Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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

by Brad Setser
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.


There are two big reasons for the rise in the state in cross border capital flows.

The first is that the state in most oil exporting economies controls the revenue from the commodity windfall. In aggregate, the oil exporters are sending more of the revenue globally from $120 a barrel oil back into global financial markets than they are spending or investing at home. Most oil exporters could cover their import bill with $50 or $60 a barrel oil. Some of this surplus goes into sovereign funds – but a lot is going into the hands of central banks. Think of the Bank of Russia, which manages Russia’s sovereign fund, or the Saudi Monetary Agency.

The second is that many states are resisting market pressure for their exchange rates to adjust. China is the obvious example. That requires intervening in the market. Jim Fallows put it well.

But saying that China has a high savings rate describes the situation without explaining it. Why should the Communist Party of China countenance a policy that takes so much wealth from the world’s poor, in their own country, and gives it to the United States? To add to the mystery, why should China be content to put so many of its holdings into dollars, knowing that the dollar is virtually guaranteed to keep losing value against the RMB? And how long can its people tolerate being denied so much of their earnings, when they and their country need so much? The Chinese government did not explicitly set out to tighten the belt on its population while offering cheap money to American homeowners. But the fact that it does results directly from explicit choices it has made—two in particular. Both arise from crucial controls the government maintains over an economy that in many other ways has become wide open. The situation may be easiest to explain by following a U.S. dollar on its journey from a customer’s hand in America to a factory in China and back again to the T-note auction in the United States.

Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China.

When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB.

This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange.

With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too.

The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes.


At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government.

One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. …This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. … Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could).

These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. ….

The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth.

The controls on Chinese capital outflows – including the surrender requirement Fallows describes – have been liberalized. China’s banks are now being encouraged to hold dollar these days. But no one in China wants to hold depreciating dollars rather than appreciating RMB, so folks with dollars are still selling their dollars to the government if they can. Conversely, China is continuously tightening its controls on capital inflows. It is also tightening its controls on the banking sector – by raising reserve requirements and forcing the banks to lend funds to the state.

Holding its exchange rate down has a host of subsidiary effects. It creates pressures for price controls (see the Gulf) to limit inflation. And in China, it means that the government has a de facto monopoly on outward capital flows.

China now has the world’s largest current account surplus. That makes it – -and specifically its government – the world’s largest external investor. Ongoing inflows (despite the controls) only add to the funds that China’s government has to invest abroad.

And the process for deciding what to buy remains driven by the state. Consider Richard McGregor’s description of the Chinalco investment in Rio Tinto.

The Aluminum Corporation of China, or Chinalco, spent $14.1bn in conjunction with Canada’s Alcoa, a junior partner in the transaction, to buy into Rio’s UK-listed arm. Executed in a lightning share raid, Chinalco’s purchase is the largest ever single Chinese investment offshore.


As a huge and growing consumer of commodities, China’s concern about the BHP takeover is unsurprising. Nor is Chinalco’s denial that the Rio raid had anything to do with the BHP bid. Such po-faced obfuscation is standard in corporate jousting around the world.

Disentangling Chinalco from China, and China Inc, however, is a much harder proposition. BHP and Rio are dealing with a huge number of demanding shareholders. Chinalco’s investor relations are a lot more straightforward. Its overseas listed subsidiary aside, Xiao Yaqing, Chinalco’s chairman, answers to a single shareholder – the Chinese state. Mr Xiao himself serves at the pleasure of the ruling Communist party’s human resources arm, known as the “Organisation Department”, which oversees all top executive appointments in state enterprises. …

Chinalco’s purchase was funded by the China Development Bank, a state policy bank, a shareholder of which is the country’s sovereign wealth fund, the China Investment Corporation. The sovereign fund, further, owns the largest Chinese investment bank, which is advising Chinalco.

The ambitious CDB itself is no stranger to doing the state’s business offshore. It has been given crucial government mandates, most importantly to fund the expansion of local companies in Africa, primarily for resource projects.

In short, you do not have to be a rabid conspiracy theorist to conclude that Chinalco is a front for China Inc. “Why does BHP really want to tempt the dragon? Chinalco has already made the message clear: they really do not want to see a merger,” Geoffrey Cheng, of Daiwa Institute of Research in Hong Kong, told Reuters. “You’re not going against a corporation. You’re going against a nation.”


The second point is the more salient one – the perception that Chinalco represents “the nation” in this transaction. A world waking up to a new fact of life in the global economy, the phenomenon of Chinese offshore investment, is naturally going to see a tangled monolith.

McGregor notes that different state bodies often have diverging interests — so the assumption that China, inc functions as a monolith is wrong (see his article with Geoff Dyer) But his description of the various ways China’s state was involved in the Chinalco bid underscores is hard to reconcile with a world where the state has retreated from the market …


  • Posted by Guest

    "…In today’s China, government is decentralized, and people can freely start businesses, find new jobs, move to new homes. After a century of powerful leaders and political turmoil, Chinese history has become the story of average citizens.

