Richard Iley

Brad Setser: Richard Iley of BNP Paribas – the author, with Mervyn Lewis, of a new book on the US current account deficit — doesn’t see the world quite the way I do.  

I put a lot of emphasis on the importance of central bank financing of the US external deficit; Richard argues that I overstate the role of the official sector. I have also argued that large deficits eventually imply a deterioration in the US net international investment position and a negative "income" balance in the current account.   Richard isn’t convinced  – and the data has gone his way over the past few years.  

But rather than try to summarize our differences, I am just going to turn the blog over to Richard Iley himself.    Monday’s current account data will offer me a chance to expand on my own views.    There is nothing like a bit of intellectual debate to make what might seem to be a dry data release come alive.

Richard Iley: 

First, let me thank Brad for this opportunity to ‘guest blog’ at RGE monitor; not many would deliberately invite and welcome opposing views in the way Brad is happy to. I only hope I can rise to the occasion.  

I wanted to begin with a little deep background ‘colour’ on how my thinking on the current account deficit has evolved. Apologies for the length of this post but I figured I may only have one shot!

Back in 2004, like most macro-economists, I was increasingly alarmed by the trajectory of the U.S. current account. Brad, of course, was in the vanguard of highlighting and amplifying these concerns. The shopping list of concerns over the deficit is a familiar one so I won’t repeat it. Suffice to say that I was so worried that I was prepared to take the ultimate radical step: write a book on the subject! But this project combined with the surprisingly benign out-turns of recent years has slowly produced a conversion on my part. My fears over the current account deficit, while not completely disappearing by any means, have slowly receded somewhat. Certainly, I have become more relaxed than Brad about the implications of, and prospects for, the US deficit.

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Europe to China: Please do not buy any more euros.

EU economic and monetary affairs commissioner Joaquin Almunia said China should not take any steps to increase its euro reserves at the moment.  Asked what message the euro zone's high-level delegation gave China late last month on its purchases on foreign exchange markets, he said: 'We told the Chinese: it's not the moment to take decisions, it's the moment to stay as you are and take decisions in other areas.'

China to the US: The renminbi isn't the problem, the dollar is.  Richard McGregor writes:

"Beijing turned the tables on the US yesterday … warning of the serious global implications of the weak dollar, recent US interest rate cuts and the subprime crisis." 

Chen Deming, China's future Commerce Minister, was quite direct (Hat tip, Michael Pettis):

"What I am worrying about now is the weakening dollar and its potential impact on global growth. The dollar is the major currency for trade, and its continuous depreciation will push up prices of oil and gold and reduce the wealth of dollar-holding nations. So I want to see a strong dollar.” 

It doesn't take much leg work to get a strong sense that there is more than a bit of friction among what might be termed the G-3.

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Today's trade data release wasn't that inspiring — it wasn't exactly front-page news on a day when the world's central banks indicated that they would jointly intervene to try to unfreeze the world's credit markets (see Felix Salmon, Steve Waldman, and Naked Capitalism — including the comments).

But like China's November trade data, the US October data did confirm recent trends.   The non-oil deficit is falling.   The oil deficit is starting to head back up.   That is to be expected.  Oil prices rose significantly this fall.    The average import price in October was only $72.5 a barrel.  It still has further to rise.   The November import price data makes that clear (the FT reports petrol import prices jumped another 10%).

Indeed, the petrol deficit is only now starting to rise on a rolling 12m basis – 

The standard narrative explaining the improvement in the United States non-oil trade balance (an improvement that started about 12 months ago) emphasizes the strength of US exports.   And no doubt they are strong — y/y export growth in October was almost 14% (the pace of growth may fall back bit in November and December, as a rise in exports at the end of last year makes the "base" a bit less favorable — but it should still be around 12% for the year).   But export growth has been strong since late 2003.   

The improvement in the trade deficit recently stems much more from a slowdown in non-oil import growth than an major acceleration in export growth. 

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Sovereign wealth funds are hot.   A senior JP Morgan Chase banker, quoted in Time:

"SWFs … are the new 'it' girl of global finance. Everyone wants a piece of them." 

Almost every investment bank is looking to sovereign wealth funds as a new source for of deals and management fees — if not for a bit of emergency funding to shore up their existing capital base.   Central banks — which tend to try to minimize the fees they pay on investments in safe assets — haven't generated half as much as much excitement.

