Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

The money is flowing out even faster than it flowed in …

by Brad Setser Friday, October 31, 2008

At least for Russia. And probably for a host of emerging economies.

Russia’s reserves fell by over $30 billion during the third week of October — tumbling from $515.7b on October 17 to $484.7b on October 24. Roughly $15 billion of the fall reflects the fall in the dollar value of Russia’s euros and pounds. But about $15 billion reflects Russian intervention in the currency market, as well as the drain on Russia’s reserves associated with the loans Russia’s government is making to Russian banks and firms seeking foreign exchange to repay their foreign currency debts.

A $15 billion weekly outflow is rather large.

$15 billion is as much as the IMF committed to lend Russia back in 1998. And the IMF actually only disbursed a third of that total.

The most the IMF ever actually lent out to a single country in the past was roughly $30 billion (to Brazil, in 2002-03). At the current rate, Russia will run through that much in two weeks.

The pace of decline in Russia’s reserves is partially a function of the fact that Russia had so many reserves back in July. Countries with less money in the bank tend to husband their scarce resources rather than spend them liberally. A lot Russia’s reserve buildup reflected private inflows rather than the oil surplus, so in some sense Russia’s government is just facilitating the reversal of those flows. In the process, of course, the Russian state is helping out some of Russia’s biggest businessmen. Russia’s state will likely end up controlling a broader swath of Russia’s economy at the end of the “deleveraging” process.

But the pace of decline in Russia’s reserves is also evidence of the scale of the reversal in capital flows to emerging economies — and the pace of the current outflow.

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At this rate the world’s financial architecture will have been remade before November 15th

by Brad Setser Wednesday, October 29, 2008

Today the Federal Reserve indicated that it would swap US dollars for Brazilian real, Korean won, Mexican pesos and Singapore dollars — effectively allowing a select group of emerging economies to borrow dollars on terms similar to those available to the G-10 economies. Or almost similar terms. The G-10 central banks can currently borrow dollars from the Fed without limit; the four selected emerging market central banks can only borrow $30 billion each. But $120 billion is real money — and if need be, the the size of these swap lines conceivably could be increased.

This move goes some way toward breaking down the line between the G-7 (really G-10) economies and emerging economies that emerged after the G-7 countries guaranteed that systemically important financial institutions in their economies wouldn’t be allowed to fail and the Fed expanded the scale of the swap lines available to European economies whose banks had a large need for dollars. Those moves reduced the risk of lending to another bank in the G-7 (or G-10), but increased the (relative) risk of lending to a bank outside the G-10. German banks needing dollars could get dollars from the ECB, which could get dollars from the Fed. Korean banks had no such luck.

Change has come to the IMF as well. The IMF used to be in the business of providing tranched, conditional loans. And for a long-time the stated goal of fund policy was to return to the funds traditional lending limits (for geeks, 100% of quota in a year, 300% of quota over the life of the program). Now it is willing to lend to some countries unconditionally. And to provide up to 500% of quota upfront. Today’s IMF press release:

The new facility, approved by the IMF’s Executive Board on October 28, comes with no conditions attached once a loan has been approved and offers large upfront financing to help countries restore confidence and combat financial contagion.

“Exceptional times call for an exceptional response,” said IMF Managing Director Dominique Strauss-Kahn. “The Fund is responding quickly and flexibly to requests for financing. We are offering some countries substantial resources, with conditions based only on measures absolutely necessary to get past the crisis and to restore a viable external position,” he said.

That’s change. There was a time when it was fairly standard to argue that the financing that the Fund provided was almost incidental to the success of a Fund program. The conditions were what really mattered. Now, for at least a subset of countries, the Fund thinks all that really matters is money.

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The CIC, the world’s best performing sovereign fund?

by Brad Setser Wednesday, October 29, 2008

To date, the CIC hasn’t exactly distinguished itself with its investment acumen. Its investments in Blackstone and Morgan Stanley are underwater. Its Blackstone shares are down something like 75%.

Even its “safe” investments haven’t been safe: it put money in the Reserve Primary Fund — the money market fund that famously broke the buck.

But it almost certainly has outperformed other sovereign funds this year. Its winning strategy?

