Brad Setser

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You know it is a crisis when the trade deficit could have been financed just by selling t-bills to China and European banks

by Brad Setser
November 18, 2008

This is an example of what Calculated Risk calls cliff-diving. Foreign demand for any US bond with a smidgen of credit risk has disappeared. Indeed, the fall in demand for Agencies over the past three months is more severe than the fall in demand for US corporate bonds (think securitized subprime mortgages and other securitized housing and consumer debt) last August.

Normally, this kind of fall-off in foreign demand would be associated not just with a credit crisis but also with a currency crisis. A country cannot finance a trade and current account deficit without financing, and two big sources of financing for the US deficit — foreign purchases of Agencies and foreign purchases of US corporate bonds — have disappeared. The US, though, isn’t a normal country. The fall in demand for risky US assets was offset by a rise in demand for Treasuries and the sale of foreign assets by Americans.

The numbers here are striking. In September, China bought nearly $40 billion of short-term Treasury bills ($39.3b). Foreign banks (there is a small risk of double counting, as this could include Chinese banks) bought nearly $60b of t-bills ($58.8b). Americans sold $35b ($35.4b) of foreign assets. All told, the US sold $111 billion of Treasuries to foreign investors in September — throw in the sale of foreign bonds by American investors you get a net inflow of $146b. That is more than enough to cover the deficit. Indeed, it goes a long way to making up for last month’s financing short-fall. (all data comes from the Treasury)

Because most private purchases of long-term Treasuries and Agencies have been revealed to be — in the course of time — official purchases, I generally add all long-term Treasury and Agency purchases to recorded short-term official purchases of Agencies to get a measure of official flows. This data clearly shows a massive shift from Agencies to Treasuries.

To complete the picture I added short-term t-bill purchases by private investors to the long-term purchases and short-term official purchases. Total Treasury purchases over the last 3 months totaled $214 billion. That’s huge.

Combining that inflow with $92 billion in net sales of foreign assets by American investors implies that the “flight to Treasuries” and “deleveraging” combined to provide about $300 billion in net financing to the US. That, in broad terms, allowed the US to run a roughly $175-200b current account deficit and cover a huge outflow from the Agency market.

China is particularly interesting case. SAFE clearly has added to the instability in the credit market over the past few months — and equally clearly contributed to low Treasury yields. That isn’t a criticism — it is just a statement of fact.

At the end of July, China stopped buying Agencies and corporate bonds and started to pile into Treasuries. Over the last three months of data (i.e. the third quarter), the US data indicates that China has bought $81.1 billion in Treasuries ($45 billion short-term) and added $17.4 billion to its bank accounts — that is a flow of nearly $100 billion into the safest US assets China can find. Conversely, China sold $16 billion of Agencies, $1.8 billion of corporate bonds and a bit less than a billion of equity.

In the second quarter, by contrast, China bought only $13 billion of Treasuries and added only $2 billion to its US bank account while buying $17 billion of Agencies and $20 billion of corporate bonds.

That is a huge swing — and frankly a destabilizing swing. The notion that sovereign investors are always and at all times a stabilizing force in the market should be put to rest. China has clearly kept the RMB dollar stable — and been a big source of demand for Treasuries. But it has been a seller of other assets in a time of stress.

Sovereigns may have long time horizons, but they also have historically been very loss-adverse. China’s current flows suggest that it was reaching for yield in a host of markets back when the RMB was appreciating, and after getting burned it retreated from any kind of risk.

The September data also should put to rest all the talk about China retreating from Treasuries. The real issue is that China has retreated from the Agency market. True, September is a long time ago — but the Fed’s custodial data doesn’t suggest anything has changed since then.*

I’ll conclude by looking at trends over a somewhat longer time horizon. Starting last August, foreign demand for most kinds of risky US assets dipped. There is a clear break in a chart showing rolling 12m purchases of corporate bonds and equities back then. More recently, Agencies got reclassified as a risk asset. There was a bit of a fall off in demand for Agencies last August — but the really big fall off has come recently.

One interesting tidbit — and this is something I’ll return to later — is that a lot of sovereign investors were likely starting to dabble in risky assets in the first half of 2007. If that is right, they ended up getting burned. And as a result, all the investment bank analysts forecasting that the rise of sovereign wealth funds would lead to sustained sovereign demand for risky assets proved way off. Right now foreigners don’t seem to be interested in any kind of risky US asset.

