Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

The mystery deepens. China’s June reserve growth is surprisingly low.

by Brad Setser Monday, July 14, 2008

China just indicated that its reserves reached $1808.8 billion at the end of June. That is obviously a huge sum — it is $126.6b more than China reported at the end of March. But the increase in June was surprisingly small — only $11.9 billion.

Moreover, the euro rose in June. After adjusting for valuation gains, China’s June reserve growth works out to something like $3 billion. That assumes that about 25% of China’s reserves are in euros — which may be too high. Still, the increase in China’s reported reserves in June is very low, both relative to the increase in past months and relative to China’s still-large trade and current account surplus.

The volatility in China’s reserve growth this year has been extraordinary. Reserve growth — without considering valuation gains – has gone from a high of $75 billion in April to a low of $12 billion in June. That is a bigger swing than the dip from close to $60 billion in January and February to $35 billion in March.

Adjusting for valuation effects (the dollar value of China’s euro reserves rises when the euro rises, and vice-versa) actually makes the swings bigger. After adjusting for valuation gains and losses, April’s reserve growth is close to $80 billion and June’s reserve growth is less than $5 billion.

Clearly the 100 bp rise in the bank reserve requirement – which may have subtracted $36 billion from June’s reserve growth — has something to do with the low total in June. But the reserve requirement also was hiked by 50 bp in April, so the bigger-than-usual increase in the bank reserve requirement in June is not the full explanation. Either hot money flows fell, or China has found a new way of keeping reserves from appearing on the central banks books.

Adding in the $36 billion in foreign exchange that China’s regulators likely pushed onto the banks in June brings the monthly total up to around $40 billion. The June trade surplus was about $20 billion, FDI inflows were a bit below $10 billion and interest income on China’s existing foreign assets were maybe $6 billion.

Sum it all up and everything roughly balances, implying modest hot money inflows. At least if the data that was reported captures the full picture. It is hard to know. China has cracked down on hot money inflows. At the same time, the huge swing in the very rough measure of hot money flows most analysts uses from April to June is a bit suspicious.

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Too Chinese (and Russian) to fail?

by Brad Setser Saturday, July 12, 2008

The epicenter of the US financial crisis now seems to have shifted to Fannie Mae and Freddie Mac — the government sponsored enterprises that dominate the market for US housing finance. Few institutions matter more for the US economy. They currently buy or guarantee an astonishingly high fraction of all new mortgages in the US. Absent that financing, home prices would fall further — dragging down the value of a lot of the “private” mortgage-backed securities issued at the height of the crisis, and health of a lot of (troubled) private financial institutions.

But Fannie and Freddie aren’t just “too-big-to-fail” US financial institutions. Not anymore. They are now global financial institutions. They have been central to the process that has turned US mortgages into securities held by the world’s central banks. Official — meaning central bank — holdings of Agencies have soared over the past two years. The US “TIC” and survey data suggests that central banks now have at least $925 billion in “Agency debt.” That is almost certainly an understatement: the monthly TIC data tends to understate official purchases, leading to large revisions when the more accurate survey data is released in June. Total official holdings are likely above a trillion — or about 20% of the $5 trillion or so in Agency debt outstanding.


As a result, the governments of China and Russia are now almost as exposed to the “Agencies” as the US government.


* This graph makes use of data collected by the CFR’s Arpana Pandey.

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Four points on the US May trade data

by Brad Setser Friday, July 11, 2008

1. Net petroleum imports fell by $1.6b. Petroluem exports rose by 0.96b while imports FELL by $0.66b in dollar terms. The fall in imports was a surprise. Oil prices rose by 9.7% or so. But import volumes were down by over 10% from April (and 14% lower than their 2007 average). The good news is that the US is importing significantly less petrol than in the past. The bad news is that the price of imported petrol isn’t going to stay at $106 a barrel.

2. The non-petroleum goods balance actually deteriorated slightly. Relative to exports, non-petroleum goods imports were up $1.8b, and non-petroleum goods exports were down $0.4b. The y/y rise in non-oil imports in May (6.9%) is higher than the y/y rise in the January through May data (4.5%), which likely reflects higher non-oil import prices more than anything else.

3. Y/y real goods exports were up close to 10% (9.4%) in May. Real imports were up less than 1% (0.8%). The slowdown in real export growth a few months back hasn’t been confirmed in the recent data. Real exports continue to do well.


