Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Is the dollar’s decline over?

by Brad Setser Friday, November 30, 2007

The Economist put the dollar on its cover this week.   The Economist’s cover is usually a lagging, not a leading, indicator:  it signals that the dollar already has fallen significantly, and sometimes indicates that it is poised for a rebound.

Perhaps more importantly, a long-standing dollar bear – Goldman’s Jim O’Neill – now expects that dollar to rebound against the euro.    Bo Nielsen of Bloomberg reports

"It's fallen a long, long way … I personally think that a year from today the dollar will be quite a bit stronger."

Morgan Stanley’s Stephen Jen presumably has a similar view — Morgan Stanley’s forecast for the dollar at the end 2008 is 1.35. 

And – as Felix hints – I am also starting to wonder if the dollar has already fallen by as much as it is going to fall against the euro.   

I have long believed that a fall in the dollar’s real value was a necessary part of a broader adjustment needed to bring the United States’ trade deficit – and the United States need for external financing — down.     And I have long argued that unprecedented intervention to support the dollar (in order to keep other currencies from rising) by the world’s central banks has impeded this correction, storing up problems for the future. 

Those basic views haven’t changed.   But it also hard to deny that the dollar already has moved substantially against the euro.    At 1.45-1.50, the US trade deficit with Europe should fall quite quickly, especially if Europe continues to grow even as the US slows.    The US bilateral balance with Europe has already started to improve in a rather big way.

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What should replace the Gulf’s peg to the dollar? More on my Peterson institute policy brief

by Brad Setser Wednesday, November 28, 2007

Oil and the dollar have not consistently moved in the same direction over the past ten years.    

  • In 1997/1998, oil tanked and the dollar soared.
  • In 2000, oil and the dollar both rose – in large part because strong demand growth from the US put pressure on global oil prices.
  • From 2003 on, the dollar’s slide has coincided with a huge rally in the world oil price.   The inverse correlation between oil and the dollar isn’t perfect.  Oil and the dollar both rose in 2005.   But recently it has been pretty strong.
  • Indeed, during the course of 2007 oil has soared to close to $100 a barrel even as the US economy slowed and the US dollar slid against most currencies.

The combination of a weak dollar and high oil prices poses some problems for the US.   Countries with strong currencies haven’t seen a comparable increase in oil prices – or in domestic price pressures from rising energy costs. 

This combination also poses rather significant – though self imposed — problems for many of the world’s oil exporting economies.   The Gulf is importing both a weak currency and US monetary policy right now.     The Economist puts it succinctly in its leader:

The combination of soaring oil prices and the tumbling dollar is distorting their economies and fueling inflation. 

Real interest rates in the Gulf are now range from zero (in Saudi) to negative 5 or negative 10 – and those calculations work off the official inflation data, which may well understate inflation.   The 3% yield on the two Treasury note is low for the US, though understandable given the weakness in the US housing sector.  3% is way too low for the Gulf.  Yet right now Gulf countries are cutting their domestic interest rates to match US rate cuts.

Two years ago, the argument — made in my Peterson institute policy brief —  that the Gulf countries dollar peg was an anachronism that is no longer in the Gulf's states interest wasn't generally accepted.  It wasn't that wildly accepted twelve months ago. The conventional wisdom – which still crops up in say Lex last week — was that the Gulf countries were a natural part of the dollar block so long as oil was priced in dollars.

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Scary graph

by Brad Setser Tuesday, November 27, 2007

I didn’t use the term “sudden stop” in my post on the September TIC data release lightly.   The attached graph — which comes straight from the TIC data — shows an extremely sharp fall in net purchases of US long-term financial assets over the last three months. 


The data here only covers long-term flows – it doesn’t pick up very short-term flows.    It also doesn’t pick up FDI flows.   That said, neither short-term flows nor FDI inflows have been a big source of financing for the US deficit over the past few years.   Most of the financing needed to sustain ongoing large external deficits has come from portfolio flows. 

