Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Borders still matter; “the world isn’t as flat as it used to be”

by Brad Setser Tuesday, April 29, 2008

On Monday, Bob Davis of the Wall Street Journal argued that the world isn’t flat, or at least it “isn’t as flat as it used to be.” National borders matter more. Barriers to the free flow of goods – oil as well as grain – are rising. Barriers to the free flow of capital too.

He is right. I actually think he didn’t push his thesis as far as it could be pushed.

Consider energy. Most oil exporters sell their oil abroad for a higher price than they sell their oil domestically. That means that the same good has one price domestically and another price internationally. It isn’t hard to see why they have adopted this strategy: if opening up to trade raises export prices, it can leave those who consume the country’s main export worse off. Only exporting what cannot be sold domestically is one way of mitigating that effect. And for most of the oil exporters, it is one (small) way of sharing the bounty that comes from the country’s resource wealth.

This isn’t new. Saudi Arabia and Russia have long sold oil domestically at a lower price than internationally. What is new is that a host of food exporters are adopting a similar policy.

Argentina was perhaps the first. After its devaluation it taxed its agricultural exports – that was a way of raising revenue, but also a way of keeping food cheap domestically. As global prices have increased, Argentina has stepped up its restrictions on say beef exports – helping to keep Argentina’s national food affordable domestically.

Argentina’s farmers aren’t happy. They prefer selling for a higher price abroad than selling for a lower price domestically.

But with food prices rising, more and more countries seem to be adopting the same policies for their rice and wheat that Saudi Arabia and Russia have adopted for their oil. They only export what cannot be sold domestically at a price well below the world market price. That helps domestic consumers at the expense of domestic producers.

It also is a way – per Rodrik (“if you are Thailand or Argentina, where other goods are scarce relative to food, freer trade means higher relative prices of food, not lower”) — of assuring that the consumers in a food exporting country aren’t made worse off by trade.
Actually, in the current case, it is more a way of assuring that consumers in exporting countries aren’t made worse off from a shock to the global terms of trade that dramatically increased the global price of a commodity. But the principle is the same.

Such policies have produced a more fragmented world. Beef is cheaper in Argentina than in the rest of world. Rice is cheaper in rice-exporting economies than many rice-importing economies. Oil is cheaper in oil-exporting economies. And so on.

Then throw in the subsidies that many oil and food consumers have adopted to mitigate the impact of higher oil prices. China sells oil domestically at a price below the world market price. The Saudis are subsidizing food imports. That implies that the same good sells for a different price in “importing” countries – not just for a different price in importing and exporting countries.

For all the calls to adopt a coordinated response that guarantees that exporters won’t take steps — like taxing exports — that hurt the importers as well discouraging increased production in the exporting economy, my guess is that the food crisis will produce more government intervention in the market, not less.

Put it this way: after seeing various food exporting countries take policy steps that would reduce their countries’ profits from exporting to keep domestic prices low, is China’s government more or less likely to trust the market to deliver the resources the Chinese economy needs for its ongoing growth? Or will China conclude that it needs to invest and exercise some control in the production of the resources if it wants to guarantee the stability of its supplies?

Then there are capital flows. Davis highlights the growing presence of sovereign wealth funds in global markets and — – citing a forthcoming Council on Foreign Relations report by David Marchick and Matthew Slaughter — the possibility that the US and Europe will respond to the rise of state investors by stepping back from their existing, fairly liberal, policies for inward investment. He also notes that many countries with sovereign funds looking abroad limit investment in their own economies. China is a case in point.

Here I don’t think Davis goes far enough.

Sovereign wealth funds are a lot smaller than central banks. Their assets aren’t growing anywhere near as fast. The overall increase in the presence of the world’s governments in financial markets is much broader and deeper than an analysis that focuses on just sovereign funds would suggest.


