Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Foreign central banks aren’t going to finance much of the 2009 US fiscal deficit; their reserves aren’t growing any more (the q4 2008 COFER data)

by Brad Setser Tuesday, March 31, 2009

The latest COFER data doesn’t show much change in the dollar’s share of global reserves: the dollar accounted for 64% of the reserves of countries that report data to the IMF at the end of 2008, exactly the same share as at the end of 2007. The dollar’s share of the reserves of advanced economies rose just bit, going from 66.9% at the end of 2007 to 68.1% at the end of 2008. And the dollar’s share of reporting emerging economies — a set that importantly excludes China — fell from 61.3% to 59.7% over the course of 2008.

Those small changes though aren’t the real story. The real story is that global reserve growth — and thus dollar reserve growth — has slowed. Look at the following chart. To estimate the stock of dollar reserves, I assumed that the countries that do not report data to the IMF held a constant 65% of their reserves in dollars (this is effectively an assumption about the dollar share of China’s reserves*). And to keep things simple, I didn’t add in the growth in the non-reserve foreign assets of China’s central bank or the growth in non-reserve foreign assets of the Saudi Monetary Agency. This is very easily replicable graph.

The obvious implication of the recent downturn in total reserve holdings — and the $180 billion fall in q4 wasn’t driven by currency moves — is that the pace of growth in the world’s dollar reserves has slowed dramatically.

In the fourth quarter, the IMF data shows a $110 billion fall in the dollar holdings of countries that report detailed data to the IMF. That all came from emerging economies — who had to sell their reserves to finance massive capital outflows. The reserves of the countries that don’t report data to the IMF also fell by $55 billion. They likely reduced their dollar holdings proportionately.

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Creditors generally do like to lend in their own currency …

by Brad Setser Tuesday, March 31, 2009

China may not be an exception after all.

A creditor than lends in its own currency doesn’t have to worry all that much about the risk that it its lending is denominated in a currency that will depreciate. The borrower assumes the risk its currency will depreciate against the currency of its creditor as a condition for getting financing.

That is good for the creditor, and not so good for the borrower.

Back its days as a large creditor, the US (both the US government and private US creditors) generally lent in dollars. That meant that if a Latin currency depreciated against the dollar, the borrower had to find the dollars it needed to repay the US – or default and accept the consequences. Latin countries couldn’t allow their currencies to fall against the dollar and, in the process, reduce the real value of their foreign debts.

China is now a major creditor. But its foreign assets though are denominated in dollars, euros and yen – not RMB. That means that if the dollar depreciates against the RMB, it is China’s problem, not the United States’ problem. The amount of dollars the US has to pay China doesn’t change. But the amount of RMB that China gets for each dollar will fall

China’s willingness to take on this risk in some sense part was a core part of the Bretton Woods 2 system where reserve growth in emerging countries like China financed the United States external deficit. Had the United States external debt not been denominated in dollars, Dr. Roubini and I would have been even more worried by the size of the United States external debt than we were back in 2004. If United States debt structure hadn’t been as favorable, the dollar’s slide from 2002 on would have generated much, much larger problems.

China seems to have woken up, belatedly, to the fact that lending to the United States – or any other country – in its borrowers currency is risky. It probably should have started to worry some time ago, before it had $1.6 trillion or so of dollar-denominated claims. As the FT noted in a recent leader, “The People’s Republic has, however, over-exposed itself to the US, piling up dollar-denominated securities.” China is currently struggling with a problem that is very much of its own making.

China could, in theory, address this problem by ending its accumulation of dollar and euro and yen denominated reserves and instead making RMB denominated loans to the rest of the world.

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The PBoC’s call for a new global currency, the SDR, the US and the IMF

by Brad Setser Sunday, March 29, 2009

A $200 billion shared pool of reserves ($250 billion counting the IMF’s supplementary credit line) is tiny relative to the world’s $7000 billion in national reserves, or — more importantly — relative to the emerging world’s short-term external debt. The IMF currently lacks enough funds to be a lender of last resort for Eastern Europe, let alone the world. George Soros:

“capital is fleeing the periphery and it is difficult to rollover maturing loans. …. To stem the tide, the international financial institutions (IFIs) must be reinforced … the fact is that the IMF simply doesn’t have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and potential needs are much greater.”