The research arms of the world's investment banks have quickly reached a consensus that sovereign wealth funds will get big fast, providing long-term support for at least some risky assets   (Merrill's analysis is typical)

Sovereign wealth funds manage at least $2 trillion now, and perhaps a bit more.   We don't know because the biggest fund also happens to be the most secretive. Estimates of ADIA's size are all over the map — I personally doubt ADIA has $875b (more on that later).  Plus the dividing line between central bank reserves and a sovereign wealth fund can be rather thin:  Russia's oil stabilization fund and the non-reserve assets of the Saudi Monetary Agency are often counted as sovereign wealth funds even though they have fairly conservative portfolios.  The Saudis have some equities, but far less than most investment funds.  Russia's oil stabilization fund is managed far more conservatively than say Switzerland's reserves!

But even if sovereign wealth funds will end 2007 managing a sum that is closer to $3 trillion than $2 trillion, they won't grow to $8 trillion by 2011 — as Merrill now estimates ("By 2011, assets under management at SWFs worldwide are projected to grow almost fourfold to nearly $8 trillion")– without getting close to a trillion a year in new assets to manage.  

Such an increase isn't entirely implausible.   Central banks are on track to add at least $1 trillion to their reserves this year, and perhaps substantially more.  Sovereign wealth funds will likely be given an additional $150-250b to manage this year, depending on whether China's Finance Ministry uses the funds it raised from its big bond sale to buy an additional $100b of foreign exchange from the PBoC for the China Investment Company in late 2007 or early 2008. 

If the emerging world's governments continue to accumulate foreign exchange at their current rate and a large share of their burgeoning foreign assets is managed by investment funds that pay juicy investment banking fees and relatively little is managed by cost-conscious central banks, Merrill's forecast isn't at all implausible.   
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Yesterday I noted the remarkable slowdown in China’s reserve growth over the last few months.     Chinese reserve growth over the last three months – after adjusting for estimated valuation gains — is now well below China’s trade surplus, let alone a broader measure of underlying inflows that captures interest income on China’s reserves and FDI inflows.   

That big fall off is hard to understand.   The pace of RMB appreciation has picked up.  Chinese deposit rates have increased (though they still are lower than CPI inflation).   US rates are falling.   The underlying economics suggest that money should be moving into China, not moving out.

And the “noise” in Chinese policy circles suggests ongoing concern about capital inflows.   Policy actions too: China recently increased the reserve ratio by a full percentage point, sterilizing the equivalent of $75b of reserve growth. 

Something doesn’t quite add up. 

So what is going on?

My best guess is that China’s government is once again shifting foreign exchange to the state banks to manage – and probably also placing pressure on the banks and state firms to hold on to more dollars in order to reduce the pressure on the central bank. 

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Chinese policy makers continue to take steps to try to limit capital inflows into China.    The recent 1% increase in the reserve ratio also suggests ongoing inflows, or at least the need to sterilize rapid reserve growth.

It is not hard to see why capital would continue to try to make its way into China.   The market now expects the RMB to appreciate at a decent clip against the dollar.  Chinese domestic interest rates are rising.   US interest rates are falling.    RMB deposits should return more – in dollar terms – than dollar deposits.   

That is why Chinese domestic savers are abandoning dollar deposits at a steady pace.  Chinese dollar-denominated household savings deposits are down by $12b so far this year, after falling by around $25b between the end of 2002 and the end of 2006

But Chinese policy maker apparent concern isn’t reflected in the data. At least not the recent data.    Starting in August, the pace of reserve growth slowed –

The following graph compares Chinese reserve growth over the past 12 months to China’s trade surplus, its estimated interest income and FDI inflows.

Make no mistake, Chinese reserve growth is quite strong.  But the trend seems to have changed.   Reserve growth is now back in line with China’s basic balance.   Hot money inflows – which account for the gap between reserve growth and the sum of the trade surplus, the interest of China’s reserves and FDI inflows – seem to have disappeared.  Even after adjusting the data to reflect the impact of the CIC, hot money flows seem to have slowed significantly recently.

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The GCC leaders didn't agree to change the GCC's peg to the dollar, but the issue is not dead.  Ahmet Akarli of Goldman writes:

Bahrain Foreign Minister Al-Khalifa told Reuters on Sunday that the GCC finance ministers and the central bank governors will gather to discuss "currency revaluations" in the coming few days…. it is clear that the GCC authorities are seriously considering policy alternatives and looking hard into what can be done to bring inflation under control. A currency adjustment is, no doubt, on the agenda.