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$120 oil and the rise of the Gulf

by Brad Setser Monday, April 28, 2008

The Economist put the Gulf on its cover this week. It isn’t hard to see why. The Gulf was booming with oil at $ 60 a barrel. It is roaring with oil at close to $120 a barrel.

Consider the following graph, which shows the Middle East’s oil export revenues over time.* For the calculations, I assumed oil will average $120 a barrel in 2008. That is on the high side – as oil would have to average more than $120 a barrel over the remainder of the year to bring the annual average up to $120. On the other hand, oil keeps on rising …


* I calculated oil export revenues by multiplying the oil price (using the IMF’s data) by a country’s net oil exports (using the BP data set)

Looking at nominal dollars though can be a bit deceptive. Relative to world GDP, the Middle East’s surplus is actually a bit smaller this time around.


Real oil prices are back where they were in 79-80. But the world has become a bit less oil-intensive over time. A barrel of oil produces more output now than in the early 80s – or, alternatively, it takes a bit less oil to generate a dollar of output.

The oil importers though shouldn’t be celebrating too much. At least not the US. The following graph shows US and EU oil imports against the Middle East’s oil exports, both plotted against world GDP.


Two things jumped out at me.

First, if oil does average $120 over 2008, the rise in the United States oil import bill would be as steep as in 1973 and 1979. Going from $70 to $120 in a year would be a shock – not the steady rise of 2003-2006.

Second, the relative position of the US and Europe have shifted. Back in the 1970s, Europe imported more oil (relative to world GDP) than the US. Now the US imports a bit more than Europe. Chalk that down to falling domestic oil production – and a vehicle fleet that is only ½ as efficient as Europe’s vehicle fleet.

The result: US oil imports are as large – relative to the world’s GDP – as in the 1970s, while Europe is importing less than in the 1970s.

What of the Gulf itself?


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What keeps Zhou Xiaochuan up at night

by Brad Setser Sunday, April 27, 2008

Friday’s Lex column highlighted the possibility that China’s real reserve growth may be far higher than the published increase in its reserves – and thus a lot more hot money may be flowing into China than the published increase in China’s reserves implies. Michael Pettis – drawing on the work of Logan Wright of Stone and McCarthy – and I have both published online estimates of the “true” pace of Chinese reserve growth. Wang Tao – formerly of the Bank of America – and Stephen Green of Standard Chartered have done similar work.

Hot money flows matter for two reasons.

For China, the scale of hot money inflows are key measure of the sustainability of China’s current policy course – and the efficacy of China’s capital controls. China has hoped to combined higher interest rates than the US with a steady (neither too fast nor too slow) pace of renminbi appreciation. That makes the RMB about as close to a one-way bet as exists in today’s financial markets. Unless the RMB falls against the dollar, an RMB deposit will deliver higher returns than a dollar deposit just because of the interest rate differential. And if the RMB appreciates, the gains are quite large.

That in turn means that the sustainability of China’s current monetary and exchange rate policy rests on the efficacy of its capital controls – controls that keep everyone in the world from trying to profit from a one way bet on China’s currency. Absent effective controls China would have to adjust its policy by either:

  • Lower Chinese interest rates to reduce the incentive to hold RMB in spite of ongoing inflationary pressures;
  • Stop the RMB’s appreciation against the dollar, again, despite inflationary pressures;
  • Or accept a large one-off revaluation, one large enough to end expectations of further RMB appreciation. See Wang Tao’s analysis in Caijing.  Frank Gong of JP Morgan seems to be thinking along similar lines.

For the rest of the world, capital inflows matter both because of their implications for the sustainability of China’s exchange rate regime and because the scale of hot money inflows – combined with the scale of China’s trade surplus and FDI inflows – determines the pace of growth in the foreign portfolio of China’s state.

