The negative correlation between the dollar and the price of oil was much in evidence  last week –

The dollar hit a record low against the euro, and is quite weak against most of the major currencies 

Oil hit a record high in nominal terms, and not all that far off its 1979 high ($109 a barrel) in real terms …

Dean Baker – and OPEC – argue that the link between a weak dollar and a rise in the price of oil is almost mechanical.   When the dollar goes down, oil has to go up in dollar terms to stay constant in say euro terms.     There is something to that.   

But this isn’t the entire story either. 

Over the past few years oil has gone up v a basket of currencies while the dollar has gone down v a basket of currencies.   Oil isn’t up as much in euro terms as in dollar terms, but it is still way up. 

Plus there have been times – like 2000 – when oil rose in dollar terms even as the dollar was rising against the euro.  During that period oil rose very strongly in euro terms.  2005 is a more recent case.

So why then is oil going up when the dollar is going down? 

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The q2 US current account data poses two puzzles. 

The first is the sharp drop off in official inflows in q2.   They fell from $150b in q1 to $70b in q2.   That fall was, incidentally, offset – mechanically – by a change in (net) FDI outflows.  The large net outflow of q1 disappeared.  Net private portfolio flows were more or less constant.

The second is the continued absence of any evidence of deterioration in the income balance.   Or, if you prefer, the continued growth of dark matter.   I am fairly sure Ricardo Hausmann and Federico Sturzenegger would argue that this the real puzzle is the unwillingness of some others to accept the evidence that the US has a lot of dark matter on its balance sheet.  After all, the US seems to be able to continually conjure up additional dark matter whenever it is needed to keep the income balance positive.

The first isn’t really a puzzle.   Not in my view.   The US data is wrong.

Not wrong in the sense that the BEA made an error in their calculations.   But wrong in a deeper sense.  The BEA’s quarterly data is based on the TIC data, and the TIC data simply doesn’t capture all official inflows.

Why I am I so confident – 

First, the last survey data revised total official inflows up by $130b between q3 05 and q2 2006.  I expect a similar revision.   The pattern here is very consistent. 

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China indicated back in the 2004 that it wanted to rebalance its economy, and shift away from export and investment-led growth.

Despite a common perception in the US business community that China’s leadership can do pretty anything (economically speaking) that it wants to do, it is increasingly clear that the policies China has adopted to try to rebalance its economy have not worked.

The World Bank’s most recent quarterly update on China’s economy report notes that net exports will contribute as much to China’s growth in the first half of 2007 as in the last half of 2006: 

“The external contribution to growth remained high …  Our estimates … suggest that the contribution of net external trade to growth remained at the high level of the second half of 2006, contributing over one-fourth of overall growth”  (Figure 1 of the quarterly has the details).

China’s current account surplus is projected to rise to $380b (12% of China’s GDP) – even with very high oil prices.   That is an increase of $300b (and 8-9% of China’s GDP) since 2004.   If the US had experienced a comparable swing — relative to its GDP — in its current account balance, it would be running a substantial surplus now. 

Incredibly, the rise in the current account surplus (an excess of savings relative to investment) has come even in the face of strong investment growth.   Sure consumption growth is strong, but consumption is such a small share of GDP that even strong consumption growth contributes less to overall GDP growth than might be expected – especially when consumption is growing more slowly than investment and exports.    The World Bank notes that “almost all of the variation in domestic demand growth recently has been driven by investment, including the upturn in the first half.”

The World Bank notes that China’s surplus the “external imbalance remains the main macroeconomic issue” that China faces.    China’s steadfast defense of a very modest pace of appreciation against the depreciating dollar influences almost every other aspect of China’s economic policy.  

But China’s huge external surplus isn’t just an issue for China.  China’s policy choices are shaping how the global economy adjusts to the US slump.    That slump – and the associated weakness in the dollar — has already pulled down the US non-oil trade deficit a bit.   But the main impact of dollar (and RMB) weakness has been an increase in China’s trade surplus. 

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So argues Ben Bernanke.  

His basic argument is very simple. 

The emerging world now has a large and growing current account surplus that finances a large and growing current account deficit in the world’s industrialized (or perhaps formerly industrialized – no advanced economy, with the possible exception of Germany, is as industrialized as China is now) economies.

From 1996 to 2004, some of the rise in the emerging economies aggregate current account surplus came from a collapse in investment in southeast Asia. 

But some also came from a rise in Chinese savings – which even then was beginning to push China’s current account surplus up.   Chinese savings was even then rising faster than Chinese investment, for reasons what remain poorly understood.    Some think the rise is tied to the policies China adopted to support its dollar peg, particularly after the dollar started to depreciate.  Others emphasize weakness in China’s financial system (which limits access to consumer credit) and the lack of a modern social safety net.

And some came from a rise in the savings of the world’s commodity exporters, fueled (literally) by the rise in the price of oil. 

In 2005 and 2006, though, Dr. Bernanke argues that there really can be no argument.

