To state the obvious, this blog looks a bit different today than it did last week. It was redesigned as part of a broader redesign of the Council’s web page — and the webpage of the Center for Geoeconomic Studies. Most of the early kinks have been ironed out I hope — but if anything seems off, let me know.

A well-deserved one too. Nouriel stuck to his core views — housing was massively over-valued, the financial system was heavily exposed to a fall in home prices and the fall out from a fall in US home prices wouldn’t be contained either nationally or globally – when those views were decidedly unpopular.

Back in early 2007, there was a great deal of complacency among America’s financial leadership. Many thought macroeconomic volatility had been vanquished, and as a result financial volatility was justly low. High levels of leverage consequently made sense — and a range of asset market prices reflected this. In the language of the time: credit markets weren’t over-valued, equity markets were under-valued. Recessions – or at least severe recessions and financial crises – were things that happened to other countries, not the US. The US had survived the .com bubble with only a shallow downturn. The 2003-2006 rise oil prices hadn’t put a big dent in the US economy. The large US current account deficit reflected high savings abroad and the attractiveness of the US financial assets; the US, after all, had a comparative advantage in financial-engineering. The IMF wrote that “innovative US fixed income markets [provided] many assets which simply aren’t available elsewhere” (see p. 12). There wasn’t much too worry about.

Read Michael Lewis’ argument that Davos man spent too much time worrying. He wrote in 2007:

Oil prices double, the U.S. housing market tanks — no matter what happens, financial markets adjust quickly and without hysteria. There are obviously a few things to worry about just now in the world, but the inability of traders to find a sensible price for the spread between European junk and European Treasuries isn’t one of them. So why do these people waste so much of their breath and, presumably, thought, with their elaborate expressions of concern?

Even the IMF – which is paid to worry – was tired of worrying. In late January of 2007, Chris Giles of the FT ran an article, based on an interview with the IMF’s Deputy Managing Director, that was titled “Big risks to global economy receding.” I thought that captured the mood of those times well.

Nouriel didn’t waver then. Others (myself included) did. Standing apart from the herd can be hard.

Over time, the focus of Nouriel’s concerns has shifted over time from the United States’ external deficit to the housing market and the financial system. But there has been a core consistency to his views: he never thought that it was healthy for the US to borrow heavily from the rest of the world to finance large fiscal deficits, high levels of consumption and lots of investment in suburban housing. And he thought this borrowing binge would end badly. Very badly.

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Not only do we live in a new “age of authoritarianism,” but we live in a world where autocratic governments increasingly finance democratic governments.

Consider a chart that shows the increase in the foreign assets of the world’s more authoritarian governments v the increase in the foreign assets of the world’s democratic government.

Right now, autocratic governments generally don’t finance other autocracies. China’s capital account is closed to Gulf sovereign funds (nearly) as tightly as it is closed to private hedge funds. China’s government is no more able to buy a stake in the Gulf’s national oil companies than private investors. China, Russia and the Gulf are all building up large financial claims on the United States and Europe far faster than they are building up financial claims on each other.

In the first chart, I included Russia and Venezuela alongside the world’s authoritarian governments. That can be debated. Both Putin and Chavez have authoritarian sides, but both have also put their governments up for a vote. But separating Russia and Venezuela out doesn’t change the story much. The rise in the foreign assets of the world’s less-than-perfectly-democratic government is driven overwhelmingly by the rise in the foreign assets of the People’s Republic of China and the Gulf monarchies.

Both graphs, incidentally, are drawn from a paper that I have been working on over the summer, so stay tuned. The graphs include estimates for new inflows into sovereign funds (and the increase in the foreign assets of Chinese state banks) as well as the growth in central bank reserves. And yes, they indicate that the increase in the foreign assets of the world’s governments – particularly governments in the emerging world — over the last four quarters has been truly extraordinary.

Earlier this week Gerald Seib noted — quite correctly — that high oil prices have increased the financial power of the world’s less-than-democratic oil exporters. Throw in the fact that high oil prices have yet to put a dent in China’s current account surplus or the accumulation of China’s foreign assets, and the shift in financial power away from from democratic governments is even more pronounced.

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The Economist – in the course of its analysis of the Fed’s response to the credit crisis — noted that only a few years ago the Fed got rid of its Agency holdings because it didn’t want its asset purchases to distort the allocation of credit in the US economy.