Three other caveats apply:

  • The data here is a three month rolling sum.   A 12m rolling sum would show a significant fall, but not quite as dramatic a fall as in the higher frequency data.
  • The split between official and private flows in the TIC data is clearly off.  Official flows make up a larger share of the total than the TIC data indicates.  I state this with a high degree of confidence for two reasons;  first, the revisions to the BoP data have consistently increased official flows once the survey data comes out; and two, the TIC data clearly isn’t picking up a lot of flows from the middle east, Russia and China and we know that they all have a ton of cash and that it is in official hands. 
  • The last data point comes from September.  We are now in late November. 

Nonetheless, a range of market indicators — not the least the slide in the dollar v the euro since the end of September — do not suggest a strong pick-up in private demand.   

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Oil math

by Brad Setser Monday, November 26, 2007

I loved the’s interactive oil map – particularly the graph showing the global flow of oil.

I was also impressed by Qing Wang’s analysis of the impact of rising oil prices on China.   China imported about a bit more than $70b worth of oil in 2006, enough to reduce China’s trade surplus by 2.7% of China’s GDP.   Wang calculates – based on Chinese import data – that $10 a barrel rise in the price of oil over the course of the year would increase China’s import bill by about $13.5b (and, absent an increase in the domestic gasoline prices, cut into the profits of China’s state oil companies by a bit over $14b).   

That was a somewhat smaller increase than I expected – which just shows the advantage of looking at the numbers.   So how much, by comparison, would a $10 a barrel increase in the price of oil impact other economies, assuming no offsetting increase in spending and investment in the oil exporting states and thus no offsetting increase in exports to the oil-exporting states? 

Using the BP data, I estimate that a $10 a barrel increase in the price of oil would: 

  • Increase the US trade deficit by about $50b over the course of the year.
  • Lead to a $46b (euro 31b) deterioration in the EU-25 trade balance.  The EU-25 imports a bit less oil than the US (12.6 mbd v 13.7 mbd) even though it produces less oil than the US and has a somewhat larger economy.  

And conversely, each $10 increase in the barrel of oil means:

  • An additional $57b for the GCC states (Saudi Arabia, Abu Dhabi, Dubai and the other emirates, Kuwait, Qatar and Oman) to spend or invest.
  • An additional $25-26b for Russia.
  • An additional $10b for the Iranian government.
  • An additional $9.5 or so for the socially conscious burghers of Norway to stash away in their already quite substantial sovereign wealth fund.
  • An additional $8b or so for Venezuela.

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Danish honesty (on the no-longer-strong dollar)

by Brad Setser Sunday, November 25, 2007

Teis Knuthsen of Danske Bank:

“Secretary Paulson claims the strong dollar policy remains in place but also that FX rates should be set in the markets, a combination that is currency inconsistent.”

Sounds about right.   Martin Wolf makes essentially the same point, citing the work of Wynn Godley and others at the Levy institute.

As Wynne Godley of Cambridge university and co-authors point out, a sustained improvement in US net trade will offset at least a part of the likely sluggishness in domestic demand.* This is why the US authorities talk about a strong dollar, but do not mean it. They want a retreating dollar, but one that does not turn into a rout.

US policy makers are caught in a dilemma.   

On one hand, essentially no one believes that the US actually has a strong dollar policy.   The reiteration of the existing US policy therefore has almost no impact.

And – it should be noted – the “strong dollar” policy has never meant that the US would direct its monetary policy toward maintaining the dollar’s external value rather than stabilizing the domestic economy.   Right now, former Secretary Summers believes stabilizing the domestic economy requires putting emphasis on supporting demand growth

“Maintaining demand must be the over-arching macro-economic priority. That means the Fed has to get ahead of the curve and recognise – as the market already has – that levels of the Fed Funds rate that were neutral when the financial system was working normally are quite contractionary today.”

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Kuwait’s dinar is now on track to appreciate by more than China’s renminbi in 2007 …

by Brad Setser Friday, November 23, 2007

Kuwait now has let the dinar appreciate by more than 5% this year — the appreciation from mid May is now in the 5.45-5.5% range.    China has let the RMB appreciate by a bit less (5.2%) this year even though it had a head-start.   The RMB had appreciated by about 1.5% before the dinar was allowed to move at all. 




