US exports have been growing faster than non-oil imports for the last two years. The August trade data hints at a slowdown in exports. But at least on a y/y basis, the slowdown remains modest.

As a result of the (large) gap between the pace of US non-oil import growth and the pace of US export growth, the non-oil deficit has fallen substantially. Alas, the overall deficit has been more or less constant (in dollar terms), as the petroleum deficit has expanded significantly.

But oil is now on its way back down. What kind of improvement can the US expect?

Well, if oil falls to $70 and stays there, the petroleum deficit will fall substantially. Over the course of the year, the annual United States oil import bill could fall back to just under $300b — a roughly $100b improvement over the deficit of the last 12 months (and a much bigger improvement from the last three months, when imported oil averaged $120 a barrel).

And if the exports can continue to grow 9-10% faster than non-oil imports, the non-oil deficit will also continue to improve. 1% nominal (non-oil) import growth, 10% nominal export growth and $70 oil produces a 2009 deficit of around $400b — almost $300b better than now.

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Some emerging market central banks have noticed that they – unlike the Bank of Japan, Bank of England, Swiss National Bank and the European Central Bank – don’t have access to unlimited dollar credit through reciprocal swap lines with the Federal Reserve.

Peter Garnham of the FT, drawing on Derek Halpenny of Tokyo-Mitsubishi UFJ, observes:

Analysts say the unlimited dollar currency swaps set up between the Federal Reserve and central banks have helped bring stability to currencies through alleviating institutions desire to purchase dollars in the spot market to satisfy overnight funding requirements. “In contrast, the lack of currency swaps put into place between the Federal Reserve and emerging market central banks has likely helped to exacerbate the pick up in emerging market currency volatility” says Derek Halpenny, at the Bank of Tokyo Mitsubishi UFJ.

Think of Korea. There is “a shortage of dollars in the Korean banking system” – and Korean banks (and the Korean government) are scrambling to obtain them. That is likely adding to the pressure on the Won.

For all the talk about how the G-7 has lost relevance, in a lot of ways the recent crisis has reinforced the G-7’s importance. Banks in G-7 countries that borrowed in dollars have access to unlimited dollar financing from their central banks – dollar financing that comes from the fact that the main G-7 central banks have access to large swap lines with the Fed.

Banks in emerging market countries have no such luck.

Korea is a highly developed emerging economy. In a lot of ways it already has emerged. But it isn’t part of the G-7 (or G-10) and doesn’t have a swap line with the Fed that allows the Bank of Korea to borrow dollars from the Fed by posting won as collateral. That means that it has to rely on its foreign currency reserves – and its government’s capacity to borrow dollars in the market – to support its banks. Unless, of course, Korea could draw on a set of East Asian swap lines, and effectively borrow from Japan and China.

The old global architecture for responding to financial crises had, in my view, two essential components:

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Sometimes a picture is worth a thousand words.

Over the last 52 weeks, foreign central banks have added $321b to their Treasury holdings at the New York Fed (and no doubt more to other accounts) and $147b to their Agency holdings — for a total of $468b. And there clearly has been a big shift towards Treasuries recently. The rise in Treasury holdings over the last two weeks, annualized, tops $1 trillion. The fall in Agency holdings over that period (after the bailout of the Agencies), annualized, also tops $1 trillion.

Stunning? Yes. Stabilizing? Not really. There isn’t a shortage of demand for Treasuries right now. But there is a shortage of willing lenders of dollars to European banks and — to a degree, s shortage of buyers for the debt issued by the US Agencies (Freddie, Fannie and the like). And remember that the Agencies are the main current source of credit for American households looking to buy a home — without their lending, home prices would fall much much further.*

The Fed’s balance sheet by contrast is moving in the opposite direction — out of Treasuries. The Fed has been selling off its Treasury holdings for a while now. But there are limits to how many loans to banks and broker dealers and European central banks the Fed can finance through the sale of its existing stock of Treasuries. The recent increase in Federal Reserve lending has been financed by both the $500b in cash raised by the Treasury and deposited at the Fed through the supplementary financing facility — and a big rise in bank deposits at the Fed. Those two sources combined to provide the Fed with about $750b in financing.

The scale of the expansion of the Fed’s balance sheet is equally stunning. The Fed is currently provided at least $950b in dollar liquidity to the US financial system through various term facilities and its direct lending, and another $450b of dollar liquidity to European central banks — liquidity that is then lent to European financial institutions that are facing a shortage of dollars. Let there be no doubt that this is a systemic crisis.

The falling purple line is the Fed’s total holdings of long-term Treasuries (really holdings of Treasuries that have not been lent out to the dealers); the falling red line is the Fed’s holdings of Treasury bills; the rising green line is the financing from the Treasury supplementary financing account and the rise in bank reserve balances at the Fed; the rising blue line is the financing the Fed is providing to the global financial system. Tim Geithner has been a very busy man this year.