Much of the rise in the emerging world’s overall surplus came from a roughly $200b rise in China’s current account surplus.   China clearly doesn’t suffer from a shortage of investment.   The surge in its surplus comes entirely from a surge in its savings, one that exceeded a large increase in Chinese investment. 

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China reported a large $25b trade surplus for August.

The US reported a roughly $60b trade deficit for July, with strong exports offsetting a rise in the US oil import bill.

Same old, same old. 

Chinese exports were up 22.7% in August, down from the very high 34% in July.   I think it is too early though to argue that there is strong evidence that Chinese export growth is slowing – the weak August might be payback for the strong July.    The three month average y/y growth rate has stayed around 27-28%.

Imports were up 20.1%, a bit less than in July, and right in line with the three month average. 

Project the current three month average growth rate for imports and exports out for the full year, and Chinese export will reach about $1240b – with imports at around $950b.   The resulting $290b goods trade surplus (customs basis) is consistent with a $350b or more current account surplus.    

It is pretty hard to argue that net exports haven’t been a key force pushing Chinese growth up to its current stratospheric (12%) levels.    

Indeed, I have been surprised that China’s leadership has continually prioritized export growth over domestic macroeconomic stability.    The persistently undervalued RMB is a big reason why China now has a very frothy stock market, 6% inflation and negative real rates. 

The way China has opted to integrate into the global economy is a real issue.  Its continued prioritization of export growth has had a huge impact on the global economy, not just the US economy.  Lots of other emerging economies now fear letting their exchange rate rise because they fear Chinese competition. Something will have to give soon though.   China’s exports are on track to rise from $265b in 2001 to $1240b in 2007.   That is a huge — $ 1 trillion – increase.   If you project current (3m average) export growth rates out for two more years, China’s exports will reach $2 trillion; project out three years and it is $2.6 trillion.    

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The US economy is faltering, at least a bit, on the back of the troubled housing market.   Uncertainty surrounding the value of debts backed by subprime US mortgages has created more than a bit of turbulence in global markets.   And particularly after the jobs data, the market expects the Fed to cut – 

Indeed, there is a meaningful possibility that the Fed’s widely expected cut in September will be followed by a series of additional rate cuts.   Dr. Hamilton has a wonderful summary of the current debate over the timing and pace of US rate cuts.

The dollar is – no surprise – once again weak relative to the other major currencies.  At least part of the dollar’s August rally seems – at least to me – to have been tied to deleveraging (including deleveraging by European banks) rather than safe haven flows.  Selling rubles and Asian equities to pay back borrowed dollars isn’t quite the same as seeking out the dollar because you expect it to rally in times of stress.

No matter.  The US economy could benefit from a boost from the export side as it works through the excesses that emerged out of the housing boom over the past few years. 

But the Fed doesn’t just set monetary policy for the US.  It also sets monetary policy for all the countries that are pegged to the dollar (The Gulf) and heavily influences the monetary policy options available to countries that manage their currencies primarily against the dollar (China).   And while a weaker dollar and lower rates are precisely what the US needs at this stake in its economic cycle, they aren’t obviously what the rest of the dollar zone needs.

Take the Gulf.   Oil prices are still high.  The Gulf countries would rater they stay high as well — they don't want to increase production as the global economy slows and repeat their mistake of the late 1990s. 

Spending and investment are still adjusting upward.   Kuwait, for example, spent less than expected in its fiscal 2006 because it couldn’t spend all the money allocated for capital improvement in the calendar year.  But that spending will no doubt take place in 2007.  A small fall in the oil price shouldn’t change this much: spending and investment decisions made over the past few years are now being implemented, and in the worst case scenario, the Gulf can finance its currently planned investment out of its existing assets rather than out its oil export revenue.   

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Combine two data points

• The August fall in Treasury holdings in the Federal Reserve Bank of New York’s custodial accounts (the data is released weekly here); and
• The very modest increase in China’s reported holdings of Treasuries this year, and an outright fall in the second quarter, in the TIC data.

You can combine them and tell a story that China is starting to sell its Treasuries.

I don’t buy it.  Not really.

China – along with some of the oil exporters – is still adding to its reserves in a quite significant way.    China’s reserve growth (like Saudi reserve growth, but surprising, unlike Russian reserve growth) stemmed far less from capital inflows than from its current account surplus.  Financial market turmoil has reduced inflows into the emerging world – and generated outflows from places like Russia – but it hasn’t reduced China’s large surplus, or for that matter the large surplus of the major oil exporting economies.

So China still likely has about $40b or so a month to place somewhere.    If China wants to transfer say $80b to its new investment fund, it doesn't need to sell anything.  All it needs to do is to park two months of the central banks' dollar purchases in the international banking system. 

Now it is true that China doesn’t seem to be putting a lot of its rapidly growing reserves into the Treasury market.    Relatively speaking, it has been buying more Agencies and corporate bonds this year, and fewer Treasuries.  