4. The US trade deficit with China is flat so far this yea: $96.0b v $96.3b. Imports from China are only up 4.4% so far this year — a pace consistent with the overall increase in non-oil imports. The combination of RMB appreciation v the dollar, rising inflation in China, rising transportation costs and a slowing US economy is having an impact. US exports to China are up $5b (comparing the first five months of 2008 to the first five months of 2007); US imports from China are only up $5.4b. The slowdown in the pace of import growth has contributed far more to the stabilization of the trade deficit than the (strong 19.7%) percentage increase in exports. That US still imports about four times as much from China as it exports.

UPDATE: Spencer provides a nice summary of real export and import trends over at Angry Bear.

China’s June exports: still chugging along, despite all the talk to the contrary

by Brad Setser Friday, July 11, 2008

Chinese policy makers are worried by the slowdown in y/y export growth. Never mind that 18% y/y growth during a US slowdown isn’t bad — or that China’s monthly trade surplus topped $20 billion in June despite very high oil prices. Policy makers are more focused on the difficulties facing some of China’s textile firms than still high inflation. The result: a growing sense that China plans to slow the pace of RMB appreciation and relax various lending curbs.

I though don’t see much evidence that China’s export machine has slowed by much. At least not yet. Some forward looking indicators suggest a slowdown. And rising transportation costs could potentially cut into China’s exports too. Reducing the “miles” a product travels is one way of reducing the world’s oil consumption. But there isn’t yet much sign of a real slowdown in the data.


Remember, in real terms, net exports contributed more to China’s q1 growth than to the United States’ q1 growth.

Sure, year over year export growth was down a bit in June, at least in percentage terms. But May was unusually strong. That likely reflects an increase in working days this May relative to last May. And more exports this May meant a bit fewer in June. Goldman (Hong Liang, I would assume) is right on this (in the FT):

However, several economists cautioned against reading too much into trade figures for one month, as they can be volatile. Goldman Sachs, the investment bank, said it made more sense to combine May and June figures, which together showed a strong growth rate for exports of 22.6 per cent, in line with last year’s trend.

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Maybe China is a typical creditor after all

by Brad Setser Wednesday, July 9, 2008

Creditors through the ages haven’t liked to take policy advice from debtors. They generally tend to think that borrowers should listen to the advice offered by those lending them money. And they often think debtors fail to pay sufficient attention to the concerns of their creditors when formulating economic policies.

Sound familiar?

China believes that the US hasn’t paid enough attention to the dollar’s value. That isn’t exactly news. Wen more or less said as much in November. Nor should any American be surprised that China no longer the US financial sector offers the best model for the future development of China’s own financial sector. Securitizing risky mortgages loans into complicated financial structures no longer looks like the highest stage of financial evolution.

But I was still struck by Edward Wong’s front page New York Times article several weeks ago. It highlighted China’s new assertiveness — and China’s increased willingness to criticize US economic policies.

Steven Weisman’s C section article that followed the completion of the Strategic Economic Dialogue wasn’t that different than Edward Wong’s big front page story. The governor of China’s central bank now argues that China needs to learn from the United States’ mistakes as well as its successes. Clever rhetoric. Those who think that the United States needs to learn from its own recent mistakes would have trouble disagreeing with Mr. Zhou.

These articles raise some fundamental issues about how China’s economic and financial relationship with the US will evolve. Right now China has lent — according to the US data — about $1.1 trillion of its savings to the US. Realistically, it has lent a bit more — let’s say $1.3 trillion. The US data tends to undercount Chinese holdings of US assets.

That is a large sum by any measure — it is roughly 10% of US GDP, and it is more like 30% of China’s GDP. given the extraordinary pace of growth in China’s foreign assets — and its large current account surplus — China’s financial exposure to the US is set to increase rapidly.

Many — see Gideon Rachman as well as the FT’s Alphaville — have argued that the growth in financial interdependence between the US and China will reduce political tension between the two. China has a large and growing financial stake in the US economy; the US relies on Chinese financing. Their economic interests consequently largely converge.

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The FT joins the chorus arguing against the Gulf’s dollar peg

by Brad Setser Tuesday, July 8, 2008

The FT’s leader concisely summarizes the arguments against the Gulf’s peg to the dollar.

“The UAE either keeps its currency pegged to the dollar, in which case too many dirhams will chase too few goods, and prices will inevitably rise; or else revalue the dirham so each one is worth more dollars.

Both options achieve the same end result but inflation has greater drawbacks. First, it is slow, whereas revaluation is instant. Second, once started, inflation is hard to stop because workers demand higher wages to compensate. Third, there is a risk of asset price bubbles in the Gulf nations because high inflation means that real interest rates are too low. Fourth, inflation hurts the poor (who do not have direct access to oil revenues), and so harms political stability.

