Note: this post is by Rachel Ziemba, filling in for Brad Setser

I can’t hope to do as good a job as Brad in parsing the TIC data, but a couple of trends seem to emerge at a quick glance of December’s data. As usual my eyes always stray to the role that China and oil exporters play in financing the U.S. so its worth noting that Chinese reduction in short-term holdings meant that it had net sales of $8b in U.S. assets during the month, the first decline since February 2008.   While most of the trends that having been playing out since September persist (increasing role of private American investors, reduced role of several central banks given reserve accumulation slowing or reversal) there are some differences including a renewed appetite for U.S. corporate bonds and a slower pace in the demand for T-bills.

Foreign investors continue to be wary of U.S. long-term assets, especially agency bonds. They (especially foreign central banks) have been net sellers of agency bonds since Fannie and Freddie’s solvency was called into question last year and December marked no change with net sales of $37 billion. Foreign investors did buy more treasury bonds but continued to make only anemic purchases of U.S. stocks. Read more »

Note: This post is by Rachel Ziemba of RGE Monitor, filling in while Brad is off in the mountains.

Many thanks to Brad for letting me fill in again.  I pay attention to macro events in China and several  oil exporters and the whole portfolio of sovereign investors for RGE monitor where this post first appeared. I’ll chime in on a few things related to sovereign investors (including their role in financing the US) this week while Brad is out.

In recent weeks CDS spreads on the debt of Dubai’s largest State-linked vehicles like Dubai Holding etc shot up dramatically after Abu Dhabi announced a unilateral recapitalization of its banks. The cost to buy prrotection on the 1 year bond has doubled since late January and now stands at 1073bps. The jump in the 5 yr has been less sharp but stands at over 1400bps. Since Dubai has limited sovereign debt (about $10b and maybe climbing given the likely fiscal deficit) so these large state-linked companies provide a proxy for the perceived credit worthiness of Dubai’s government. Given Dubai’s debt stock ($80b or 148% of GDP), its vulnerability to global liquidity and the worsening outlook for its domestic property market despite the ability to control supply, it is perhaps not a surprise that the outlook for the emirate seems much more precarious, particularly in contrast to its cash rich neighbour, Abu Dhabi. Given the links of these debtors to the government, and the effect that their vulnerabilities could have on the UAE federation, it has widely been assumed that the UAE govt (or rather Abu Dhabi) would come to the aid of Dubai when the crunch came. However, there has been more uncertainty than some expected. Key tests are ahead in coming months as Dubai adjusts to a world where leverage remains scarce. Read more »

I am taking a few days off. Rachel Ziemba of RGE Monitor will be guest blogging, and Paul Swartz of the Council’s Center for Geoeconomic Studies will be adding a couple of posts as well. There is some chance I will chime in as well. I am certainly curious to see what the December TIC data will show …

Do pay attention to the blog bylines though. Not all posts that appear here this week will be written by me.

China’s GDP growth stalled in the fourth quarter, which represents an enormous deceleration from its typical fast growth.

US GDP fell at a close to 4% annualized rate in the fourth quarter. The decline would have been steeper but for a big buildup in inventories. That will subtract from growth in q1.

Japanese GDP growth fell by around 10%. Some estimates are now even putting the q4 fall, annualized, at close to 12%. The fall in smaller Asian economies was often even larger.

And now we know that Europe’s GDP fell by 1.5% q/q, or 6% annualized. Germany, until recently Europe’s strongest economy, contracted at an 8% annual rate.

According to the European Union’s statistics office, the economy of the 16 countries sharing the euro currency declined by 1.5 percent in the fourth quarter. On an annualized basis, that would indicate a contraction of 6 percent — considerably deeper than the 3.8 percent annual rate of decline in the American economy in the same quarter. The performance was worse than many economists had expected, and it was even more pronounced in Germany, the euro zone’s most important economy. There, the economy shrank by 2.1 percent from the third quarter, when it had already contracted by 0.5 percent.

There is a lot of spare capacity in the global economy now.

Back in the 1990s, the vogue was to talk of capital account crises. A “sudden stop” in capital flows to an emerging economy triggered big fall in output; countries that relied on capital inflows to cover their external deficits had to bring their imports down suddenly — and that usually meant a sharp economic contraction.