    But there are risks when a nation depends on the individual dreams of 1.3 billion people rather than a coherent political system with clear rule of law. China faces an environmental crisis… The gap between rich and poor has become dangerously wide… Each of these problems is far too broad to be solved, or even grasped, by the average citizen. And because the government continues to severely restrict political freedom, people are accustomed to avoiding such issues. My students taught me that everything was personal—history, politics, foreign relations—but this approach creates boundaries as well as connections. For many Chinese, if a problem doesn’t affect them personally, it might as well not exist…"

    "…45 percent of Chinese urban residents are at health risk due to stress, with the highest rates among high school students… In China, there is no concept of the rebellious teenager. Across Chinese society, parents appear completely at sea when it comes to raising their children… She intends to marry a foreigner because they are richer and more reliable… Some observers of Chinese society look at children like Bella and see political change: Her generation of individualists, they predict, will one day demand a say in how they are governed. But the reality is complicated. Raised and educated within the system, they are just as likely to find ways to accommodate themselves to it, as they have done all along…"

  • Posted by DC

    Oh please, CIA Director Michael Hayden still doesn’t get it. It really doesn’t matter what the Washington Consensus thinks anymore. The US can barely take care of its own domestic problems and issues. Bye-Bye US Global Hegemony. Hello, new multi-polar world order. – DC

    China Threat to be focus of U.S. attention in Asia: CIA Director Michael Hayden

    "China, a communist-led, nuclear state that aspires to — and will likely achieve — great power status during this century, will be the focus of U.S. attention (in Asia)," CIA Director Michael Hayden said. China is an economic and strategic competitor with the United States, Hayden said in a Kansas speech on 21st-century trends, adding the country was likely to continue a "troubling" military buildup.

  • Posted by DC

    US Central Intelligence Agency program to Balkanize China

    US CIA even financed a $245,000 investment to the University of Hawaii to research whether the tense situations in ethnic areas of China would lead to a split of the country. Actually, the research results disappointed their aim. America has been continuously backing the independent movement of Tibet all along. A movie "Seven Years in Tibet" produced by U.S. fooled the American with distorted historical facts. Funding was poured into foundations in U.S. to continue the anti-Chinese activities.

    “Humanitarian Interventionists and Benevolent Global Hegemonists, most of whom lack even a rudimentary understanding of China’s long and complex history, share a particularly nasty trait. Many of these Globocops imagine because they have downloaded a few pages of separatist propaganda from, and shed a tear or two while watching ‘Seven Years in Tibet,’ that qualifies them as China experts. They believe this qualifies them to pass judgment about whether China ‘deserves’ to remain intact or be forcibly Balkanized by the World’s Only Remaining Superpower. Their attitude rivals that of the most contemptible 19th century imperialists.”

    The CIA-attempted Balkanization of China has already come with its own blowback of anger at the US from China. And, whatever you think of China, remember we owe them nearly $300 billion in loans. They lent us the money for Bush’s recent rebate. Bottom line, it’s pointless that the US and other Western nations keeps creating impressions that the Chinese are hitting on Tibetans, when in fact recent the recent video from China showed just the opposite, Tibetans in their region attacking Han Chinese who live there.

  • Posted by DC

    Chinese GDP to overtake US Economy by 2015 – Economist Angus Maddison

    A recent study by the economist Angus Maddison projects that China will become the world’s dominant economic superpower much sooner than expected – not in 2050, but in 2015. Angus Maddison’s forecast (which uses purchasing power parity) isn’t built on outlandish assumptions. He assumes China’s growth will slow way down year by year, and America’s will average about 2.6% annually, which seems reasonable. But because China has grown so stupendously during the past decade, it should still be able to take the crown in just seven more years. The world’s largest economy until 1890 was China’s. That’s why Maddison says he expects China to "resume its natural role as the world’s largest economy by 2015." That scenario makes sense. Then the Industrial Revolution sent the West on a more prosperous path. Now the world is returning to a common economy, this time technology- and information-based, so once again population triumphs.

  • Posted by Twofish

    don: Those are neat points. But I wonder. Would China have the same trade surplus without official exchange intervention? I can’t help but believe that they would have a smaller surplus and lower income growth, perhaps more in line with spending growth. Which would mean lower saving.

    Most of Chinese income and growth comes from domestic sources. The trade surplus is a politically hot topic in the United Staes, but it’s not the main source of Chinese economic growth. The roots of Chinese saving started during the central planning era when money wasn’t useful so people saved lots of it.

  • Posted by Twofish

    HZ: First let’s be clear that domestic pension investing (assuming total savings/investing is unaffected) merely changes how the gdp pie is/will be sliced. The same thing could be done through fiscal policies.