Instead they are buying Treasuries.

And remember this is just a chart showing foreign purchases of long-term Treasuries. In addition to buying roughly $385 billion in long-term Treasuries, foreign investors snapped up another $240 billion (gulp) in short-term Treasuries. That works out to a net inflow in the Treasury market of over $600 billion …

Of course, Treasuries aren’t entirely risk free. I don’t believe that there is a real risk the Treasury would default. Buying credit-default swap protection on the US is something by colleague Paul Swartz calls an end-of-the-world trade. But foreign investors holding long-term Treasuries are clearly taking a lot of currency risk — especially if they are buying in now, after the dollar has rallied …

The US is taking a risk too. The rising stock of short-term bills held abroad does potentially leave the US more exposed to a rollover crisis.

* The Fed’s custodial data also suggests that the official private split in the TIC data shouldn’t be taken too seriously. Between September 3 and October 1, central banks added $87 billion to their custodial accounts — far more than the $16.4 billion in recorded official inflows in the TIC data. It is quite possible that some central banks that don’t use the Fed were selling US assets while other central banks that do use the Fed’s custodial facilities were buying. But it is also likely that the September US TIC data overstates private purchases and understates official purchases. There clearly is a large gap between the TIC data and the FRBNY data. Going forward though total official flows should fall off — as central banks reserve growth almost certainly turned negative in October.


  • Posted by bsetser

    mdenver — GNMAs are agencies, so they are part of the data set. there is no way of knowing from the TIC data whether central bank selling has extended to ginnie maes or whether they have been spared b/c they have a full faith and credit guarantee. I would need to go on bloomberg and figure out how to calculate GNMA spreads

  • Posted by bsetser

    RBG — some of the adjustment will come from a fall in investment, not just a rise in savings. Goldman is forecasting a net 6% of GDP improvement in the private sector’s balance (more savings and less investment in 09) after a 3% improvement in h2 of 08 (see my next post).

    that frees up a lot of funds for a fiscal deficit.

    also note that if the TARP puts equity capital into a bank and the bank buys treasurties with the cash, there is no need to borrow from abroad to cover the treasuries issued to finance the TARP. indeed, a lot of bank recapitalizations are done without any direct market debt issuance — the government just hands the banks treasuries in return for their existing assets/ new equity. it is a hard concept to grasp, but in this case the money does really move in a circle.

    djc — so long as treasury rates are falling there isn’t much pressure to issue in yen

  • Posted by Pete Murphy

    Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today’s recession may be just a preview of what’s to come.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?

    At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.

    Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at

    Please forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, “Five Short Blasts”

  • Posted by Euraussian


    Quite a few things in your post require consultation of facts. For instance, the assertion that the US workforce is the most productive on earth. That statement does not look right, unless tems like “US workforce” and “productive” have unusual meaning. Output per man-hour in several European countries, Singapore, Japan etc is simply higher. If one goes to specific industries (and for instance leaves out services and construction) the US may be doing better, since most labor intensive production of tradables has been moved offshore (using US production technology of course). That was just one example.

    However the main reason for commenting is that one of your intuitions is correct, an that is that consumers living in high density environments have physical limitations on their spending, as well as logistical bnefits unqique to urban environments. Residents of Tokyo can easily afford several cars per houshold but have generally no place to put them or may even require a permet in certain neigborhoods. The same goes for residents of Manhattan..Urban people tend to have less space for transportation equipment and, they usually have a communal alternative that is also cheaper.

    But that is not a good reason why there should not be fre trade between LA and Manhattan..Or would you like to tax only foreign urbanites?

  • Posted by Ecto

    Did someone notice on last TIC that the biggest contribution to Treasuties holding comes from the UK and not China? I don’t know whether this has already been discussed on this site but I’ll be glad to hear experts on this issue. Do we know a bit more about the actual holders of aggregate UK holdings?

  • Posted by ReformerRay

    I like Pete Murphy’s attempt to create a new theory but I do not find it appealing.

    Whatever the correlations of population density with the trade deficit, they are beside the point. The U.S. has a large trade deficit because it tried to immplement free trade theory and other nations, except England, did not.