Cash. Lots of it. SWF Radar highlighted a Thomson Reuters report that indicated:

[the] “CIC has been very stable so far, because at a time when global stock markets are dropping dramatically, it has more than 90 percent of its assets in cash,” the official Shanghai Securities News cited Lou Jiwei, head of CIC, as saying.

Apparently the CIC didn’t put most of its money to work. Which, if nothing else, means it didn’t lose all that much.

On the other hand, it really isn’t necessary to create a sovereign fund just to invest in money market funds.

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JP Morgan is now forecasting a global recession

by Brad Setser Tuesday, October 28, 2008

Via Martin Wolf and Nouriel Roubini comes the latest global forecast from JP Morgan:

“Once again, we have taken an axe to near-term growth forecasts for the developed world and will likely follow up with additional downward revisions for emerging economies in the coming weeks. Already, our forecasts suggest that global gross domestic product will contract at a near 1 per cent annual rate” in the fourth quarter of 2008 and the first quarter of 2009.

JPMorgan expects shrinkage this quarter at an annualised rate of 4 per cent in the US, 3 per cent in the UK and 2 per cent in the eurozone. It is forecasting 0.4 per cent global growth in 2009, with advanced countries shrinking 0.5 per cent and emerging ones growing 4.2 per cent.”

Ouch. And that is before the forecast for emerging economies has been revised down to reflect recent turmoil.

The soaring yen

by Brad Setser Monday, October 27, 2008

Back when it was fashionable to talk about the end of macroeconomic volatility, it was also common to note that volatility had disappeared from the currency market. The FT’s resident financial anthropologist Gillian Tett :

A couple of years ago – or before banks started to go bust – economists sometimes liked to talk about a phenomenon they christened The Great Moderation. This was the idea that the 21st-century financial system and global economy had become so stable and sophisticated that dramatic swings in activity had seemingly disappeared. Volatility, in other words, was supposed to be an issue of the past.

The absence of volatility — in turn — made carry trades (borrowing in a currency with a low yield to buy a currency with a higher yields) attractive. Carry trades pay off if not much changes.

Alas, the return of macroeconomic volatility (Jeff Sachs’ back of the envelope calculations suggest that the pace of global GDP growth could fall sharply next year) has also led the return of currency market volatility.

The yen — a favorite source of low-cost credit — has soared. Or, put differently, a host of currencies have fallen sharply against the yen. Just look at moves in the euro and the Australian dollar against the yen.

(thanks to Paul Swartz for help with the graph)

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The case for a bigger IMF

by Brad Setser Sunday, October 26, 2008

The Wall Street Journal (Slater and Hilsenrath) reports that Brown Brothers Harriman estimates that Russia, Mexico, Brazil and India have spent $75 billion in the foreign exchange market defending their respective currencies so far this month.

The most the IMF ever lent in a year to the world’s emerging economies? About $30 billion.

Nor have emerging economies limited themselves to just intervening in the spot market. Brazil committed to doing $50 billion of currency swaps. Korea has guaranteed $100 billion of bank liabilities. Russia’s different commitments add up to something like $200 billion – though to be honest I have lost track.

The IMF’s total lending capacity (without drawing on its supplementary financing lines): roughly $200 billion.

Right now, the IMF is too small to meet the foreign currency liquidity needs of the larger emerging economies – those economies like Mexico, Korea, Russia, India and Brazil that have GDPs of around 1 trillion dollars and substantial financial ties with the rest of the world. At least if the IMF has to draw on its own resources. If Japan or China lends alongside the IMF, it could mobilize bigger sums than it can lend on its own.

The IMF clearly still has a role – whether supplementing the reserves of some larger countries in a modest way or supporting smaller countries. It is now lending — or soon will be — to Iceland, Ukraine and Hungary. But in a world where Dani Rodrik argues the IMF needs to be lending hundreds of billions rather than tens of billions (“What will be required now is more of the order of hundreds of billion dollars”), it lacks the resources* to be at the center of the international financial system.

In very broad terms, the dollar liquidity needs of borrowers outside the US have been met in three different ways.

— European banks effectively have been given access to the Fed. Not directly. But indirectly. European central banks can borrow dollars in the Fed in literally unlimited quantities by posting euro or pound or Swiss franc or Swedish krona collateral. And European central banks can then onlend the dollars they borrowed from the Fed to their own (partially nationalized) banks.