    If you do it view fiscal policies then you get into the very messy world of public finance. One is also constrained by the fact that the pension liabilities have already been promised, and you really can’t change the benefit structure without having riots. Also, one problem with aggregate numbers is that it misses the question of "who gets what?" Brad’s point that the policies of the Chinese government might reduce total return for the Chinese economy is valid, but it misses the "who gets what?" question.

    This is an important blind spot since a lot of economic theory is based on the premise that organizing an economy in a certain way will boost efficiency and increase total output and that is a good thing. It is, but if you boost efficiency and people don’t get that extra output, you might find yourself in trouble.

    HZ: CIC is certainly acting as a strategic investor not a financial investor. Why should it be the one to re-capitalize the agriculture bank? Since it is funded with debt, it should mostly invest in debt as well.

    CIC shouldn’t re-capitalize ABC. Also CIC is funded with debt, but those debts are now on the balance sheet of the Chinese government and not on CIC’s balance sheet.

    HZ: Suppose it provides companies like BHP with low cost project funding, then hurdle rate of RoA could go down and still give BHP a decent RoE. This will then create more supply at lower cost.

    Which is useless to CIC, if it can’t get any of that extra funds, and it’s useless to the Chinese government if it can’t access any of the productivity boost via taxation. Also decreasing the cost of raw materials might be a bad thing. The problem from a public administration point of view, is that what *will* happen is that BHP will collude with CIC to provide low cost loans which will boost BHP’s profits. This may not be a good thing. Also "transparency" isn’t going to solve the problem. I know that California farmers are given access to water at below market rates, and I know that Chinese SOE’s are also given preferential treatment by banks. Now what?

    The way CIC does it is that if CIC gives away loans at low interest, then there is less money to pay bonuses at the end of the year. The investor wants to maximize returns on loans. The borrower wants to minimize it. You get a balance. If the lender has incentives to reduce the interest rate, then the lender and borrower will collude to give away free money. This is generally a bad thing.

    People have these strange ideas about "transparency" missing that large parts of the financial system are intentionally opaque. Would you do business with a bank that made your checking account transactions public?

  • Posted by Twofish

    I don’t think that it is a good thing that Chinese banks are the world’s largest by market capitalization. Most of the banks that were the world’s largest by market capitalization in 1990 were Japanese. High market capitalizations usually means that the market is overvalued.

    Also, I don’t think that the dangerous people are in the CIA now. The CIA fought hard against the Iraq war, and the Bush administration had to bypass and vilify the CIA to get the Iraq war started. The danger in focusing on the CIA is that you miss where the danger comes from. The CIA stopped being used for most covert operations in the 1970’s with the Church Commission, and then it moved to the NSA. Once people started looking at the NSA, it moved elsewhere.

    Finally, I don’t think very highly of Yasheng Huang’s ideas. He sees everything in terms of a "transitional economy" which I think is bad framework. Also he talks about the golden age of the 1980’s when rural industries had access to large amounts of capital and neglects to mention that this age ended in the early-1990’s when the rural financial institutions went broke.

  • Posted by HZ


    While your criticisms are valid, what I suggested may still be the least bad alternative. Alternatives are limited in the first place:

    1) If they want to be an active financial investor in the public market, well the game is zero sum. For some to make above market returns others must make below market returns. Taking into account of the size of investment pool, high cost structure of active management and the risk their managers might expose them to, I don’t see this as attractive. Pension funds could do passive investing and count on returns in decades, not years.

    2) If they want to PE or strategic acquisition they will run into a lot of resistance in the West.

    3) If they want to do greenfield — well, CIC doesn’t have the expertise.

    So they might as well set a moderate goal. They did say that they will be doing mostly corporate debts, didn’t they? Tilting it towards increasing supply of commodities that China will surely need doesn’t sound too bad a policy either. If BHP makes more profit, so be it. If they set a moderate goal, they could still set up the incentive structure so that good performance is rewarded and bad performance penalized on the managers’ part.

  • Posted by Twofish

    HZ: If they want to be an active financial investor in the public market, well the game is zero sum. For some to make above market returns others must make below market returns.

    The efficient market theory argues that for any given risk level there is given rate of return and you can’t boost return without boost return, Making the expected return for a given level of risk is a hard thing to do. My point is that above $50 billion, passive investing is impossible.

    HZ: If BHP makes more profit, so be it. If they set a moderate goal, they could still set up the incentive structure so that good performance is rewarded and bad performance penalized on the managers’ part.

    The trouble with that structure is that CIC managers have no control over decisions that BHP makes. If CIC loans money or is a supplier for BHP then what is good for BHP is bad for CIC, and vice versa, and so rewarding CIC mangers for BHP performance will cause problems.