Few topics are quite as polarizing as the “savings glut.” The very term is often considered an attempt to shift responsibility for the current crisis away from the United States.

That is unfortunate. It is quite possible to believe that the buildup of vulnerabilities that led to the current crisis was a product both of a rise in savings in key emerging markets, a rise that — with more than a bit of help from emerging market governments — produced an unnatural uphill flow of capital from the emerging world to the advanced economies, and policy failures in the U.S. and Europe.

The savings glut argument was initially put forward to suggest that the United States’ external deficit was a natural response to a rise in savings in the emerging world – and thus to defuse concern about the sustainability of the United States’ large external deficit. But it was equally possible to conclude that the rise in savings in the emerging world reflected policy choices* in the emerging world that helped to maintain an uphill flow of capital – and thus that it wasn’t a natural result of fast growth in the emerging world. This, for example, is the perspective that Martin Wolf takes in his book Fixing Global Finance. Wolf consequently believed that borrowers and lenders alike needed to shift toward a more balanced system even before the current crisis.

From this point of view, the savings glut in the emerging world — as there never was much of a global glut, only a glut in some parts of the world — was in large part a result of product of policies that emerging market economies put in place when the global economy — clearly spurred by monetary and fiscal stimulus in the US — started to recover from the 2000-01 recession. China adopted policies that increased Chinese savings and restrained investment to try to keep the renminbi’s large real depreciation after 2002 – a depreciation that reflected the dollar’s depreciation – from leading to an unwanted rise in inflation. The governments of the oil-exporting economies opted to save most oil windfall – at least initially. Those policies intersected with distorted incentives in the US and European financial sector – the incentives that made private banks and shadow banks willing to take on the risk of lending to ever-more indebted households (a risk that most emerging market central banks didn’t want to take) to lay the foundation for trouble.

On one point, though, there really shouldn’t be much doubt: savings rates rose substantially in the emerging world from 2002 to 2007. Consider the following chart – which shows savings and investment in emerging Asia (developing Asia and the Asian NIEs) and the oil exporters (the Middle East and the Commonwealth of independent states) scaled to world GDP.

Investment in both regions was way up. But savings was up even more.

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On Friday I tried to show why the US net international investment position deteriorated in 2008 – and also why it didn’t deteriorate in the previous years. Even after the market and currency gains of the past evaporated in 2008, the US net debt isn’t quite as big as an analyst who looked at the United States large cumulative current account deficit would expect. Some of the debt that the US thinks it sells to the rest of the world every year seems to disappear when the US goes out and tries to count the total amount owes the world – and how much equity in US companies have been sold to foreign investors.*

Yet even if the US data doesn’t show quite as much debt as it probably should, it still tells a lot going about what was on in the US – and the global – economy in the run up to the crisis.

It is consequently tempting to try to do a bit of forensic accounting to help understand how vulnerabilities built up. One thing quickly becomes clear. The US was piling up external debts in the run-up to the crisis even if the United States’ net international investment position wasn’t deteriorating.

The data in the NIIP can be disaggregated into debt and equity fairly easily. It is also fairly easy to separate out net official and net private claims. There isn’t a separate breakout for “official” investments in equities – as central bank and sovereign funds’ equity investments are aggregated together with their investments in US corporate bonds. But the US survey data indicates that official holds of equities were over three times official holdings of corporate bonds in the middle of 2008, so I don’t feel too bad considering “other official assets” a proxy for central bank and sovereign funds’ investment in US equities.

But don’t get bogged down in the details. There is no doubt that the US was clearly racking up debts to both official and private creditors in the run up to the crisis. Net US external debt (US borrowing from the world, net of US lending to the world) is now close to 40% of US GDP — a fairly high level for a country with a modest export sector.

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For a long time, large US trade and current account deficits didn’t push up the total amount the United States owed to the world, at least not if the market value of US investment abroad was netted against the market value of foreign investment in the US. The net international investment position of the US stayed around negative $2 trillion even as the US chalked up $500 billion, $600 billion even $700 billion annual deficits, defying those who projected that rising deficits would put the US external debt on an unsustainable trajectory.

Why? The euros’ rise pushed up the value of US investments in Europe. The US external position actually benefits from a falling dollar, as most US liabilities are in dollars while many US assets are not. And foreign equities did better than US equities.

Those who argued that the US was attracting funds because it was the best place in the world to invest generally forgot to note that during the period when the US deficit was rising the US was consistently doing better on its investments abroad than foreigners were doing on their investment in the US.