That matters for a host of reasons. Suppose fx traders see the PBoC selling $60 billion worth of dollars for euros and pounds in a single quarter. If China’s reserves are increasing by $120 billion, that kind of scale would suggest diversification at the margin – i.e. China is trying to reduce the dollar share of its overall portfolio. If China’s reserves – counting the funds in the CIC and state banks – are growing by $200-240 billion, such sales would be consistent with maintaining the current dollar share of China’s reserves. China’s purchases have an impact on a host of asset markets.

So what is going on –

In the comments on an earlier post, a reader requested a graph showing the contribution of valuation gains to China’s reserves growth. I have consequently plotted both China’s “headline” reserve growth against the likely sources of its reserve growth – valuation gains on its existing holdings, its trade surplus, its estimated interest income and FDI inflows. The gap between reserve growth and these known inflows is the standard measure of “hot money”.

I have also added the likely increase in the banks foreign assets due to the “suggestion” from the PBoC that they meet their reserve requirement by holdings dollars. This has emerged as significant sources of additional “quasi-reserve” growth over the past nine months. Transfers to the CIC reduce reported reserve growth, and foreign exchange held by the banks at the request of the PBoC has the same effect. The precise timing of the transfers to the CIC isn’t known – I have assumed that all the RMB1.55 trillion the CIC raised was transferred by the end of q1 and further assumed that the $67 billion the CIC spent buying Huijin still shows up in the reported reserves of the People’s Bank (i.e. the CIC’s total purchases, net of huijin, are roughly $135-140 billion)*

Basically, this is the same data that Michael Pettis reported in early April, just presented graphically.*


What does this data show? Well, if the CIC received large sums in q1 – as seems likely – China’s foreign asset growth is really very, very high. The increase over the last 12 months is close to $750 billion – and only about $65 billion of that increase is explained by valuation gains (note: if China has a higher euro share of its portfolio than I have assumed, valuation gains would explain more of the increase)


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Adapting to the state’s growing role in global equity markets

by Brad Setser Thursday, April 24, 2008

Central bank purchases of traditional reserve assets still dwarf sovereign wealth fund purchases of riskier assets — as well as central bank purchases of equities. But over time, it is reasonable to expect that many over-reserved sovereigns will diversify their portfolios. The recent decision to increase the share of the CIC’s initial $205-210 billion in capital that it can invest abroad and SAFE’s increased willingness to purchase equities as well as bonds are examples.

I didn’t agree with everything that Knut Kjaer (the former director of Norway’s Government Fund) wrote last Monday in the Financial Times. But I thought he framed the core issue raised by sovereign wealth funds, central bank purchases of equities and state-backed firms expanding abroad quite well. The basic issue is how institutions in both the “investing” and “receiving” countries need to adopt to a world increasingly defined by state rather than private flows.

Kjaer doesn’t dance around the fact that the rising presence of the state in the market is a real change:

A far more challenging issue is how the huge increase in financial assets managed by potentially non-economic agents will affect the efficiency of the global capital market and the allocation of risk and resources. ….

Parts of Kjaer’s framing – notably the risk that non-economic actors will distort the allocation of resources — differ the framing favored by many of those looking to earn fees managing sovereign funds. They tend to argue that sovereign funds have been around for a long time, so there is nothing “new” about sovereigns investing in equities.

It is true that many (though not all) sovereign funds have been around for a long time. But that doesn’t mean that nothing has changed.

The existing oil funds — who have long been active in the equity market — have a lot more money with oil at $115 than with oil at $20-25 – or with oil at $50.

And then there is China. China enormous foreign asset growth in the first quarter implies that it might be able to add more to its reserves and sovereign fund in 2008 than all the oil-exporters combined even if oil stays at its current levels. Even if China falls a bit short of the oil-exporters, it still looks to be close race.

China consequently has an enormous latent capacity to alter the composition of global capital flows by changing the composition of its portfolio: right now it could put another $200b in the CIC and still have $500b left over for other state institutions to play with. Those kinds of sums are new – as is possibility that China might soon be a big buyer of equities.