Kuwait hasn’t just managed the dinar against a (dollar-heavy) basket.    It has let the dinar appreciate against its basket.   That is the right policy.   Before it shifted to a basket, Kuwait had let the dinar follow the dollar down.  It needs to correct a real undervaluation not just protect itself from further currency volatility. 

China, by contrast, hasn’t really managed the RMB against a basket.    It basically just has a crawling dollar peg.   The rate of crawl varies.   Right now the market expects the pace of appreciation (v the dollar) to pick up.   But for 2007, the total appreciation is likely to be around 6%.    

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The new global norm

by Brad Setser Wednesday, November 21, 2007

The Washington Post on India, a couple of weeks ago:

Surjit Bhalla, who heads Oxus Fund Management, an economic research firm in the capital, New Delhi, said that the Indian government should manipulate the rupee the way that China keeps the yuan undervalued.

"By intervening, the government will keep the Indian rupee competitive. That is what the whole world does," Bhalla said. "Why should India try to be a hero on a white horse and let our currency appreciate? It is a body blow to our economy, and we end up helping China. The government has created a monster, and I hope they fix it soon." [Emphasis added]

Judging from the pace of Indian reserve growth over the past few months, I would say India  already has a “competitive” rupee policy, not a strong rupee policy.  It has joined the "world."  It certainly is spending a fair amount of money trying to limit the rupee’s pace of appreciation. India's reserves have increased by $40b or so since the end of August.   They are up by over $90b for the year-to-date.    Some of the increase comes from the rising dollar value of India's euros and pounds, but most of it comes from actual intervention in the market.

Comments like these also illustrate why China matters so much for global adjustment; China’s policy choices impact the entire world.    Right now, fear of appreciating against China is a major constraint on the appreciation of other currencies.   After experimenting with a bit of exchange rate flexibility earlier in the year, both India and Thailand look to me to have effectively repegged (though at a somewhat stronger exchange rate).

They thought they had exited Bretton Woods 2.  But countries who compete with China have generally found it far harder to get out that they expected; the price of appreciation is too high.  Alas, the price of (foreign exchange market) intervention is also rising …

A little too late …

by Brad Setser Tuesday, November 20, 2007

China's premier,  Wen Jiabao, has joined the chorus voicing concern about the dollar's recent weakness.   Cheng Siwei comments two weeks ago seem to reflect rather widespread worries among China's top leadership.  The FT reports:

Premier Wen Jiabao told a business audience in Singapore it was becoming difficult to manage China’s $1,430bn foreign exchange reserves, saying that their value was under unprecedented pressure.

“We have never been experiencing such big pressure,” Mr Wen said, according to Reuters. “We are worried about how to preserve the value of our reserves.”

China keeps the currency composition of its reserves a state secret, but some analysts believe that more than two-thirds are probably still held in dollars.

Wen certainly has reason to worry.   No one has made a bigger bet on the dollar that China's government.   I personally suspect that China's state — counting the assets of the State Administration of Foreign Exchange, the China investment corporation, China's big state banks and the national social security fund — hold around $1.2 trillion in fairly long-term dollar-denominated debt.   The precise number depends on just how many dollars the banks are currently holding (their holdings of foreign debt securities likely are well over $200b by now) as well as just what fraction of China's roughly $1.5 trillion in formal reserves (China had $1433.6b at the end of September and is steadily adding to its reserves) are in dollars.   

The capital loss on those dollars could be considerable.   The dollar hasn't held its purchasing power relative to the euro, or relative to oil.  But what should really worry China's leadership is that the dollar is very unlikely to hold its value relative to the RMB.   After all, China's government has financed its dollar purchases by issuing RMB debt.  Willem Buiter argues:

If the dollar falls by another twenty or thirty percent, which is certainly possible, the Chinese and Japanese authorities would each be presenting their tax payers with a further $200bn to $300bn capital loss. That's a heavy price to pay for access to US markets for your exports, especially for a poor country like China

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Another bad TIC data release

by Brad Setser Monday, November 19, 2007

I am back in the United States, and ready to get back to work.  