It consequently is striking to me that the countries with the steepest falls in output in q4 have been the countries that are known for relying heavily on exports for growth –

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The US trade deficit — which is a good proxy for the current account balance (the income surplus offsets a transfers deficit) — is now around $40b a month. At its peak it was more like around $60b a month. That implies, if nothing changes, the 2009 current account deficit would be around $500b, down from a peak of $700b.

In fact, if nothing changes the trade balance balance might improve a bit more. The US imported an unusually large amount of oil in December, and that rise in volume obscured some of the benefits from the fall in the price. The US paid an average of around $95 a barrel for its imported oil in 2008, but only about $50 a barrel in December.

Remember this the next time someone argues that the US will be borrowing more from the rest of the world to finance its fiscal deficit: the total amount the US borrows from the world is defined by the current account deficit and the current account deficit clearly went down in the fourth quarter even as the US fiscal deficit (and the Treasury’s borrowing need) soared. That is because the rise in government borrowing offset a contraction in private investment and a rise in private savings.

Of course, it would be far better if the global economy adjusted through strong growth abroad not a collapse in private US demand growth. But, well, we are where we are. Y/y nominal non-oil imports were down about 10% in December. Nominal export growth was down a bit less, more like 8%.

Real goods exports and real goods imports are both falling. The improvement in the non-oil trade balance now reflects a faster fall in imports than exports.

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The sharp fall in China’s exports (down 17.5% y/y) and imports (down 43% y/y) shouldn’t have been a complete surprise. Korean and Taiwanese exports are down far more than China’s exports, in large part because of sharp falls in their exports to China. And, given the intra-Asian supply chain, that has long augered bad news for China.

The Chinese New Year cut into China’s January exports and imports. After adjusting for this, China’s exports are down, but not quite as much as the headline figure suggests. But that, alas, likely implies further falls in the future. Even if — as Stephen Green highlights in his latest note — “processing” exports (i.e. exports with significant imported content) are falling far faster than non-processing exports, it is a little hard for me to see how Korean and Taiwanese exports to China could be down 40% if Chinese exports are only going to fall 5-10%.

Historically, the correlations between Japanese, Korean and Taiwanese exports to China and China’s exports to the world have been fairly tight. Of course, China’s exports now have more domestic content, so the correlation could change. But I am worried. Paul Swartz helped with the following chart:

The current downdraft is clearly far more than just an artifact of the seasonality in China’s trade. A rolling 3m sum of China’s exports and imports smooths out some of the volatility. Exports and imports usually do fall in the first quarter — but nothing like they are falling now. The trough — on a rolling 3m basis — usually comes in March, not January. Yet we already know the this year’s trough will be a lot lower than last year’s trough.

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Two weeks ago, George Soros memorably framed the core choice the US now faces as a choice between buying toxic assets or taking over toxic banks.

“The hard choice facing the Obama administration is between partially nationalising the banks, or leaving them in private hands but nationalising their toxic assets.”

There is perhaps a third option: handing the toxic assets over to the banks’ existing equity investors and the banks long-term unsecured creditors, assigning the deposits to the remaining “good” bank and recapitalizing the new bank with public funds.

Judging from this week’s press reports, Treasury Secretary Geithner didn’t like these options.

If Floyd Norris is right, the US Treasury will propose a fourth option: providing credit to private investors that are willing to buy the banks toxic assets.

Private investors then would have to figure out the right value of the banks existing toxic assets. In return, they would get all of the upside. They would also take some of the downside. But perhaps not all the downside.

If the government provided credit to private investors who put up cash to buy toxic asses, the private investors would take the first loss. That discourages overpayment. But with a non-recourse loan the government on the hook if the value of the toxic assets fell by too much. The private investors could extinguish its debt by handing the toxic assets it bought over to the government.

This seems like a transaction that requires the government take on additional risk. But that probably isn’t totally accurate, as the government already in some sense has most of this risk.

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Dr. Mankiw labels complaints about China’s practice of intervening in the market to hold its currency down protectionist.

But Mankiw isn’t defending a world where governments do not intervene to shape trade flows.

An undervalued exchange rate acts as a subsidy for that country’s exports – and it also protects its domestic producers from competition from imports. Ask Dr. Bernanke. Dr. Subramanian of the Peterson Institute writes: “An undervalued exchange rate is in effect a combination of export subsidies and import tariffs.”