A bigger IMF implies a somewhat larger role for the IMF’s unit of account: the Special Drawing Right (SDR), itself a basket of dollars, euros, pound and yen. When the IMF lends, its loans are denominated in SDR – not dollars, euros or yuan. China may argue that SDR-denominated lending is the first step toward creating a new “supranational” reserve currency. But that is a stretch. No one made such an argument back when the IMF was making a lot of SDR-denominated loans to Asia in the 1990s.

The IMF pools contributions from many countries, so denominating its accounts in a composite of the world’s main currencies make sense. Using the SDR inside the IMF isn’t a threat to the US dollar either. Last I checked, the dollar has somehow managed to maintain its position as the world’s leading reserve currency even though United States’ contribution to the IMF (its quota) is measured in SDR.

Indeed, the SDR – as the IMF explicitly recognizes on its website – isn’t actually a currency.

“The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.”

Countries intervene in the foreign exchange market with dollars and euros not SDR. An IMF loan is just denominated in SDR – so the amount a country has to repay doesn’t change all that dramatically when the dollar moves v the euro. In practice countries actually want to borrow “freely usable currencies” not SDR. In other words, they generally want dollars and euros.

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Leveraged desert real estate (squared)

by Brad Setser Saturday, March 28, 2009

Dubai’s government, which owes its (now diminished) fortune to a leveraged bet on real estate in the Gulf, decided to diversify by, well, making another leveraged bet on desert real estate.

And Dubai World’s investment in Las Vegas’ real estate doesn’t seem to be working out so well

Suffice to say that Dubai would have been better off now if hadn’t sunk $4.3 billion into the troubled Vegas City Center project. It could currently use some of those funds to sort out its own problems.

China v US money market funds

by Brad Setser Thursday, March 26, 2009

China’s purchases of US Treasuries in 2008 (Setser/ Pandey estimate): $245 billion

US money market funds purchases of US Treasuries in 2008, from the flow of funds: just under $400 billion

China’s purchases of US Agencies in 2008 (Setser/ Pandey estimate): $38 billion. That reflects $85 billion in purchases through July, and $47 billion in sales since then …

US money market fund purchases of US Agency bonds: $542 billion

China’s purchases of Treasuries and Agencies in 2008: $283 billion
US money market funds’ purchase of Treasuries and Agencies in 2008: $942b

I am waiting for a round of stories pondering whether money market funds will continue to buy Treasuries and Agencies at their 2008 pace!

US money market funds holdings of Treasuries and Agencies rose by close to 350% in 2008, as their combined Treasury / Agency portfolio rose from from $392b to $1334b. That pace of growth of growth won’t be sustained. The large rise came from a low base.

But money market funds did hold more Treasuries and Agencies ($1357b) at the end of 2008 than China ($1233b) did.

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“This is unquestionably the worst global economic crisis since the 1930s”

by Brad Setser Wednesday, March 25, 2009

So writes Martin Wolf. And despite some signs of hope this morning, he is certainly right.

The IMF’s latest global forecast leaves no doubt on this point. The IMF should be commended for dropping its usually measured language when circumstances, unfortunately, call for candid, vigorous prose. The IMF’s note for the G-20:

“The prolonged financial crisis has battered global activity beyond what was previously anticipated. Global GDP is estimated to have fallen by an unprecedented 5% in the fourth quarter (annualized), led by the advanced economies, which contracted by 7%. GDP declined by around 6% in both the United States and Europe, while it plummeted at a post-war record of 13% in Japan. Growth also plunged across a broad swath of emerging economies … against this backdrop, global activity is expected to contract in 2009 for the first time in 60 years.” (emphasis added)

Both the IMF and World Bank are now forecasting an outright fall in global output in 2009, with a larger contraction than previously forecast in the advanced economies and sharply lower expected growth in the emerging world. I am not sure that even Nouriel Roubini was forecasting an outright fall in global output a year ago. Anything below 2% is generally considered a global recession.