There is also a specific problem with pegging to the dollar. Gulf currencies have actually had to depreciate against the euro in order to follow the dollar, the exact opposite of what they need, and a shift that will cause even more inflation.”

Alan Greenspan has suggested that the Gulf should allow their currencies to float. It would be hard, though, for the UAE and Qatar and Kuwait to float if Saudi Arabia remains pegged — especially if they aspire to form a monetary union. If the Saudis floated, the rest of the Gulf could peg to the riyal, but that also seems like a remote possibility.

The FT suggests that the GCC shift to a basket peg. The risk of shifting to a basket peg now though is that it locks in the Gulf’s depreciation against the euro. If the dollar were to rebound against the euro, a basket peg would imply that the Gulf’s currency would need to depreciate against the dollar to avoid appreciating against the euro by too much — no matter what happens to the price of oil. That doesn’t make much sense. A basket peg protects against further dollar depreciation, but it doesn’t address the core problem: the Gulf, like China, needs to appreciate against the ensemble of its trading partners.

The FT suggests addressing this by combining a revaluation with a basket peg. It then goes one step further and suggests that the Gulf should consider including oil in their basket.

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak. That would make for smoother adjustments than double-digit inflation.”

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The quiet bailout continues …

by Brad Setser Monday, July 7, 2008

The roughly $30 billion sovereign wealth funds provided to troubled US financial institutions (Citi, Merrill, Morgan Stanley) attracted a lot of attention.*

The (almost) $30 billion of Bear Stearns’ assets that the Fed took onto its balance sheet (as explained here) to facilitate JP Morgan’s takeover also has attracted a great deal of attention. Understandably so. The Fed’s decision to orchestrate JP Morgan’s takeover of Bear and its subsequent decision to make liquidity available to the broker-dealers are, as of now, the defining moments of the crisis.

The $283.5 billion increase in central banks’ holdings of Treasuries and Agencies in the custodial accounts of the New York Fed during the first half of 2008 hasn’t attracted nearly as much attention.

But $283.5b — $567b annualized — is a big number. A 10% fall in the dollar against the currencies of those countries adding to their accounts at the New York Fed would generate paper losses equal to the total (known) exposure of the world’s sovereign funds to US financial institutions, or the Fed’s total exposure to Bear’s own debt portfolio. A bigger fall in the dollar would produce bigger paper losses. And given that many of the countries adding to their reserves most rapidly are doing so precisely because their currencies are facing strong pressure to appreciate, such a slide in the dollar isn’t hard to envision. It might even be probable …

Between June 4 and July 2, central banks added $45.2b to the custodial accounts at the New York Fed; between May 28 and July 2 (a five week period) central banks added $54.6b to their accounts. That wasn’t as much as April — but it was a lot more than May. It brought the total for Q2 up to $132.7 billion (nearly equally split between Treasuries and Agencies) — only a bit below the $150.8b increase in q1.

Not all central banks make use of the New York Fed, though someone big clearly is. The growth in the the Fed’s custodial holdings consequently is a minimum, not a maximum. Total official purchases of US debt are far higher than the increase in the custodial accounts at the Fed. Nonetheless, it is worth noting that the increase in the Fed’s custodial accounts so far this year, annualized, is well in excess of total recorded official purchases in 2007.

This matters. The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies — a fiscal stimulus, monetary easing — designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons – ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US — the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up — not down – at least in nominal terms.

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Good news for the fourth of July

by Brad Setser Friday, July 4, 2008

The US economy has absorbed its share of blows over the last year:

Jobs have disappeared;
Oil prices have soared;
Consumer confidence is way down;
An important broker-dealer collapsed, prompting the Fed to facilitate the take-over of a very-troubled financial institution by a less-troubled financial institution;
And more financial institutions could have faced trouble absent access to Fed liquidity support.

There isn’t a lot for the US economy to celebrate this fourth of July.

But one thing hasn’t gone wrong.

The US net international investment position — if US direct investment abroad is valued at its market value — actually improved, absolutely and relative to US GDP.


Source data for the graph

The red and green bars reflect the improvement in the US international investment position from exchange rate moves (the dollar’s fall increases the dollar value of US investment abroad) and market moves (if foreign equity markets rise by more than the US equity market, the value of US investment abroad rises more rapidly than the value of foreign investment in the US) relative to what would be expected from simply summing up financial flows.

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Read the annual report of the Bank of International Settlements

by Brad Setser Wednesday, July 2, 2008

International institutions usually put out reports filled with turgid and overly-qualified prose.