China’s exports would not have grown as fast as they have – goods exports went from $250 billion in 2000 to $1430 billion in 2008 – if China hadn’t added about $2 trillion to its reserves over this period. If the RMB hadn’t say depreciated against the euro over this time period, I rather doubt that China’s exports to Europe would have grown even faster than China’s exports to the US. The weak RMB also created incentives to produce goods in China that might otherwise have been imported, including a lot of the components for China’s exports.

Mankiw effectively is arguing that the US benefits from China’s intervention in the market, and consequently shouldn’t object to China’s export subsidy. Europe presumably is in the same boat.

China cannot subsidize its exports without also subsidizing US consumption of Chinese goods – and US borrowing. Of course, some in the US are on the losing end of the “low-priced Chinese goods for high-priced US government bond” trade – and those losses aren’t equally distributed. Some parts of the country tend to produce more goods than compete with Chinese goods than others. But the US as a whole benefits from China’s willingness to subsidize US borrowing … and the purchase of China’s goods.

Call me skeptical.

For one, China cannot subsidize its exports through a dollar peg without also importing US monetary policy — and it isn’t clear if that is good for China or the world. For example, China didn’t need loose monetary policy at the height of its own boom in late 2007. Yet that is what it got when the subprime crisis led the Fed to cut US rates. Nor will the effects of a monetary policy that is wrong for China necessarily be confined to China. Back in 2007, the loose monetary policy China imported from the US ended up reverberating globally – as the boom fueled by negative real rates in China (and other countries pegged to the dollar) contributed to the run up in commodity prices.

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Paul Swartz, my colleague at the Council’s Center for Geoecononomic Studies, continues to track how the current recession compares to past recessions. The United States fiscal deficit is now rising faster than in past cases. The biggest previous change was in 2000-2001 recession, when W’s tax cuts combined with a big cyclical fall in tax revenue to produce a large swing in the United State fiscal position. A modest surplus quickly turned into a large deficit. The swing in the United States fiscal position this time around is likely to be even larger. Counter-cyclical fiscal policy is back.

As Dr. Krugman notes, though, the case for a large policy response is simple: the economy is declining at a rapid pace. The US actually started to slow back in 2006, when residential investment tailed off. The recession formally started in late 2007 or early 2008. For a while it was possible to hope that the recession might prove to be fairly shallow. Exports were doing well, and the contribution of growth from net exports helped offset the fall in residential investment. And the American consumer seemed quite willing to keep spending.

But, well, things have changed. Rather than getting better, things are still getting worse. Exports are poised to fall sharply, as the world not just the US has slowed. And the fall in US industrial production has accelerated. The following graph comes from Paul’s chart book. The fall in industrial production in the current cycle is already worse than the fall in an average post World War 2 recession.

To help put this fall in context, Paul compared the current fall not just to the average but to the best and worst trajectories in the past data.

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Macroman reports that there is a bit of optimism in the air about China right now. Loan growth was strong in January. Steel prices have picked up a bit. The latest Chinese purchasing managers survey wasn’t as bad as the last one. The fall in the pace of contraction in activity has generated hope that China’s economy will rebound later in the year. China’s stimulus will help, as will the fact that China’s state banks are liquid and have clear instructions to lend …

Everyone looks at China through their own lens. My lens is the trade data. And there I still don’t find much basis for optimism. China’s January trade data isn’t out, but Korea’s data is — and it was awful. The sheer scale of the fall in Korean and Taiwanese exports shows up most cleanly if monthly exports are plotted over time.

A plot of the y/y change confirms that the current slowdown is sharper than past slowdowns, and given the strong growth in exports over the past several years, a bigger percentage change interacts with a bigger base to produce a far bigger absolute fall.*

I share Paul Krugman’s and Kevin Drum’s assessment of the “Buy American” provisions in the stimulus package: the impulse behind these provisions is understandable, but their likely costs exceed their likely benefits.** But I do wish that there was a bit more recognition on the part of those bankers highlighting the risks poised by protectionism of the scale of the collapse in trade that has ensued from the collapse of the financial sector. Not all risks to the flow of goods across borders emanate from Washington DC.

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