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One easy thing China could do to help stabilize global markets: buy Agencies!

by Brad Setser Saturday, October 25, 2008

There is constant talk – too much, in my view – about whether sovereign funds will come to the rescue of western financial institutions.

Qatar did put a large sum of money into Credit Suisse recently, but in general the Gulf funds are reeling from large losses on their existing portfolio even as they are facing increased domestic demands (see Mufson and Pan of the Washington Post and Steven Johnson of Reuters) . “Rescuing*” US banks but not your own countries’ markets – and our own countries financial institutions — is hard. And some Gulf countries’ ability to carry out their ambitious local development plans will hinge on the availability of financing from their sovereign funds is oil stays at its current levels.

China is still cash rich. But the CIC has yet to prove that it can manage a $100 billion balance sheet (its “frozen” investment in the Reserve Primary Fund is the latest case in point) let alone manage a US or European financial institution with a far larger balance sheet. Moreover, it would seem a bit bizarre – at least to me – for the US taxpayer to guarantee the liabilities (and thus be on the hook for most future losses) of an institution that is effectively owned by China’s government. As Uwe Reinhardt notes, US taxpayers are already on the hook for most of the downside – and handing over both the upside and control to another country’s government (typically a non-democratic government) hardly achieves the goal of keeping major financial institutions in private hands.

But there is something that China could do that would be both stabilizing and pose few difficult policy issues: it could resume its purchases of US agency bonds.

The US hasn’t technically guaranteed the Agencies liabilities because it doesn’t want their (large) book to be consolidated on the US government’s balance sheet. But it has signaled that it stands behind the Agencies – and so long as the Agencies are the only source of mortgage credit for American households, that guarantee is quite credible. This guarantee led PIMCO to add to its already large bed on Agency bonds – but it hasn’t reassured the central banks that until recently were large purchases of Agency bonds.

Agency spreads remain wide. Accrued Interest has reported that they will remain wide until “real” money — and apparently more real money than even PIMCO can mobilize — returns to the Agency market, given the difficulties leveraged investors now face.

In the past, Asian central banks — and especially the PBoC — were a key source of demand for Agency paper. But the Fed’s custodial data – which seems to capture about 90% of all central bank holdings of Agency paper – leaves little doubt that the world’s central banks are now fleeing the Agency market. In the first three weeks of October, the latest New York Fed custodial data indicates central banks have added $53.9b to their Treasury holdings while reducing their Agency holdings by $51.4b. Since September 3 – roughly the time when the Treasury announced it would recapitalize the Agencies as needed – central banks have added $130.2b to their Treasury holdings while reducing their Agency holdings by $40.7 billion.

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At least London is affordable again

by Brad Setser Friday, October 24, 2008

When the pound falls more in a week than it did during the week of Black Wednesday, the week when Soros famously “broke the Bank of England,” you know big changes are afoot. Bloomberg reports:

Today’s drop in the pound brought the decline this week to 10.1 percent, the most since at least 1971 …. The currency lost 9.8 percent in the week when U.K. Prime Minister John Major pulled the pound out of the Exchange Rate Mechanism on Sept. 16, 1992 in what became known as Black Wednesday.

“These moves are absolutely without precedent,” said David Watt, a Toronto-based currency strategist at Royal Bank of Canada Ltd. “The 1970s are pretty much the extent of the data you’re going to get because currencies didn’t even float that far back.”

The dollar is rising against everything except the yen — which just hit a 13 year high against the dollar. The Indian rupee hit a new low against the dollar — which implies that the yen has really shot up against say the rupee, and pretty much everything else.

That tells you all that you need to know. This is much more of an unwinding of carry trades than a flight to quality — though there is an aspect of that too. Some Russians for example, seem to have rediscovered the joy of holdings dollars rather than rubles.

The dollar’s rally has a silver lining. It has pulled the RMB up too — and the RMB needed to appreciate against most European and emerging market currencies. The real appreciation of the RMB over the last few days and weeks has been far larger than the real appreciation associated with the RMB’s 20% nominal appreciation against the dollar.

That is good. China is the major oil-importing economy with the fastest growth, the biggest current account surplus and the lowest fiscal deficit (a surplus actually) going into the current crisis. It has the most capacity to use counter-cyclical fiscal policy to support its growth. Its currency should be appreciating in real terms right now.