“Politicians have asked the Fed to favour certain industries or keep interest rates low almost from its birth. In 1921 the Fed rejected requests from Congress to buy long-term agricultural debt. In the 1940s and again in the 1960s, under pressure from the Treasury, it bought bonds to hold down long-term interest rates. In the 1970s, at the behest of Congress, it bought the debt of federal agencies such as Fannie Mae and Freddie Mac.

A 2002 staff study pointed out the risks of favouring particular assets or borrowers: it could result in too much investment in preferred sectors and too little in others, drag the Fed into arguments about fiscal policy and compromise its monetary policy. In recent decades the Fed largely extracted itself from anything resembling credit allocation. The last of its Fannie bonds matured in 2003.”

Obviously, the Fed has shed its inhibitions here over the past year — though helping the banks avoid forced sales of their existing assets into an illiquid market arguably has less impact on the allocation of future credit than buying securities other than Treasuries when times are good. still, there are concerns that the Fed is now shaping the allocation of credit in the US economy. The Economist writes:

“The central bank is lending to private companies on an unprecedented scale and is thus making decisions it long sought to avoid about the allocation of credit. It is also acquiring new powers of oversight. Politicians could chafe at the Fed’s power: why, they might ask, should unelected officials choose who benefits from taxpayers’ money? And they might press the central bank to pursue political ends—such as propping up favoured borrowers—that interfere with monetary policy ….

That brings up an interesting question: If Americans are uncomfortable having the Fed shape the allocation of credit in the US economy, shouldn’t they be equally uncomfortable when foreign central banks — notable China’s central bank — shape the allocation of credit in the US economy through their asset purchases?

The PBoC now has a larger dollar balance sheet (on the asset size) than the Fed. It holds around a trillion dollars of Treasuries and Agencies (over $950b can be identified using the TIC data, and the TIC data understates China’s holdings … ). The Fed has around $900 billion in assets — $940 billion, to be precise.

Moreover, the PBoC’s dollar balance sheet is growing far faster than the Fed’s dollar balance sheet. The Fed has responded to the credit crisis by changing the composition of the assets it holds, not by increasing its holdings. The PBoC by contrast is adding to its foreign assets at an extraordinary rate.

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Via SWF Radar comes news that two of the smaller sovereign funds in the Gulf want to gear up.

Abu Dhabi’s Taqa looks more and more like a sovereign fund specializing in energy, and it too uses leverage.

Some sovereign funds also are interested in a bit more than returns — they also look to invest abroad in ways that will further the economic development of their home country. Or try too.

The closer you look, the harder it is to generalize about sovereign funds. Some are unleveraged and focus on returns, in much the same way as a typical pension fund. Some are leveraged. Some have a mandate that extends beyond financial returns, looking more like industrial policy vehicles than a typical pension fund. And some don’t disclose enough for anyone to know what they really do …

Incidentally, while I don’t agree with every argument that George Abed makes, I do think he did a good job of summarizing the debate over sovereign funds. His FT oped is certainly worth reading closely.

In July, China posted rather impressive export growth — all things considered. US imports from China in July aren’t known, but US imports from China were only up 2.9% y/y in June. During the first half of the year, US imports from China are only up 4.2%. The US hasn’t been driving Chinese export growth — Europe has.

And in June, US exports were up 21.1% y.y ($164.4b v $135.7b). Non-petrol good exports were up 17.7% y/y — so it wasn’t all driven by higher prices on the United States (small) petroleum exports. Real goods exports were up 11% in June, and 9.6% for the first half of the year. And real non-oil goods imports aren’t growing. Real non-petrol goods imports in June 2008 were 2.7% lower than in June 2007 — and for h1, real non-petrol goods imports are down by a bit less than 1%.

Exports of corn, beans (and other oilseeds) and wheat are up 90% in nominal terms, rising from $13.6b in the first half of 2007 to $25.9b in the first half of 2008. It isn’t all just higher prices — real exports of foods, feeds and beverages are up 10%. The United States’ financial capital should be grateful it is linked in a currency union to the agricultural Midwest; think where the dollar would be if the US only exported repackaged residential mortgages. Quips about flyover country should stop …

Not so long ago, important voices often argued that exchange rates had little effect on trade — and particularly no effect on US-Chinese trade. I though would challenge anyone to explain — credibly explain — how both China and the United States experienced strong export growth in the first half of this year without mentioning exchange rates. Dollar depreciation is having the expected effect on US exports. And the RMB’s depreciation against the euro has had the expected effect on China’s exports to Europe.