The most visible manifestation of the scale of the downturn continues to come from Asia — with the sharp fall in Asian exports to the world mirroring the sharp fall in global demand. Japan’s exports are now down 50% from last February. The IMF is now forecasting a 6% of GDP contraction in Japan in 2009. That is a contraction of magnitude as emerging economies experience during their crises.

While growth is expected to be stronger in many parts of Asia than in Japan (India and China are expected to be able to find domestic sources of growth), the trade data doesn’t alas, look at that different.

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China’s call for a new international financial system

by Brad Setser Tuesday, March 24, 2009

I spend a lot of time tracking — or trying to track — what China is doing with its reserve portfolio. I consequently tend to interpret the public statement of China’s government through the lens of recent shifts in the composition of its reserves.

And to be honest, China’s recent rhetoric hasn’t tracked its portfolio, best that I can tell. SAFE clearly has increased its holdings of Treasuries over the past few months. China’s visible Treasury purchases have exceeded its reserve growth over the past few months. I am not sure of this is clear evidence that the dollar share of China’s portfolio is rising, as the shift towards short-term Treasuries may simply have increased the share of China’s reserves that show up cleanly in the US data. But it hardly suggests a shift out of the dollar.

I have tended to put more weight on what China has done over the past several months — including pegging tightly to the dollar — than on what China has said over the past few months. But I increasingly think that the apparent rise in the Treasury and dollar share of China’s portfolio may have led me to discount Chinese rhetoric expressing concern about its dollar exposure a bit too heavily.

China’s shift toward Treasuries clearly is a reaction to a legacy of a series of bets that China’s government made back in 2006, 2007 and 2008 that went bad. China hoped to offset the dollar’s depreciation against the RMB with higher returns on its dollar assets. But in general, taking more risk produced lower not higher returns — as Chinese investors bought risky US assets at the wrong time. China also seems to have concluded that its huge Agency bet was a mistake. Scaling down that bet also has meant buying Treasuries in huge quantities.

But China is now — some might argue belatedly — worried about the scale of its resulting exposure to low-yielding dollar assets. Plan A, taking on more credit and equity market risk to offset the dollar’s decline while continuing to add massive quantities of dollars to its reserves, didn’t work. The end result has been more Treasury exposure than China really feels comfortable with; if nothing changes, China soon really will have a $1 trillion Treasury portfolio.* It already has over trillion dollars of Treasuries and Agencies. China consequently does seem to be looking seriously for a Plan B.

PBoC governor Zhou has made that clear by putting a set of serious proposals on the table, proposals that should — and no doubt will — be considered carefully. The hint that China might be interested in multilateral management of a portion of its reserves alone should get attention.

China has tended to argue that it had no choice but to build up dollar reserves so long as the dollar occupied a central place in the global financial system. Analytically, I don’t think this is true — China didn’t have to peg to the dollar, it didn’t have to keep its peg to the dollar at the same rate as the dollar fell from 2002 to 2005 and it didn’t have to limit the pace of RMB appreciation against the dollar in 2005 and 2006. A different set of choices would have produced smaller Chinese current account surpluses and a smaller Chinese reserve portfolio.

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Financial de-globalization, illustrated

by Brad Setser Monday, March 23, 2009

The financial world has changed — even if the scale of the change isn’t obvious in the financial sector’s 2008 bonuses.

Here is one indication of the scale of the change: the US government was — according to the latest US balance of payments data — a large net lender to the world. Yes, a net lender, not a net borrower. Foreign central banks are no longer providing the US with much new credit. Indeed, they withdrew $13.6 billion of credit from the US in the fourth quarter, as central banks’ agency sales ($96b) and the fall in their deposits in US banks (bank CDs fell by $80 billion) produced a net outflow despite record purchases of US treasuries ($179b, all short-term bills). And the US — through the Fed’s swap lines — provided a rather large sum of credit ($268 billion) to the rest of the world. For the year as a whole, the BEA data indicates the US government lent $534 billion to the rest of the world while foreign governments lent “only” $421 billion to the US.

Judging from the data on net flows, Bretton Woods II has in some sense come to an end. The world’s central banks are no longer building up reserves and thus are no longer a net source of financing to the US. It just didn’t end in the way the critics of Bretton Woods II expected — on this, Dooley and Garber are right. The fall in official flows* was offset by a rise in (net) private inflows.

