of everyone, eventually reverted to benign conditions.  Some well-known examples might be the Overend Gurney Crisis in 1866, the Panic of 1907, or the 1976 Peso Crisis and, I am willing to bet, the sub-prime mortgage crisis of 2007.  Each of these crises was severe and frightening, and each resulted in significant subsequent changes in regulations and banks, but each also ended with minimal damage to the economy and a quick reversion of the earlier optimal liquidity conditions.  The jury is still out, of course, but I expect the same will occur over the next few weeks and months as the impact of the sub-prime mortgage crisis fades away. 
These liquidity cycles do eventually end, of course.  Typically when they do end they end badly.  The 1873-80 depression, the Great Depression, and the Latin American Lost Decade are all examples of a real close to the liquidity cycle, but these real endings are very different from the liquidity panics that interrupt them.

We are pretty certainly living through a major liquidity expansion cycle, and in my opinion there have been two important causes of the current expansion.  The first was the beginning of the massive securitization of illiquid assets, especially of mortgages, in the 1980s, which had the effect of turning a huge amount of illiquid assets into extremely liquid and widely-traded securities.  I believe that Robert Mundell would argue that increasing the “money-ness” of an asset is analogous to increasing the money supply, and this massive securitization process had that very impact.   More important than securitization, especially in recent years, has been the Asian recycling of the massive and growing US trade deficit.  To me this recycling process is a machine that converts a big chunk of US consumer spending into Asian savings, leading to what Bernanke has called the global savings glut, and may have had some similarities with the petro-dollar recycling that fueled the LDC lending boom of the 1970s. 

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Trading up – Peking University’s Michael Pettis will be guest blogging here for a few days

by Brad Setser Thursday, September 20, 2007

There is an awful lot of interest going on in the world — whether today's rise in long-term treasury yields, the dollar's new lows v the euro and Canadian dollar, the rise in Chinese money market rates or the Saudis' seemingly inconsistent desire to maintain their dollar peg without importing US monetary policy.  

But I can still take a hint.  I intend to take the next few days — indeed, almost all of next week — off.  

Internet addicts don't need to worry.  Michael Pettis, a professor of Finance at Peking University's Guanghua School of Management, has generously agreed to fill in for a few days.   

Needless to say, I am thrilled.  Mr. Pettis is true emerging markets guru.   His book – the Volatility Machine – shaped my own thinking about emerging economies more than any other single book.   

In the past few years, he has turned his attention from the emerging world in general to China in particular — and even more recently, he started his own blog: China Financial Markets.

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The politicial consequences (if any) of the United States’ dependence on Chinese financing

by Brad Setser Thursday, September 20, 2007

I am participating in the Mellon Sawyer seminar on “debt, sovereignty and power” at Cambridge University today and tomorrow.   Expect light blogging.

My own intervention will focus on a topic close to my heart – “Can the world's biggest borrower also be the world’s greatest power?”   The question can perhaps be framed a bit differently:  does the maintaining the “balance of financial terror” require that the US accept some constraints on its own policy choices, or can the US count on the world’s central banks for financing no matter what policies it adopts?

I suspect opinion here divides on the question of whether or not the United States’ current dependence on Chinese financing – and specifically Chinese government financing, since private Chinese savers currently prefer RMB to dollars —  is a good thing, or a source of concern.

One point though shouldn't really be open to all that much question: US dependence on official Chinese flows has now reached a rather impressive level.  If current trends continue – the US current account deficit is around $200b a quarter in the second half of 2007, Chinese reserve growth is around $125b a quarter and Chinese keeps around 70% of its reserves in dollars – China could end up providing close to ½ of the net financing the US needs to sustain its current account deficit in 2007.    


China provides a smaller share of gross inflows than net inflows.  But unless you think Chinese inflows have induced a large share of the outflows – the net is what matters.  Without a big net inflow from China, the US economy would look very different.   The current account deficit would be smaller.   Some of key financial variables – little things like benchmark interest rates – might be different.   And the composition of US output would likely be a bit different as well.

US economic and financial stability may now depend as much on continued financing from the Chinese government as on the continued flow of Saudi oil. 

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The July TIC data

by Brad Setser Wednesday, September 19, 2007

A few quick observations on yesterday's TIC data.

  1. Foreigners sure didn't like US long-term debt in July.   The "quality" of the financing of the US deficit fell dramatically.   Almost all the inflows, including almost all the net official inflows, were short-term.  Foreign demand for US corporate debt — a category that includes mortgage-backed securities and CDOs — was way down.  Indeed it was the lowest since 1995.    That is unlikely to have changed in August or September.  Stephen Johnson of Reuters quoting David Powell of IDEA: "

    Net purchases of U.S. corporate bonds hit their lowest level since December 1995 and purchases of agency securities, such as those issued by home loan funding company Fannie Mae (FNM.N: QuoteProfile , Research), also fell sharply. "The real culprit here is the credit crunch, which has caused a drastic slide in purchases of corporate and agency bonds, and I think it's only a taste of what's to come because the real problems didn't hit until August" said David Powell.

  2. The fall in official purchases of long-term US Treasuries in the July data is a bit misleading.  Official actors — basically central banks — bought T-bills rather than long-term bonds.   Long-term Treasury holdings were down by about $7b, but holdings of short-term T-bills were up by $15b.  And I would bet that a decent share of the $16.4b of long-term Treasuries that private actors in the UK bought in July ended up in central bank hands.

  3. Moreover, the fall in long-term holdings was almost certainly driven by Norway's sale of $12-13b of long-term Treasuries, and those sales aren't real "sales."  Norway periodically has a big impact on the data as a result of one of Norges Bank's trading strategies.  Norway's short-term holdings (specifically its "other" short-term holdings) increased by almost as much as its long-term holdings fell. 

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The first true twenty-first century financial crisis?

by Brad Setser Monday, September 17, 2007

Larry Summers – picking up on a phrase perhaps first used by Michel Camdessus — liked to call the Mexican crisis the first financial crisis of the 21st century.   Mexico’s decision to exhaust its reserves defending its dollar peg in 1994 led to difficulties rolling over its tesobonos in 1995– so Summers and Camdessus were ahead of the (naming) curve. 

But Mexico — because of the tesobonos — was the first sovereign financial crisis that could not be addressed by calling together a group of big banks and getting them to agree to modify the terms of their maturing loans to provide the borrower with more time to pay.  It consequently required a different kind of response.

The August 2007 subprime crisis is in some sense the first real financial crisis of the 21st century.    The bursting of the tech bubble in 2000 feels like the denouement of the roaring 90s.     Argentina’s 2001 crisis also feels like the conclusion of the mini-boom in emerging market sovereign bonds that characterized another part of the 1990s.   Argentina’s crisis was in some sense one the last of the series of emerging market crises that started with Mexico.   Brazil and Turkey still had trouble in 2002, but they – with more than a little help from the IMF – avoided default.    Today most emerging economies (setting some parts of Eastern Europe aside) are in a far, far better financial shape.    

The debts – and a lot of the instruments – that caused trouble in the late summer of 2007 are entirely a product of the 21st century. 

And a lot of the key (financial) players this summer seem to have names that could come straight from the droid wars.

SIVsABCPCDOsSynthenic CDOs.   If only a CPDO would get into real trouble … 

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