That changed in 2008. The US borrowed $505 billion from the world.* The dollar’s rise reduced the value of US investment abroad by $685 billion ($583 billion without including direct investment). Foreign portfolio equity investments in the US fell in value by about $1.3 trillion. But US portfolio equity investments abroad fell in value by about $1.9 trillion. Add in changes in the value of US and foreign bonds and changes in market prices reduced the value of US portfolio investment abroad by $720 billion more than the changes in market prices reduced the value of foreign portfolio investment in the US. The size of that total losses rises if changes in the market value of US and foreign direct investment are also factored in. All told, changes in market prices (other than exchange rate changes) led to a $1.7 trillion deterioration in the United States net investment position.

Combine those valuation changes with ongoing US borrowing and the net international investment position deteriorated in a rather dramatic fashion. The US NIIP — the blue line in the following graph — deteriorated by $2.5 trillion if FDI is valued at market prices.

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Central banks haven’t lost their appetite for Treasuries. At least not shorter-dated notes. John Jansen noted before yesterday’s 2-year auction “the central banks love that sector [of the curve].” And the auction result certainly didn’t give him cause to backtrack. Indirect bids — a proxy for central banks — snapped up close to 70% of the auction. Jansen again:

The Treasury sold $ 40 billion 2 year notes today and the bidding interest from central banks was frantic. The indirect category of bidding ( which the street holds is a proxy for central bank interest) took 68 percent of the total. That leaves about $ 13 billion for the rest of us.

Central banks also seem increasingly interested in five year notes. Indirect bids at today’s five year auction were quite high as well.*

Strong central bank demand for Treasuries shouldn’t be a real surprise. Reserve growth picked up in May: look at Korea, Taiwan, Russia and Hong Kong. There are even rumblings – based on the data that the PBoC puts out — that Chinese reserve growth picked up as well. The rise in reserve growth fits a long-standing pattern: emerging markets tend to add more to their reserves — and specifically their dollar reserves — when the euro is rising against the dollar. A fall in the dollar against the euro often indicates general pressure for the dollar to depreciate — pressure that some central banks resist (Supporting charts can be found at the end of a memo on the dollar that I wrote for the Council’s Center for Preventative Action).

And the Fed’s custodial holdings (securities that the New York Fed holds on behalf of foreign central banks) have been growing at a smart clip. Recent talk about a shift away from a dollar reserves by a few key countries actually coincided with a surge in the Fed’s custodial holdings. Over the last 13 weeks of data, central banks added $160 billion to their custodial accounts, with Treasuries accounting for all the increase.

$160 billion a quarter is $640 billion annualized — a pace that if sustained would be a record. Of course, $640 billion in central bank purchases of Treasuries would still fall well short of meeting the US Treasuries financing need. The math only works if Americans also buy a lot of Treasuries. That is a change.

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Japan’s exports to China are still way down on a y/y basis in May, despite China’s stimulus.

Shipments to China, Japan’s biggest trading partner, fell 29.7 percent, more than April’s 25.9 percent. Exports to Asia slid 35.5 percent from 33.4 percent a month earlier.

hat tip, Yves Smith of Naked Capitalism.

That isn’t good news. US exports to China are also down (15.6% y/y, through in the first four months of 2009, though a bit less in April itself). The eurozone’s exports to China are also down — though the 8% or so fall y/y fall in the eurozone’s exports to China seems a bit more modest than the fall in Japan’s exports to China.

China’s economy may have expanded over the last year, but that expansion clearly hasn’t fed through into more Chinese demand for US, European or Japanese goods.
Not yet at least. Pick your explanation. China’s stimulus may have been directed at domestic producers. The process of substituting Chinese components for Japanese components in China’s exports may be accelerating. Or China’s recovery just may not be quite as robust as some believe.

The best that can be said of Japan’s May trade data is that Japan’s exports to China aren’t down as much as Japan’s exports to the US and Europe.

Shipments to the U.S. fell 45.4 percent in May after dropping 46.3 percent in April, the ministry said. Exports to Europe slid 45.4 percent from 45.3 percent.

The y/y comparison will get more favorable soon. But there is now real way to put all that positive gloss on Japan’s 41% year over year fall in exports. It is an epic fall.

Japan’s May 2009 exports were even a bit lower than its April 2009 exports. There may be some benign explanation for the slight dip in May, but I don’t think there is any way to suggest that the Japan’s May trade data suggests a robust global recovery.

Now that the markets have lost a bit of their froth, it seems fitting to note just how sharply trade — and private financial flows — have contracted over the past year. The US q1 balance of payments data is rather stunning.

Trade (as we all know) contracted far more rapidly during this cycle than in the past.

But the fall in private financial flows — outflows as well as inflows — has been even sharper than the fall in trade flows. US private investment in the rest of the world rebounded a bit in the first quarter, but private demand for US financial assets remained in the doldrums. Private investors were still pulling funds out of the US in the first quarter.