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Very true — “The globalization of the credit crunch” has produced a series of currency crises in the emerging world

by Brad Setser Thursday, October 23, 2008

Alan Ruskin argues that the moves in the foreign exchange market today — with the dollar and yen rising sharply against nearly everything — reflect an unwinding of bets made on the assumption that the world economy would remain strong and market volatility would remain low even as the US slowed.

The dollar’s rise since July is part of a reversal in longstanding investment trends that prevailed during years of plentiful borrowing, strong growth and low financial-market volatility. “Essentially, every large trade that built up a head of steam in the go-go years has blown up or is in the process of blowing up,” wrote Alan Ruskin, chief international strategist at RBS Greenwich Capital, in a report to clients. “That goes for almost every asset class.”

That seems more or less right to me.

Crises have a way of clarifying what happened in the past. I think it is now clear that the scale of emerging market reserve growth from the end of 2006 to q2 2008 should have been a leading indicator that a lot of investors — probably too many — were betting that emerging markets (and indeed the world) could continue to grow rapidly even as the US slowed. Reserve growth was running well in excess of the emerging world’s current account surplus, as private capital was flowing into the emerging world in a big way. The IMF data indicates that private flows to the emerging world in 07 and the first part of 08 ($600b a year in 2007 — over twice the average pace of 04-06; see table A13 of the IMF’s WEO) were well above the levels seen before the 97-98 crisis.

Those capital flows — plus very low real interest rates, as many emerging markets followed the US rates down even though they were still booming — helped fuel surprisingly strong global growth even as the US slowed. The US actually wasn’t driving global demand growth over the last two years. Europe and a few booming emerging economies were. The world did decouple. Energy prices certainly decoupled from the trajectory of US demand. But only for a while.

In retrospect, large inflows to the emerging world – and expectations that emerging currencies were generally on an appreciating trend, making it safe to borrow in foreign currencies (or sell insurance against a large depreciation of an emerging market currency) led investors to take on a lot of risk. Consider for example the rise in borrowing from global banks by many emerging markets (documented by my colleagues at the Council’s Center for Geoeconomic Studies) over the past few years. The fuel for the current market fire was there.

I still never would have experienced that the emerging world could experience a sudden stop like it is experiencing now while it was still running a large aggregate current account surplus. Particularly after most emerging markets had built up rather substantial reserves. Both should have helped to buffer against a huge swing in market sentiment, at least in aggregate.

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The end of Bretton Woods 2?

by Brad Setser Tuesday, October 21, 2008

In late 2004, Nouriel Roubini and I wrote that “the tensions created [by the Bretton Woods 2 system] are large, large enough to crack the system in the next three to four years.” In a 2005 Wall Street Journal online debate with Michael Dooley I tried to hedge a bit, and gave the system six years.

“we [Roubini and Setser] never said the system would collapse at the end of 2005. A collapse in 2006, maybe. A collapse before 2008, likely; before 2010, almost certainly.

I used to worry that these dire warnings would prove to be wrong – and that Michael Dooley and Peter Garber would remind me of them at a time and place of their choosing. Now I am starting to worry that Nouriel and I may end up being partially right.

The available trade data for q3 does not show a fall in either the US deficit or China’s surplus. But I increasingly suspect that the combination of falling oil prices and falling demand for imported goods will produce significant fall in the US trade and current account deficit in the fourth quarter, with a corresponding fall in the emerging world’s combined surplus. The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much.

And rather than ending with a whimper, Bretton Woods 2 may end with a bang.

In some sense Bretton Woods 2 has been on life support for a while now. China’s recent export growth has depended far more on Europe than on the US. US demand for non-oil imports peaked in 2006. One irony of the past year is that the US was borrowing far more from China that it was buying from China. Campaign rhetoric that the US was paying for Saudi oil with funds borrowed from China isn’t far off – though it leaves out the fact that the US also borrows from Saudi Arabia to pay for Venezuelan, Mexican and Nigerian oil.

If Bretton Woods 2 ends in 2009 – if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down – it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up – pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy. As Brad DeLong notes, it didn’t quite play out that way. The US and European banking system collapsed before the balance of financial terror collapsed. Dr. DeLong writes:

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