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This morning’s TIC data release tell us two things:

One, the dollar can rally without any obvious supporting inflows. Net TIC flows in August (line 30) were essentially zero (-$0.4b). Foreigners (apparently led by official investors, but the data here is deceptive) were net sellers of US long-term assets, selling about $9b. Americans sold $23b of their foreign assets — providing the US with a bit of financing. But things like amortization payments on the outstanding stock of Agency bonds (line 20) cut into the inflow from the sale of US assets abroad. Net long-term flows were essentially zero. And so were net short-term flows.

Don’t ask me to explain how the US has sustained a $120b trade deficit in July and August on the back of a $34b net outflow of funds over those two months in the TIC data. Something doesn’t quite compute.

Two, the argument that official investors are a stabilizing presence in the market needs to be marked to market — or at least marked to the observed flow. And the observed flow suggests an enormous flight by official investors out of bonds with any hint of credit risk and into Treasuries. That hasn’t been stabilizing. It has added to the stress in the credit and inter-bank markets — and ultimately contributed to the broad financial environment that forced the Treasury to step in and guarantee the Agencies and now most bank debt.

The evidence here is overwhelming.

The TIC data release indicates that official institutions sold $13b of long-term Agencies, reduced their holdings of short-term Agencies by about $9b and sold another $2b of corporate bonds and equities while buying $5b of long-term Treasuries and $12b of short-term Treasuries.

That though likely understates the swing, as most “private” purchases of long-term Treasuries and Agencies have recently been from the official sector (see the pattern of revisions that followed the June 2007 survey — which found that official buyers accounted for nearly all foreign purchases of Treasuries and Agencies). Overall, foreign investors — including official investors — bought $35b of long-term Treasuries (and $55b of short-term Treasuries) while reducing their holdings of long-term Agencies by $30b and their total holdings of Agencies by close to $40b (the fall in short-term Agencies is on line 39 of this data release). Stabilizing that was not.

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The recent fall in oil prices, if sustained, should bring down the external surplus of the oil exporters. $80 a barrel is well above the average price of oil for most of the 1990s – or for that matter 2003, 2004, 2005 and 2006. But the oil exporters are spending and investing (and thus importing) a lot more as well. By next year, a $80 a barrel oil price won’t generate a big surplus to be managed by the oil exporters central banks and sovereign funds.

The yen has long looked very weak relative to the euro. But that too has changed. The yen’s recent rally – if sustained – should, over time, work to reduce Japan’s surplus (though the fall in commodity prices works the other way).

That more or less leaves China’s surplus – and the offsetting deficits in the US and Europe. There is good reason to think China’s export growth should slow over the next year. Neither the US nor the European economy looks likely to expand much in the near future. The dollar’s recent rally has led to a much more significant broad appreciation of the RMB than the RMB’s appreciation against the dollar ever did. Back then, the RMB never appreciated enough against the dollar to make up for the dollar’s fall. This broad appreciation should make it more difficult for China to offset weak growth in its exports to the US with strong growth elsewhere.

But there isn’t much evidence of a slowdown in China’s exports yet. Nominal export growth is chugging along at about 20% y/y – which implies the China is on track to export about $250 billion more this year than last year. That has kept China’s overall trade surplus more or less constant even as China’s (commodity) import bill soared in the first few quarters. China’s q3 2008 trade surplus ($83.3b) was about $10b more than its trade surplus in q3 2007 ($73.2b). Yes, the pace of real export growth has slowed. But at something like 10%, China’s real export growth is still comparable if not stronger than US export growth. Net exports contributed positively to China’s GDP growth in q1. The World Bank’s economists believe that they will contribute to q2 GDP growth – and I would be shocked if they don’t contribute positively to China’s GDP growth in q3 as well.

Looking forward, export growth should slow – in both nominal and real terms. But nominal import growth should slow as well, as China’s commodity import bill falls. I don’t yet see much evidence that China’s overall surplus will fall. And lest we forget, China has by far the largest surplus of all the major economies. The great boom in China’s exports that started in 2002 or 2003 looks – at least to me – to be continuing.

China is an outlier when it comes to reserve growth as well. In q3, many emerging economies saw their reserves fall. Not China. It – along with Saudi Arabia – likely will keep global reserve growth from turning negative. China’s stated reserves increased by $96.8b in q3, bringing total reserves to just over $1.9 trillion.

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Obviously very well-deserved.

Of course, I am more-than-a-little biased.

A few weeks ago, I was thrilled to find out that this blog was on the reading list of an upper level Princeton course on international finance. So I am even more thrilled to be able to say that both this blog and an IMF working paper that Mark Allen, Nouriel Roubini, Christoph Rosenberg, Christian Keller and I wrote on the balance sheet effects of currency crises are on the reading list of an upper level international finance course taught by a Nobel Laureate!

Over the weekend, the countries of the G-7 indicated that they would do “whatever it takes” to prevent another Lehman-style bankruptcy. They pledged to “use all available tools to support systemically important financial institutions and prevent their failure. ”

Many European banks need access to short-term dollar financing to support their dollar assets, as we discovered after Lehman default’s led to a run on money market funds. Today, the Fed and the major European central banks made sure that any European bank that needs dollars will get dollars:

“The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.”

Emphasis added.

Any word, when over-used, loses its impact — but this really is unprecedented.