A close examination of the graph indicates that demand for US financial assets by private investors abroad actually peaked in the second quarter of 2007 — a peak that came after gross private flows (inflows as well as outflows) rose strongly in 2005 and 2006. That surge was — in my view — linked to the chain of risk associated with a world where central banks took the currency risk associated with financing the US external deficit and private intermediaries took the credit risk associated with financing ever more indebted US households.

Any interpretation of what caused the crisis has to explain this surge. But any interpretation of the crisis also needs to explain why US imports and exports continued to rise — and the US trade and current account deficit remained large — even after private inflows collapsed.

I suspect that part of the answer is that a lot of private inflows were linked to private outflows — as special investment vehicles operating in say the US could only buy long-term US mortgage bonds if someone in the US bought their short-term paper. The fact that private outflows collapsed along with private inflows meant that net private flows didn’t fall at the same rate. Indeed, at times – notably in q4 2008 — the fact that US investors pulled funds out of the rest of the world faster than foreign investors pulled funds out of the US provided the US with a significant amount of net financing.

And part of the answer is that private investors never were the only source of financing for the US current account deficit. Strong central bank demand — especially in late 2007 and early 2008 — offset a fall in private flows.

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The good news in the latest World Bank China Quarterly:

One. China is growing, thanks to China’s government. The World Bank estimates that the government’s policy response will account for about 6 percentage points of China’s 7.2% forecast growth (p. 8). That’s good. There is a big difference between growing as 7% and growing at 1%. This was the right time for China’s government to “unchain” the state banks. Ok, it would have been better if China had allowed its currency to appreciate back in late 2003 and early 2004 to cool an overheated economy instead of imposing administrative curbs on bank credit and curbing domestic demand. Then China might not have ever developed such a huge current account surplus and avoided falling into a dollar trap. But better late than never: this was the right time to lift any policy restraints on domestic demand growth.

China has, in effect, adopted its own version of credit easing. It just works through the balance sheets of the state banks rather than through the balance sheet of the central bank. Andrew Batson:

By some indicators, credit in China is even looser than in the U.S., where the Federal Reserve has extended unprecedented support to private markets. … China’s methods for pumping cash into the economy are quite different from those of other major economies. Its banks, almost all of which are state-owned, made more than three times as many new loans in the first quarter as a year earlier. Central banks in the U.S., Europe and Japan lack such control over lending, and have instead used extremely low interest rates and direct purchases of securities to support credit.

Two. China’s fiscal deficit will be closer to 5 percent of GDP rather than 3 percent of GDP. That’s cause for celebration in my book. Last fall I was worried that the desire to limit the fiscal deficit to three percent of GDP would mean that there was less to China’s stimulus than met the eye (or hit the presses). I was wrong. If the likely future losses on the rapid expansion of bank credit are combined with the direct fiscal stimulus, China almost certainly produced a bigger stimulus program than any other major economy.

Three. China’s current account surplus is now projected to fall in 2009. Exports still haven’t picked up — and we now have data through the first five months of the year. Imports by contrast are starting to pick up. That shows up clearly in a chart of real imports and real exports, a chart that draws on data that that the World Bank’s Beijing office generously supplied me:

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The fall in China’s recorded Treasury holdings in April has attracted a fair amount of attention. Too much, in my view. Best that I can tell, China shifted from bills to short-dated notes in April rather than actually reducing its overall Treasury portfolio. It just so happens that China buys all its short-term bills in ways that show up in the US TIC data, but only a fraction of its longer-term notes in ways that show up in the US TIC data. A shift from bills to notes then could register in the US data as a fall in China’s total Treasury holdings and a rise in the UK’s holdings.

This is actually a well established pattern. The past five surveys of foreign portfolio investment in the US have all revised China’s long-term Treasury holdings up (in some cases quite significantly) even as they revised the UK’s holdings down. The following graph shows the gap between Chinese long-term Treasury purchases in the TIC data and China’s actual purchases of long-term Treasuries– as revealed in the survey. With the help of Arpana Pandey, I have smoothed out the impact of the survey revisions. But when there is a hard data point — say June 2006 — the y/y increase in China’s Treasury holdings in the adjusted series should match the increase in the survey.

The last survey data point though comes from June 2008, so the subsequently data includes some estimates — specifically estimates of the share of the UK’s Treasury purchases that should be attributed to China. I am pretty confident though that it is no more inaccurate than the published US TIC data, which systematically under counted Chinese purchases of long-term bonds over the last five years

Here are three signs to watch to know when China really is reducing its US holdings.

First, the TIC data should show a fall in China’s holdings, i.e. net sales of Treasuries.