The potentially dramatic increase in sovereign investment in equities over the next few years raises a host of issues. (More follows)

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Stable capital? Or scared capital?

by Brad Setser Wednesday, April 23, 2008

A host of banks have raised new capital over the past couple of weeks, in a whole variety of ways — rights issues, convertible bonds, preferred stock and the sale of new equity.

However, they haven’t tapped last year’s savior: the big sovereign funds. At least not directly. Some of the private equity firms that have invested in the banks may be flush with cash that they raised (at least in part) from sovereign investors. Still, the Gulf has largely sat out the most recent round of recapitalization, despite plenty of petrodollars.

What are sovereign investors doing with their funds instead?

That isn’t hard to decipher. Over the last six weeks, foreign central banks custodial holdings at the New York Fed have increased by an average of $17.8 billion a week.

A week. Let me try to put that in context. $17.8b a week, annualized, is OVER $900 billion a year. If oil averages $100 a barrel in 2008, $900 billion is large enough to cover the US oil import bill (net of petroleum exports) two times over. If oil stays at $115, $900 billion doesn’t quite cover the United States oil import bill two times over, but still provides a comfortable margin of extra financing.

The average increase over the past two weeks was even higher — $18.5b. That, annualized, is just short of a headline grabbing $1 trillion figure. It is real money.

All that money is going into safe Treasuries and almost-as-safe Agencies – not “risk” assets.

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Ut-oh! Is China starting to blame the US for its currency losses?

by Brad Setser Tuesday, April 22, 2008

It is commonly argued that growing economic ties tend to create common interests that will reduce tension between nations (see FT’s Alphaville). The enormous amount China has lent to the US — a total that the US data (which tends to underestimate Chinese holdings) now puts above $1 trillion — will, according to this view, prevent other sources of conflict from getting out of hand.

Alas, relations between creditors and debtors are rarely quite so free of tension. Creditors want to get paid back in full. Debtors would rather pay back at little as possible.

Mei Xinyu, a senior researcher under the Chinese commerce ministry writing in a personal capacity for the Shanghai Daily, argues that China needs to put pressure on the US at the Strategic Economic Dialogue to do more defend the dollar. With the dollar at 1.60 against the euro, it isn’t hard to see why.

Mei goes on to argue that if the US doesn’t do more to defend the dollar, it is effectively defaulting on China.

“The negative results of the US dollar’s decline are evident: the rising prices of all primary products, the intensified pressure on inflation globally, the confusion in the settlement of international transactions, etc. Worst of all, this is the US’ disguised way of avoiding paying off its debts to foreign countries.

It should be noted that the US is the biggest debtor country in the world.
… By the end of 2006, the US’ accumulated net debt overseas hit US$16 trillion. As most of the debts were calculated in US dollars, the US is actually welshing on its debts malignantly by allowing the devaluation of US dollars. Since China is the country with the world’s biggest foreign exchange reserves, most of which are calculated in US dollars, China thus is hurt most greatly from the US dollar devaluation.”

One man’s exorbitant privilege is another man’s disguised default. Just think what might have happened it CITIC had invested in Bear and China had gotten back depreciated pennies on its initial dollar … More follows

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Not all that sophisticated

by Brad Setser Monday, April 21, 2008

Back in 2005, Ragu Rajan warned that the banks were taking on the hard-to-sell leftovers from the securitization process. As a result, he argued that the banks were becoming less liquid – and that the process of risk transfer was incomplete. I assumed that this meant that the banks were holding small amounts of the most risky tranches that emerged from bundling a lot of different loans and securities together. That assumption seems to have been off. The risky bits carried high yields, and seem to have been easy to move. Instead the banks were holdings large quantities of the safest (and lowest yielding) securities – the “super-senior” tranches.