But a bit of caution is in order even here.    Someone is holding a lot of Treasuries in London — UK holdings have increased by about $135b in the past 12 months.   And for the past two years, a lot of the UK’s supposed Treasuries really turned out to belong to China (look at the adjustments in the historical data).   The high-frequency US data clearly doesn’t capture all Chinese Treasury purchases.   China is likely buying fewer Treasuries, but not quite as few as the TIC data suggests. 

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One of the mysteries of the global flow of funds is the very large role investors in Europe have played – at least if you believe the US TIC and survey data – in financing the US current account deficit.    

Large flows from Europe are a puzzle because Europe – as a whole – doesn’t have a current account surplus.    And there is a lot of evidence that suggest the surplus countries in Europe are the main financiers of Europe’s deficit countries (Spain, the UK and Eastern Europe) – they can finance those countries in euros, and thus avoid exposure to the euro/ dollar. 

But there is no question that Europe has been a big source of demand for US financial assets – and specifically for US debt.   “Corporate” debt in particular.   Corporate debt in the US balance of payments sense is a catch all term that includes any long-term claim other than Treasuries or Agencies — mortgage-backed securities, other asset-backed securtiies and CDOs all count as "corporate debt."

Some of the flows from Europe are pretty easy to explain.    Most of the UK’s purchases of Treasuries, for example, seem to be bought by institutions that are either acting for the world’s central bank or doing a roaring business buying US treasuries when the US market is open and selling those Treasuries to China (and others) when their markets are open.    Every year the survey revises the UK’s holdings of Treasuries down by something like $100b, and revises the holdings of China and others up.    Much the same process likely happens with Agencies, though in that market, Russia could be almost as important as China.

But indirect Chinese demand cannot fully explain Europe’s large purchases of US “corporate debt” – the survey actually hasn’t revised Chinese holdings of that kind of debt up.   

And most corporate debt isn’t a classic reserve asset.   

I have long thought that the most likely explanation involved Europe’s role in the intermediation of petrodollars, but I am now starting to have a few doubts.   A surprisingly large share of "European" purchases of US long-term debt may have come from the off-balance sheet activities of US banks.  Those activities were likely offshore (for tax reasons) as well as off-balance sheet (to conserve regulatory capital).

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China’s reserve managers – the State Administration of Foreign Exchange – recently reported that they have exactly zero exposure to US subprime mortgages.   

“"China's official forex reserves don't include [the US subprime securities]," Wei Benhua, deputy director of the State Administration of Foreign Exchange, said on the sidelines of a financial industry meeting in Beijing”

Unlike many, SAFE apparently didn’t buy instruments with embedded risks that they did not understand, and in the process contribute to the dispersion of credit risk …

To be honest, though, I am more than a little surprised. 

Not by the fact that SAFE’s exposure to subprime is small – or even the now near-certainty that the recent fall in dollar interest rates increased the market value of China’s portfolio by more than enough to offset any credit related losses.  

China’s real exposure is to currency risk, not credit risk. 

But by the fact that SAFE somehow managed to invest close to $500b – I kid not – in global markets over the last 18 months without buying a cent of subprime.    An awful lot of that $500b was invested in dollar-denominated debt.  SAFE put a lot of that money to work in the US markets precisely at that point in time when mortgage-backed security insiders believed the the US market was generating some real toxic debt.   

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Buried in a column on iconoclastic  (and fashionista) tax policy expert Lee Shephard is this little gem:

"“The whole Midwest was engaged in metal-bashing of some sort back then[when she was growing up],” she said. “Now they make loans instead of cars.”

Michael Pettis would disagree.   He thinks the stereotype of that the US economy produces "spread and correlation products" — i.e. debt — rather than real products needs to be revised. He approvingly cites CATO's claim that the value-added in the US manufacturing sector is the world's largest. 

Peter Goodman of the Washington Post similarly emphasizes the size of the US manufacturing sector: 

"The United States makes more manufactured goods today than at any time in history, as measured by the dollar value of production adjusted for inflation — three times as much as in the mid-1950s, the supposed heyday of American industry. Between 1977 and 2005, the value of American manufacturing swelled from $1.3 trillion to an all-time record $4.5 trillion, according to the Bureau of Economic Analysis.

With less than 5 percent of the world's population, the United States is responsible for almost one-fourth of global manufacturing, a share that has changed little in decades. The United States is the largest manufacturing economy by far. Japan, the only serious rival for that title, has been losing ground. China has been growing but represents only about one-tenth of world manufacturing."

I am a little more skeptical.   The US manufacturing sector is bigger today than in the 1950s because the US economy is bigger today than it was then.   And since the US has the world's largest economy by a factor of around 3 — and remains remains more than four times larger than China's economy (at market exchange rates) –  the US should also have the world's biggest manufacturing sector.  It certainly has the world's largest service sector, the world's largest retail market and the world's largest mortgage market.  

But I still wouldn't claim the US manufacturing sector is in rude health — even if overall manufacturing output is rising and exports have picked up recently.

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