The US and the major European central banks have effectively agreed to lend without limit to make good on their pledge to avoid a systemic bank failure. All major financial institutions in the G-10 ultimately now have access — through their national central bank — to the Fed. This isn’t quite a global lender of last resort (in dollars) but it is close. Banks are different than countries, so the analogy is imprecise — but back when emerging economies had trouble rolling over their short-term dollar debts during the crises of 97-98, the G-7 never pledged to lend “any amount” needed.

Lending to countries through institutions like the IMF isn’t collateralized — but it also was never unconditional. The G-7′s guarantee of liquidity doesn’t seem to be linked to steps the banks could take to help themselves — like suspending dividend payments on their common stock.

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Words no Managing Director of the International Monetary Fund ever wants to utter:

“Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”

(source: FT)

Lehman’s default – and the resulting $400 billion run on money market and “prime” funds – precipitated the current, intense crisis. Van Duyn, Brewster and Tett of the FT report:

As word of the Reserve Fund’s predicament spread, investors fled. By that weekend, more than $200bn had been pulled from money market funds, by both retail and institutional investors. When other short-term funds, such as prime funds, are included, the amount that was taken out of short-term investments quickly reached $400bn. That shift brought the funds under heavy pressure to sell into an illiquid market, simply to ensure they had enough cash to pay investors withdrawing their money. For banks, heavily reliant on these investors for their funding needs, it created a spiral of liquidity crises. “It was the straw that broke the camel’s back,” says Joe Lynagh, a portfolio manager at T. Rowe Price, an investment company. …

The run on money markets created problems for a host of institutions that relied on the money markets rather than deposits for dollar financing. Think European banks – and the large former investment banks. It turns out that American money market funds were financing the large European purchases of US corporate debt. That explains why less risk was dispersed than the regulators thought – and why Europe was providing less financing to the US than the TIC data indicated. Van Duyn, Brewster and Tett:

The impact of the investor pullback is borne most heavily by banks that are predominantly reliant on wholesale funding, a group that includes many European banks,” says Alex Roever, analyst at JPMorgan. “This investor pullback from the secured dollar bank commercial paper market is a contributing factor in the recent wave of liquidity issues at European banks.”

Lehman’s default clearly triggered the run. But the ultimate cause of the crisis is more troubling: a large number of large commercial and investment banks seem to have been borrowing not on the strength of their own balance sheets but rather on the expectation that they were too big and too systematically important to fail.

“Prior to Lehman, there was an almost unshakable faith that the senior creditors and counterparties of large, systemically important financial institutions would not face the risk of outright default,” notes Neil McLeish, analyst at Morgan Stanley.”

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Central banks with lots of reserves have not been running away from the dollar. But they do seem to be running away from any dollar asset with a hint of risk. Right now, it is hard not to focus on the relentless slide of the stock market (the FT is calling this week a global crash), the enormous daily moves in the foreign exchange market or oil’s sharp slide. But New York Fed’s latest custodial data is stunning in its own way.

Since September 10, central banks have added close to $100 billion to their custodial holdings of Treasuries. Custodial holdings of Treasuries reached $1537.6b on Wednesday — up from $1513.1b last Wednesday, and up from $1438.1b on September 10.

Some of the increase in Treasury holdings is explained by a slight fall in Agency holdings — which fell from $956.6b on September 10 to $944.8b on October 8. But the roughly $8b fall in Agency holdings cannot explain the huge increase in Treasury holdings.

Solid data on global reserve growth in September doesn’t yet exist – China and Saudi Arabia matter, and they don’t release data quickly. But the reserves of nearly every country that reports data quickly fell in September. I have no doubt that the Fed’s custodial holdings are increasing far more rapidly than global reserves.

That either means that:

a) Central banks are shifting from euros to the dollar, adding to their dollar holdings;

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The authors of the IMF’s World Economic Outlook have a difficult job. They have to forecast the trajectory of the global economy — itself not an easy task. Their forecast will be judged and evaluated in real time. But the work according to a schedule set by the need to consult the IMF board and the demands of physical rather than virtual publication. In practice, that means that the forecast never fully reflects the most recent data. “IMF Board” time, “internet” time and “market” time are all very different things.

Sometimes that doesn’t matter. But right now is one of the times when it does. A lot happened this September. And I suspect that much of what has happened isn’t reflected in the IMF’s forecasts.

Specifically, I now expect a larger fall in US output and a larger fall in the US current account deficit — and for that matter, the combined current account deficit of the US and the EU — than the IMF currently forecasts (see the WEO’s data tables).

In the past I have argued that the IMF has had a tendency to forecast problems like the US current account deficit away, and in effect assume that the US current account deficit would tend to shrink even if neither China nor the US adjusted their policies. The IMF has also tended to downplay the role the official sector has played in financing the US.

Now I suspect that there will be more adjustment than the IMF expects.

Specifically, the IMF now forecasts that the 2009 US current account deficit will fall to $485b in 2009 (around 3% of US GDP)– well below its 2006 peak of $790b, and down from an estimated $665b in 2008. The deficit has been running at around $700b, so the IMF is forecasting a fall in the deficit in the second half of the year (see Table A10).

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