But not the BIS. At least not this year. The introduction and conclusion of its 78th annual report are a pleasure to read. The prose is clear and direct. An example:

“If asset prices are unrealistically high, the must eventually fall. If savings rates are unrealistically low, they must rise. If debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks or palliatives will only make things worse in the end.” (p. 145)

Outgoing Chief Economist William White’s is unsparing in his criticism of both the big private banks and the major central banks. Central banks, in White’s view, held rates too low for too long after the equity bubble burst – creating asset bubbles that fueled excessive demand growth to offset what he views as the natural fall in prices associated with the integration of large new pools of labor into the world economy. Private banks ignored the risks building on their balance sheets

And central banks and private bankers alike failed to appreciate the risks created by the new world of securitized mortgage finance – particularly a world where a lot of exposure was held off-balance sheet in “vehicles” of various kinds.

“Recent innovations such as structured finance products were originally thought likely to produce a welcome spreading of risk-bearing. Instead the way in which they were introduced materially reduced the quality of credit assessments in many markets and also led to a marked increase in opacity. The result was the eventual generation of enormous uncertainty about the size of losses and their distribution. In effect, through innovative repackaging and redistribution, risks were transformed into higher-cost and, for a while at least, lower-probability events.”

It isn’t hard to get the impression that White thinks innovation increased the both the cost and probability of a crisis by contributing – along with low policy rates – to reduced credit standards and asset bubbles. He clearly thinks that the credit losses that followed the bursting of the bubble cannot be “cleaned up” easily.

“It is not clear where the losses [on “new financial instruments”] are, how they should currently be valued or how large they might grow given ongoing declines in the prices of underlying assets.”

The solution? In the first instances, the banks who originated and distributed (sometimes to their own treasury or internal hedge) the bad loans should take their losses.

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Central banks still buy dollars when no one else wants to …

by Brad Setser Tuesday, July 1, 2008

I tell pretty much anyone who cares to listen (and some who don’t) three things:

1) Central banks are providing the US with far more financing than sovereign wealth funds, and still have a much bigger impact (for better or worse) on US markets than sovereign funds. The high profile capital injections from sovereign funds into US banks are not representative to the bulk of official capital flows; boring old purchases of Treasuries and Agencies are.

2) The scale of growth in central bank foreign assets is hard to overstate, as is the extent to which central banks are now central to the financing of the US deficit. The US capital flows data significantly understate official purchases of US assets.

3) More and more of the increase in official assets is coming from places that either don’t transparently disclose the increase in the foreign assets of their governments (the Gulf doesn’t disclose inflows into its sovereign funds, China doesn’t disclose the pace at which it is transferring funds to the CIC or the extent to which the state banks have been forced to hold dollars) or that don’t disclose — even to the IMF — the currency composition of their reported reserves. As a result, the quality of the available data on how official actions are impacting and influencing markets is going down quite rapidly. (Graphs supporting all three points can be found at the end of this article)

The rising share of flows coming from countries that don’t report much is one reason why efforts to increase sovereign wealth fund — and central bank — transparency matter. In q1, “dark” official flows, flows from countries that don’t report detailed reserves data to the IMF or countries that channel their foreign asset growth through sovereign funds that don’t disclose much, were larger the US current account deficit. Countries that don’t report detailed data to the IMF accounted for $227 billion of the overall headline increase in global reserves in q1. And that doesn’t include the $45 billion the Saudis added to SAMA’s non-reserve foreign assets or the funds China shifted to the CIC and state banks in q1. The overall increase, absent valuation adjustments, easily topped $300 billion.

The extent of these dark flows means that we really don’t know how central banks and sovereign funds are influencing the market. The actions of funds that do report data to the IMF may not be representative. Their activities could be overwhelmed by the actions of countries that do not report data.

But it is fairly clear that the countries that do report data weren’t responsible for the euro’s rise in the first quarter. Central banks that report data actually sold euros in q1 (the rise in the dollar value of their euro holdings is entirely due to the euro’s rise v the dollar). That means that they were classic “stabilizing” speculators, taking the opposite side of private market players. Or perhaps the opposite side of sovereign funds, the PBoC or another central bank that doesn’t report data to the IMF — we don’t really know. If valuation gains are stripped out, about 80% of the “flow” from emerging economies that report data to the IMF went toward the dollar — and between 85% and 90% of the (smaller) flow from industrial economies that report data went toward the dollar.

These euro sales were not quite enough to keep the dollar’s share of total reserves from slipping. Reporting emerging economies — which have an average dollar share of around 60% — are adding to their reserves at a faster pace than the industrial economies, pulling the global total down. And if the industrial economies would have needed to sell more euros than they did to keep the dollar share of their reserves from trending down.

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