Before turning to the TIC data though, let me first thank Michael Pettis for filling in here so ably once again.    I cannot overstate how much I appreciate the ability to outsource (to China even) the responsibility for putting up new content every so often.

Most of the headlines that followed the TIC data release generally indicated that “capital flows to the US bounced back” from their August lows in September.   

Foreign investors were net buyers of  US long-term assets in September, unlike in August.  And foreign purchases ( after adjusting for the repayment of principal on asset-backed securities) of US long-term assets were even slightly larger than net US purchases of long-term foreign assets.

But the main story in the September data is that capital flows to the US remain very weak.   At least to my ming, the right headline for the September data is the continued absence of foreign demand for US assets, not the (relative) improvement from August.

  • Net purchases of long-term US assets ($26.4b) remain well below the roughly $65b a month needed to finance the US current account deficit. 
  • Net (private) long-term inflows remained negative (-$2.1b), as private US investors took more money out of the US ($29b) than private foreign investors brought in ($26.8b).  
  • The positive overall number comes entirely from recorded official – i.e. central bank – inflows.    And there is good reason to think that the US data understates real official inflows.    Some of the $22.4b in Treasuries sold to the UK in September were bought by (private) banks and hedge funds looking to hoard liquidity, but some were also likely bought by central banks. 
  • If – as I think likely – the adjustment associated with the payment of principal on asset-backed securities can largely be assigned to the private rather than official side of the ledger, net private inflows were even lower – negative $17.5b.   Official investors hold asset backed securities, but they often use private fund managers for this portion of their portfolio.   That is one reason why the US data understates official inflows.

Once the adjustment for principal payment is made and short-term flows are added in, net flows were negative in September.    Negative $14.7 to be precise. And once short-term flows are added in, net (private) flows were really negative in September.  Negative $27.8b.    That is better than the negative $129.6b net private flow in August, but it is still a rather substantial outflow of private funds from the US.

Bottom line: private demand for US financial assets has disappeared.   In emerging market terms, the US has experienced a sudden stop.   

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The Gulf seems determined to let everyone take a punt on a December revaluation

by Brad Setser Sunday, November 18, 2007

Note: This is Brad Setser, Not Michael Pettis 

The heads GCC countries will meet in early December.  They are expected to announce that the launch date of their currency union will be delayed – and presumably will discuss whether or not to continue to peg to the dollar in the interim

I understand the need for the Gulf countries to try reach consensus so they can move together, but I am not sure that countries with open capital markets can announce that they are considering a revaluation on a fixed data without effectively being forced to revalue.  Bloomberg

“Six Gulf Arab states will discuss a proposal next month to revalue their currencies, Abdul Rahman al- Attiyah, the secretary general of the Gulf Cooperation Council, said today.”

Even a small 2% revaluation in early December produces a roughly 24% annual return on holding GCC currencies over the next month.    That is kind of tempting.  GCC interest rates have fallen, cutting into the return, but not enough to make such a bet unattractive.  See Simon Derrick of the Bank of New York 

After all, the GCC currencies offer a one-way bet.   They either will revalue, shift to a basket (likely with a small revaluation) or do nothing.   They won’t devalue. 

The Saudis insist that they aren’t about to change (Central bank governor al-Sayari denied any plans to change, and Finance minister Ibrahim al-Assaf said that there is `no plan to use a basket of currencies for the Saudi riyal and we do not have a plan to revalue'').   But they almost have to say that if they do not plan on changing their policy right now.    The sequence of updates of the initial Bloomberg story suggests the official denials followed the initial indication from a source familiar with Saudi monetary policy that a proposal to change the peg had indeed been put on the table.

The UAE rather clearly is ready to move to a basket, but doesn’t want to do so unilaterally.  Qatar may be in the same position.    

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