Gillian Tett:

The concept of super-senior debt was essentially invented by creative bankers about four years ago to refer to the chunk of debt that sits at the very top of the capital structure of a collateralised debt obligation. It is the bit that gets paid off first, before other investors, if the CDO ever defaults. In theory, it makes this debt super-safe; indeed, so secure that rating agencies have been happy to give super-senior CDO debt a triple-A tag, irrespective of what lay inside the CDO.

When I first heard about this asset class a couple of years ago I initially assumed this stuff might appeal to risk-averse institutions such as pension funds. But nothing could be further from the truth. In fact, key buyers for super-senior in recent years have been banks such as Merrill Lynch and UBS. Most notably, as these banks have pumped out CDOs, they have been selling the other tranches of debt to outside investors – while retaining the super-senior piece on their books. Sometimes they did this simply to keep the CDO machine running. But there was another, far more important, incentive: regulatory arbitrage.

Most notably, because super-senior debt carried the triple-A tag, banks were only required to post a wafer-thin sliver of capital against these assets – even though this debt has typically offered a spread of about 10 basis points over risk-free funds. Thus, banks such as UBS and Merrill have been cramming their books with tens of billions of super-senior debt – and then booking the spread as a seemingly never-ending source of easy profit. It is not just the CDO desks that have been playing this game; treasury departments have been playing along. So have many hedge funds, including those financed by . . . er . . . the major investment banks

It turns out that the super-senior tranches carried a lot more risk than many thought – Combing a bunch of CDOs composed of subprime securities into a new security didn’t make the underlying risk go away. Plus these instruments were illiquid and thus hard to sell.

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Inequality in America

by Brad Setser Sunday, April 20, 2008

Unions in the American manufacturing sector used to have the bargaining power to secure a middle class wage for their members. Not any more. And no one else – apart from corporate CEOs, hedge fund managers and star athletes – seems to have all that much bargaining power either.

The chart that accompanies Justin Lahart and Kelly Evan’s report on voter angst in Pennsylvania is worth the price of the Saturday Wall Street Journal. It isn’t (yet?) available online; for some reason it isn’t part of the graphics package that accompanies the online story. It shows the enormous gulf between the income of the top 0.1% of the income distribution and the rest of the population. It also shows that family income, adjusted for inflation, has fallen by 4% for the bottom 90% of the population while rising 22.2% among the top .01% (all parts of the top one percent saw income gains greater than 5%, but the gains were biggest at the top. The graphic I liked is based on the Piketty/ Saez data, and the income calculations exclude capital gains.

UPDATE: the key graph can be found here; hat tip to an anonymous contributor.

I am not sure than Makiw’s explanation – a fall-off in educational achievement and slower growth in the supply of highly-skilled workers – is a sufficient. The top 5% of the American families are all reasonably well-educated. But even among the 5%, almost all the income gains have been concentrated at the top. A fall-off in educational achievement can perhaps explain why the real income of the top 10% of American families is rising (a bit) while the income of the bottom 90% isn’t. But it cannot explain increasingly inequality among those at the top.

It isn’t that hard to see why so many Americans think the US is on the wrong track. Most Americans didn’t benefit from the expansion of the past few years. And now the economy isn’t expanding.

It also isn’t hard to see why public support for “trade” has eroded dramatically, despite the Bush Administration’s ongoing rhetorical critique of “economic isolationism.”

The Doha round has stalled. Trade hasn’t. China’s exports increased from under $250 billion in 2000 to $1220 billion in 2008. It isn’t clear that increased trade with low-wage countries has contributed to lower wages for less-skilled workers in the US. Krugman didn’t find a strong link. But increased access to cheap goods clearly didn’t keep family income – adjusted for inflation and excluding capital gains — from falling for 90% of American families. The impact of globalization on prices isn’t all that clear: competition for oil has pushed its price up. Cheap oil was a big part of the post-war American lifestyle. Cheap financing from the rest of the world did make it easier for Americans to make up for falling wages by borrowing against their homes. That strategy was never sustainable, and it has clearly run its course.