There is only one problem with this story. Bringing the US deficit down, it now is clear, required dollar depreciation, stronger demand growth outside the US than inside the US and stable oil prices. Strong global growth in particular cuts both ways — as it pushes up the price of oil and thus the US oil import bill even as it pushes US exports up. Falls in the dollar also cut both ways, at least to the extent that dollar weakness pushed oil up. I personally find the argument that high oil pushes the dollar down a bit more compelling, but there is a big debate on this.

In the first half of the year, the US non-petroleum goods deficit fell by $51 billion. But the petroleum deficit increased by $69 billion, pushing the goods deficit up. The services surplus improved by $25b — bringing the overall deficit down a bit, but only a bit.

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China’s July trade data is now out. Strong export growth (27% y/y) produced a much larger than expected trade surplus. Exports from May through July 2008 are running about 23% above exports from May through July 2007. That is pretty good in my book. The troubles of China’s textile sector simply may not be representative of China’s broader economy. Michael Pettis notes:

the woes of a small but powerful segment of the export industry – low-value-added processors in the south of China, who have been hit primarily by rising wages and a welcome shift in the southern economies towards higher-value-added goods and services – have created a false impression about dire conditions for China’s exporters

Earlier I suggested that it would be hard to argue that Chinese exports were really slowing so long as monthly exports were running $20b a month higher than in 2007. July 2008 exports were $29b above July 2007 exports. That suggests an acceleration in export growth, not a slowdown. But I wouldn’t necessarily read too much into the July data — there seems to be a lot of unusual seasonality in China’s data this year. Some August exports may have been pulled toward to help minimize congestion around the Olympics. The sharp fall in German export orders and anecdotal evidence that American manufacturers are seeing a fall in European demand do suggest a broader slump in trade is in the cards, and it is hard to believe that China won’t be touched. If Danske Bank is right, real exports already have slowed significantly, with about 10% of the nominal export growth now coming from higher prices. But 15% real export growth is still quite strong. The US would be thrilled with that kind of growth.

But when I look back, I really don’t see strong evidence that China’s export boom has slowed in any meaningful way. Consider a plot showing the rolling 12m sum of exports and imports. The overarching story of this decade continues to be that China has enjoyed one big sustained export boom.

A plot that shows the difference (in billions of dollars) between China’s exports over the last 12 months over a comparable period a year ago (i.e. I subtracted the sum of China’s exports from August 2006 to July 2007 from the sum of China’s exports from August 2008 to July 2007) suggests export growth has leveled off at a high level — not that it is falling. Imports are up in dollar terms — as one would expect given the rise in commodity prices. But exports have held up well. The surprise isn’t that higher oil has pulled down China’s trade surplus a bit. The surprise is that China’s trade surplus hasn’t fallen by more in a period when US demand for Chinese goods stalled and oil prices soared.

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Mark Thoma linked to a VoxEU article summarizing new work by Robert Koopman, Zhi Wang and Shang-Jin Wei on the “Chinese value-added” of China’s exports. They find that the Chinese value-added in China’s export sector is about 50% of the total, higher than some past estimates. They also find that the domestic value-added in China’s export sector has been more or less constant over the past few years. It was 48.7% in 2002 and 50.6% in 2007 (see their Table 1). That surprised me. World Bank and IMF work (see this paper by Li Cui and Murtaza Syed, or this summary of their work) highlighting the migration of the electronics components industry to China led me to expect the value-added in China’s export sector would be rising over time.

Koopman, Wang and Wei argue that one implication of their finding is that exchange rate appreciation will have a smaller impact on China’s trade surplus than is sometimes argued:

“Our best estimate suggests that the share of domestic content in China’s exports is about 50%, which is much lower than most other countries. This implies that a given exchange rate appreciation is likely to have a smaller effect on China’s trade surplus than for other countries.”