It certainly should be.   The underlying economics haven't changed.  Unless the Gulf countries are willing to save all the oil windfall, it is hard to see how their currencies avoid appreciating in real terms.   With the GCC currencies depreciating against the world, such "real" appreciation — a rise in the domestic price level relative to world prices — can only come from faster inflation. 

Gerald Lyons of Standard Chartered:

"There is a fundamental mismatch between the economy at the centre of a currency system [The US] and those elsewhere [The GCC] … [The Middle East's] ties to a weakening dollar mean rising inflation, and the US is cutting rates just when the Gulf needs a tighter monetary policy. These tensions will get worse"

They already are.  Recent data indicates that inflation is picking up across the Gulf.

Saudi inflation is now close to 5% – and not because of higher domestic oil prices. 

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Opinion — informed opinion — is divided.

The currency team at the Bank of New York says yes.  Simon Derrick wrote on Monday:

"our own view [is] that one of the driving forces behind the EUR’s sustained strength over the past six years has been reserve diversification (FX reserves globally have all but tripled since the first quarter of 2002)" 

Bernhard Eschweiler– the head of JP Morgan's Central Bank Group — says no.   He wrote in the FT: 

the idea that central banks are undermining the dollar makes neither sense nor is there evidence in the data.

Why?   Countries that manage their exchange rate against the dollar are, according to Eschweiler, forced to hold dollars.

The principle mistake that many commentators make is the assumption that central banks can separate the currency allocation of reserves from their exchange rate objectives. In practice, this is often not the case, especially for the large surplus economies in Asia as well as the oil-exporting countries. These countries all follow some sort of dollar standard, whether it is an outright peg or a dirty float.

So, when they intervene to prevent their currencies from appreciating against the dollar, they get mostly – or even exclusively – dollars (also because most of their trade and capital flows are dollar denominated).

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In James Clavell’s Noble House, there is a scene where a fictional Scottish trading house operating in colonial Hong Kong ends either a run on its bank or a run on its stock (or maybe both – I forget) by obtaining an emergency loan from China’s communist government.  The loan didn’t come directly from China’s government – it came though the Hong Kong branch of Bank of China – but it clearly required Beijing’s approval.     

Clavell's novel was set in a time when China’s government was still really communist.   1949 wasn’t a distant memory in the 1960s.  

The world has changed since then.   Chinese Communist have turned into capitalists.  And fiction has turned into fact.  

Last week, a capitalist icon turned to government – and not its home government — for help in a time of stress.   About two weeks ago Citi's top executives boarded a private plane to fly half-way around the world to cement the sale of a decent chunk of Citi's equity to the Abu Dhabi Investment Authority (ADIA).

Depending on your point of view, Citi’s recapitalization is structured so that ADIA either gets a generous coupon before it is obligated to buy Citi's stock, or the generous coupon is a way of disguising the discounted future sale price of Citi’s stock.   See ALEA for the real details (hat tip Naked Capitalism).  

ADIA’s investment is structured to stay below the 5% threshold that requires Fed approval (for a bank), let alone the 10% threshold that requires CFIUS (Committee on Foreign Investment in the United States) review.   Still, it is hard to believe that Citi’s new CEO won’t pay a visit to ADIA along with Prince Alaweed soon after being selected.    He (or she) might even get flown over in a private A380 rather than Citi’s corporate jet …

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Today’s Financial Times has an important article by Geoff Dyer and Sundeep Tucker examining the overseas expansion of Chinese companies in general, and Chinese state companies in particular. 

It is an important topic.  One of my main conclusions my recent trip to Beijing was that the Chinese Investment Corporation (China's sovereign wealth fund) is going to a somewhat smaller force in global markets than many expect and Chinese state firms and banks a somewhat bigger force.   

Dyer and Tucker offer two key insights:

First, Chinese state enterprises compete among themselves.

The best example:  the different Chinese banks have all apparently expressed interest in buying Temasek’s stake in Standard chartered:

“Three Chinese banks – China Construction Bank, Industrial and Commercial Bank of China and Bank of China – have approached Temasek of Singapore in recent months to discuss buying its stake in Standard Chartered.” 

The deep irony here is that all three are share the same large shareholder: the China investment corporation bought Central Huijin’s stake in these three banks (Huijin received equity in return for the reserves the PBoC provided the banks back in 2003 and 2005).  If all three compete against each other to bid up the price of Temasek’s stake, Temasek wins and the CIC loses –

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