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Events in Iran (rightly) dominate the headlines, along with the Obama Administration’s plans to revamp the United States’ system of financial regulation.

And it doesn’t take much to overshadow the release of the United States’ balance of payments data, as it largely tells us things that we already know — whether from the trade data (the trade deficit is way down) or the TIC data (private investors didn’t put much money in the US in q1).

But there are still stories to be found in the balance of payments data. Give the US a bit of credit. No other country releases as much detail about its balance of payments as the United States. Play with the interactive tables for a while; it is hard not to be impressed.

I have a particular reason to pay attention to those details. I have long argued — actually screamed at the top of my lungs to anyone who would listen — that central banks and sovereign funds were the main source of financing for the US current account deficit from the start of 2007 to the fourth quarter of 2008. And at long last, I can now point to a genuine official data release to support my argument. The BEA (finally) revised its estimates for official inflows over this period. Guess what? The BEA now thinks that official inflows are a lot higher than they used to be.

Total inflows — according to the revised data — peaked at around $700 billion in third quarter of 2008. That fits what we know about global reserves far better than the unrevised data; the enormous increase in the pace of reserve growth dominated in change in the dollar’s share of total reserves. Studies that use the unrevised data — essentially any study that works off the monthly TIC data series — to argue that the fall in central bank inflows after 2004 had no impact on yields so central banks had no impact on the market need to be revised. It turns out that there really was no sustained fall off in central bank demand for US assets. The recent $700 billion peak easily exceeds the $400 billion 2004 peak.

A lot of ink has been spilled analyzing whether the recent crisis has reduced US global power. That framing though misses a key point, namely, that the pre-crisis world — one where the US relying ever more on a small set of governments to finance a large trade deficit — wasn’t exactly on a favorable trajectory for the United States.

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I highly recommend Anton Brender and Florence Pisani’s recent monograph, “Globalized finance and its collapse.” In a lot of ways, it is something that I wish I could have written. I don’t agree with every detail, but in my view they get the broad story right.

Brender and Pisani both teach at Paris-Dauphine. But Anglo-Saxon chauvinism shouldn’t get in the way of appreciating quality work. And in this case, there is no excuse: the translation (by Francis Wells) is superb.

In some deep sense, Brender and Pisani have updated the core arguments of Martin Wolf’s Fixing Global Finance (also highly recommended) to reflect many of the things what we all have learned in the last nine months of crisis.

Like Martin Wolf, Brender and Pisani recognize that globalization took an unusual turn over the past several years: the globalization of finance resulted in a world where the poor financed the rich, not one where the rich financed the poor. And what’s more, this “uphill” flow was essentially a government flow. Despite the talk of the triumph of private markets over the state a few years back, the capital flow that defined the world’s true financial architecture over the past several years was the result of the enormous accumulation of foreign exchange reserves in the hands of the central banks of key Asian and oil-exporting economies.

Dooley and Garber recognize this. They don’t pretend that private investors in the emerging world drove the uphill flow of capital. But Dooley and Garber also assert that there is no connection between this uphill flow and the current crisis. In a March Vox EU piece they wrote:

“We have argued that the decisions of governments of emerging markets to place an unusually large share of domestic savings in US assets depressed real interest rates in the US and elsewhere in financial markets closely integrated with the US … Low risk-free real interest rates that were expected to persist for a long time, in the absence of a downturn, generated equilibrium asset prices that appeared high by historical standards. These equilibrium prices looked like bubbles to those who expected real interest rates and asset prices to return to historical norms in the near future … Along with our critics, we recognised that if we were wrong about the durability of the Bretton Woods II system and the associated durability of low real interest rates, the decline in asset prices would be spectacular and very negative for financial stability and economic activity … This is not the crisis that actually hit the global system. But the idea that an excessive compression of spreads and increased leverage were directly caused by low real interest rates seems to us entirely without foundation.” Emphasis added.

It actually isn’t that hard to find examples of how low returns on “safe” investments induced more risk-taking throughout the system, especially private intermediaries started to believe in the essential stability of Bretton Woods 2. The Wall Street Journal recently reported that many bond funds underperformed their index in 2008 because their managers had been taking on more risk to juice returns in the good years, and thus went into the crisis underweight the safe assets that central banks typically hold. US money market funds that lend ever-growing sums to European commercial banks were making a similar bet. As were the European banks that relied on wholesale funding to cover their growing portfolios of risky dollar debt. The inverted yield curve forced vehicles that borrow short and lend long to either go out of business or take ever more credit risk — and as volatility fell and spreads compressed, there was a constant temptation to take on more leverage to keep profits up. The pressures to take more risk were there.

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