I would put it a bit differently. Exchange rate appreciation should have a smaller impact on China than on countries with similarly sized export sector and higher-domestic value-added. But given China’s geographic size, China’s export sector is actually quite large relative to its economy. If the “Chinese content” of China’s goods export sector is around 50%, goods exports account for between 17 and 18% of China’s GDP. Exports of goods and services account for about 12% of US GDP — and that number hasn’t been adjusted for imported content in US exports (Boeing, for example, imports components from around the world, so the US content of US aircraft exports isn’t 100%) so it isn’t really comparable to the adjusted Chinese data. I consequently would expect that exchange rate appreciation would potentially have a bigger impact on China’s trade balance than on the United States’ trade balance …

The Koopman, Wang and Wei data also lets us estimate just how China’s exposure to the world economic cycle has changed over the past few years. I assumed that 50% of the value of China’s exports comes from embedded imports and thus subtracted 50% of China’s exports from both China’s export data and its import data. That provides, I think, a rough estimate of the value-added in China’s export sector as well as the goods China imports for domestic consumption. I then scaled everything to China’s GDP (calculated on a rolling 4q basis — the quarterly jumps in GDP contribute to some of bumpiness of the data). The results are rather interesting, I think.

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The big financial story today is the dollar’s rally –

The dollar fell when oil rose, and now it is rising as oil falls.

Plus, a couple of the key factors that have supported the euro against the dollar — the ECB’s tightening bias and Europe’s resilience (and specifically Germany’s resilience) in the face of the US slowdown — seem to be withering away. I agree with John Jansen: this is more a story about incipient weakness in Europe than strength in the US. Only yesterday US Treasuries rallied (i.e. yields fell) on the back of bad US news.

A dollar rally is one way for the RMB to strengthen against its largest trading partner — though at the end of the day, the RMB needs to strengthen against both the euro and the dollar to help reduce the world’s imbalances, not just to strengthen against one or the other.

Most of the data I follow looks back not forward — even the weekly custodial data reported by the New York Fed. I though was struck by the strong increase in the Fed’s custodial holdings (money the New York Fed holds for foreign central banks) last week: Total custodial holdings were up $24.5b, with a $25.6 increase in the Treasury holdings and a slight $1.0b fall in custodial holdings of Agencies.*

The $24.5b weekly increase is almost as large the $29.1b increase in July. And the $25.5b in Treasury purchases isn’t that much smaller than the roughly $35b sovereign funds have invested in US financial institutions.** It is a huge number.

Right now there are only three countries adding to their reserves at a rate than could explain this kind of growth: China, Russia and Saudi Arabia. Of course, a large country that isn’t adding to its reserves could also shift funds over to the New York Fed, increasing its custodial holdings in the absence of an increase in its overall reserves — but I suspect that at least one of the countries now adding to its foreign assets at a rapid clip is making heavy use of the New York Fed’s custodial accounts.

And it is striking that all the increase went into Treasuries. Treasury Secretary Paulson is in Beijing for the Olympics. I would be a bit surprised if he also doesn’t swing by SAFE and explain how the US government plans to backstop the Agencies …

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Airbus is looking to source more parts (and produce more) in the dollar zone. Selling a product denominated in dollars with a euro cost structure isn’t currently a recipe for enormous profits.

China is part of the dollar zone, for better or for worse. It will soon be making A320s.

So is Abu Dhabi, though it is quite hard to see why an oil-exporter with a huge external surplus like Abu Dhabi should be in the dollar zone. Being a part of the dollar zone is a big reason why inflation is very high (and probably far higher than reported) in the Emirates.

Abu Dhabi could easily import all the airplanes and airplane parts it wants. $100 billion in export revenues split among a small population produces a lot of buying power. Abu Dhabi’s native-born residents are far too wealthy to spend their time building planes. They prefer flying them …

But Abu Dhabi aspires to do more than pump oil. And its proliferating sovereign funds have the resources to make most dreams come true. Or try too.

ADIA is Abu Dhabi’s best known fund, but it is far from alone. Over the past few years it has been joined by Mubadala, the Abu Dhabi Investment Council (a fund set up to manage ADIA’s regional investments) and perhaps Taqa (an ambitious state energy company that is investing in energy projects outside of the Gulf — and in effect doubling down on Abu Dhabi’s energy exposure rather than diversifying away from it). Wayne Arnold writes:

There are at least eight Government-owned or Government-controlled institutions now investing sovereign funds on behalf of Abu Dhabi. Far from just trying to drive up short-term gains, most share the goal of securing the long-term prosperity of the emirate, whether by providing nest eggs for retirement, securing long-term supplies of food and energy, promoting the development of new industries that create skilled jobs and reduce Abu Dhabi’s dependence on oil, or just amassing endowments.

While ADIA may have a portfolio that looks rather like a pension fund or a university endowment, Mubadala is more of a “sovereign economic development fund.” Its mandate goes beyond returns. It is also supposed to promote Abu Dhabi’s internal economic development.

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