Then again, Bretton Woods II also didn’t anchor a stable international financial system in the way Dooley and Garber suggested either. Both private and official demand for US financial assets has collapsed. Gross inflows are close to zero.

How then can the US still run a large current account deficit if the rest of the world isn’t buying its financial assets? There is only one answer: Americans have pulled funds from the rest of the world (call it deleveraging, call it a reversal of the carry trade or call it a flight to safety) faster than foreigners have pulled funds from the US market. Words cannot really capture the sheer violence of the swings in private capital flows that somehow produced a a rise (net) private demand for US financial assets. The modest change in net flows reflects an enormous contraction in gross flows. Look at the quarterly data — not a rolling four quarter sum — scaled to US GDP.**

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Last week’s move in the Treasury market …

by Brad Setser Sunday, March 22, 2009

When financial historians get around to writing the history of the great crisis of 2008 (or great crisis of 2007-09?), they will no doubt focus on the collapse of the market for securitized mortgages — and in reality, almost all forms of credit risk. The corollary of that fall, though, has been the rise in the price — and fall in yields — of comparatively safe financial assets. And US Treasuries are still considered safe.

The first year of the crisis was marked by three upward spikes in the price — and sharp falls in yield — of short-term Treasury bills: one in August 2007 (subprime, quant funds), one in the spring of 2008 (Bear) and one in September 2008 (Lehman, AIG, Merrill and in all probability nearly every other financial institution but for the extension of a government backstop to the system).

The ten year Treasury bond didn’t really rally until late November, well after Lehman. It then soared (i.e. yields fell) in late 2008 before selling off this year — before the Fed stepped in.

My guess is that gyrations in the ten year bond will mark the next stage of the crisis. Bank bailouts — and counter-cyclical fiscal policies — are very expensive. Last week the CBO confirmed what students of Reinhart and Rogoff already suspected. But the Fed rather clearly doesn’t want yields on the ten-year to head back to the 3.5-4.0% range of early last fall. Not when the economy is weak.

Christoph Schmidt is concerned about the risk of future inflation in the US. But the Fed — like Jan Hatzius of Goldman and Dr. Hamilton of UCSD — is far more worried about the immediate risk of deflation. And with so much spare capacity globally, I tend to agree with the Fed. German industrial production is now down over 20% y/y. Eurozone output is now almost 20% below its level a year ago. And parts of Asia — like Taiwan — are in even worse shape.

Did the Fed bail out China by buying Treasuries?

by Brad Setser Friday, March 20, 2009

No. Not really. At least not in the sense that is usually argued. China has no need to sell foreign assets like Treasuries to finance its domestic fiscal stimulus so long as it is running a large external surplus.

But China could use a large buyer for some of its Agencies. Now it has one. Though here the Fed isn’t so much bailing China out as substituting for the falloff in Chinese and other central band demand.

And I would be curious to know if China is worried by the latest bout of dollar weakness or relieved that a weaker dollar is pulling the RMB back down. China’s biggest financial exposure isn’t to the equity market, it is to the dollar. It thus benefits financially from dollar strength. But a strong dollar also doesn’t exactly help China’s exporters. And exporters have long driven China’s policy choices.

Let’s start with the first point. Does China — as Felix’s correspondent implies — need to sell Treasuries to finance its fiscal stimulus?

The simple answer is no, it doesn’t.

Foreign exchange reserves can finance a current account deficit or a capital outflow. Foreign assets aren’t needed to finance a fiscal stimulus. The US is a case in point; it has financed a large fiscal deficit by selling dollar-denominated bonds — not by selling off its reserves. China would only need to draw on its foreign exchange reserves to cover its fiscal deficit if its fiscal deficit led to a trade and current account deficit.

And China no need to worry there. It isn’t Russia — a country that looks set to run both a fiscal and a current account deficit this year, and thus will need to draw on its reserves to meet the balance of payments needs associated with its fiscal deficit.*

Don’t take my word. Read the World Bank’s latest China Quarterly. Thanks to David Dollar, Louis Kuijs and the rest of the staff of the Beijing office, it remains the best single source for analysis of macroeconomic trends in China.

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