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Surplus countries depreciating when they should be appreciating

by Brad Setser Thursday, April 17, 2008

Most Asian currencies have depreciated significantly against Europe since 2003.

And don’t get me started about the Gulf. It remains wed to the depreciating dollar even as oil soars. Following the dollar as it fell from 0.85 or 0.9 to close to 1.60 against the euro as oil went from 20 to 115 doesn’t make economic sense. The Gulf’s currencies should be appreciating along with the price of their main export.

As a result, exchange rate moves, broadly speaking, haven’t helped to facilitate global adjustment. Don’t take my word. The IMF, in the WEO, comes to much the same conclusion:

“Bilateral and multilateral exchange rate movements since 2006 have born little semblance to the distribution of current account surpluses, in contrast to past episodes of dollar depreciation in the 1980s when the currencies of the major surplus countries all went through larger appreciations than other currencies. In the current episode, a number of countries with large current account surpluses have linked their currencies tightly to the dollar, thereby hindering adjustment. A continued mismatch in this regard could result in a reallocation of – rather than a reduction of – global imbalances.

The dollar has moved v Europe, but Europe isn’t the world’s big surplus region. Indeed, so long as the surplus countries link their currencies to the dollar, dollar weakness against the euro only pushes the currencies of big surplus countries down more. Visual evidence that surplus countries have tended to depreciate can be found here.

The IMF deserves a round of applause for its direct language — and, for that matter, also having the courage to forecast a more prolonged US slump than the Fed formally expects.

My read of the WEO’s long-term balance of payments forecast is that the IMF is expecting more of a reallocation of the world’s imbalance than a reduction. To be sure, the IMF expects that a sustained US slump will help bring down the US deficit. Over time, however, the IMF expects the European Union’s deficit to rise. And once the oil shock wears off and the oil exporters surplus starts to fall, the IMF also expects a further rise in Chinas surplus, at least in dollar terms.

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Blog envy: on Europe, the G-7 and the Fed

by Brad Setser Wednesday, April 16, 2008

Paul Krugman (who hardly needs a plug from me), Macro Man and Steve Waldman (of interfluidity) have all written posts that I wish I had written.

Krugman elegantly shows that a lot of American stereotypes about Europe are based on data from the 1990s. By some measures, Europe’s labor markets no longer look more sclerotic than America’s labor markets. The percentage of French men between 25 and 54 without jobs is now pretty much the same as the percentage of American men between 25 and 54 without jobs.

The similarities don’t end there. The European Union as a whole also now runs a current account deficit financed in no small part by the world’s emerging economies.

Macroman had the brilliant idea to compare the most recent G-7 Communique to the G-7 (and G-5) communiqués that marked big changes in the foreign exchange market. The most recent communiqué clearly contained new exchange rate language – language no doubt intended to give a boost to the sagging dollar. But the G-7’s new language lacked the vigor of the key communiques of the past. Back in 85 and 95, the G-7 didn’t just complain about disruptive moves. It indicated the direction it wanted the market to move.

Moreover, as Macroman notes, the G-7 countries themselves aren’t necessarily the key countries setting G-7 exchange rates. The amount of dollars that China, Russia and the Gulf want to sell for euros, pounds and other currencies also matters:

“it’s far from clear that the G7 are the relevant authorities; after all, it’s not Japan or Germany or the UK that is buying billions of EUR/USD every month; it’s China and Russia and the Middle Eastern Countries. And Macro Man didn’t see their names attached to any document expressing concern.”

I also recommend Dr. Chinn’s analysis and — if you have an RGE subscription/ receive BNP research – Lee and Speranza’s post G-7 rant (link is through the RGE subscription service). They argue that the G-7 spent its time focusing on currencies when currency markets aren’t the problem — as dollar weakness basically reflects weak US fundamentals — and didn’t do anything to address distress in the credit markets. Lee and Speranza, speaking to the G-7:

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