Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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Not just emerging markets

by Brad Setser
June 3, 2009

Dani Rodrik:

“Foreign borrowing can enable consumers and governments to live beyond their means for a while, but reliance on foreign capital is an unwise strategy. The problem is not only that foreign capital flows can easily reverse direction, but also that they produce the wrong kind of growth, based on overvalued currencies and investments in non-traded goods and services, such as housing and construction.”

Rodrik was writing about the challenges facing developing countries looking for strong, sustained growth. But it is hard not to hear echoes of the United States experience over the past several years in his description. The influx of foreign funds that financed the widening of the US trade deficit during the last cycle clearly financed more than its share of “investments in non-traded goods and services, such as housing and construction.”

The combination of low US rates and the depreciation of the dollar and the renminbi from 2002 to 2005 led to a surge in investment in tradables production in China — China’s exports rose from around $270b in 2001 to over $1400b in 2008, a truly stunning increase that required enormous investment — and a surge in residential construction and household borrowing in the United States.

The unique feature of the United States’ foreign borrowing is that the United States was borrowing, in no small measure, from other countries governments. Especially Asian central banks resisting pressure for their currencies to appreciate and the treasuries of the oil-exporting economies. Yes, there was a lot of borrowing from entities in London, but a lot of those entities themselves borrowed from US banks and money market funds. They weren’t generating large net inflows. And all the net inflow from the emerging world came from their governments, not private investors.*

That insulated the United States from the kind of capital flow reversals that traditionally plague emerging economies. Central banks have provided the US with more financing when private flows have fallen off, keeping overall flows (relatively) stable. That was especially true in 2006, 2007 and early 2008 — back when private money was pouring into the emerging world. And it seems true once again. The strong rise in central banks custodial holdings at the Fed in May is almost certainly offsetting a fall in private demand for US assets. That is why the custodial holdings are up and the dollar down. Paul Meggyesi of JP Morgan, in an interesting note today:

“Central banks which control their currencies against the dollar are in some sense forced to take the opposite side of private trade and capital flows … we are [currently] witnessing is a resumption of both global trade flows and risk-taking by US investors, who are re-entering those foreign markets which they were quick to exit as the global economy sunk last year. The result is that the US private sector balance of payments is deteriorating. Central banks are attempting to offset this by buying a greater quantity of dollars … “

The United States benefits from this pattern, to be sure. It hasn’t faced the kind of destabilizing swings in net capital flows that other large borrowers have encountered.

But this stabilization has a price. It has left countries like China holding more dollars than they really need (or want). That itself is a risk, as the markets increasingly realize. Especially now that private money is now almost certainly flowing back into China, forcing China to add to its-already-large (too large) dollar stockpile.

And — at least in the past — it also allowed the US to avoid necessary adjustments. It, for example, is one reason why the housing and construction and consumption boom went on for as long as it did.

*The IMF’s data on this is clear. Private investors were moving money into the emerging world not out of the emerging world. This is especially clear if you adjust the 2006 data for the surge in “private” outflows from Chinese state banks investing SAFE’s money abroad. The outflow from the emerging world was all an official flow, and the magnitude of the official outflow exceeded the emerging world’s current account surplus.


  • Posted by Glen M

    Hmm… Regardless of how many diet candies I eat, I still cannot loose weight.

  • Posted by Csco

    “The unique feature of the United States’ foreign borrowing is that the United States was borrowing, in no small measure, from other countries governments.”

    So where can we see what proportion of U.S. borrowing was borrowed from where. Say, for every trillion the U.S. (consumer, government, whatever) has borrowed, what is the rough breakdown of where that money has come from? We constantly hear that China is America’s creditor, but in the scheme of the giant numbers thrown around even pre-dating 2009 it’s clear there are boatloads of money coming from other sources.

  • Posted by guest

    It may have become more transparent when US banks found funding from abroad more difficult and had to rely on public fund (in markets parlance they call it a meltup)
    They are many countries besides the USA that are showing the same funding gap and worrying concern.

  • Posted by ReformerRay

    Finanical flows, in and out, of the U.S. is a complicated business. In flows may be lending but they also may be purchase of assets other than debt. Out flows may be paying for debts or they may be purchses of assets existing in foreign countries. The outflows paying for debts may be paying for a trade deficit or they may be redemning a U.S. Treasury bond that has come due.

    We have gross flows and net flows. The U.S. is lending money at the same time it is borrowing money. Both flows are important and may, to some degree, offset each other.

    Then there is the net result of all these flows (of both financial assets and goods and services) which is the level of ownership of U.S. assets by foreigners minus the level of ownership of foreign assets by U. S. citizens. This is the Net International Investment Position, which has been growing against the U.S. each year by the amount of the U.S. Current Account. However, yearly adjustments to that amount in terms of changes in inflation and the trade weighted value of the dollar (plus a third, other, category) just happen to work in favor of reducing size of the net loss to the U.S. (for the last several years).

    Borrowing is important because a debt must be repaid. However, in another sense, it is the net effect of all this in terms of asset ownership that is ultimately more important. Ownership of U.S. assets can always be translated into debt by exchanging the U.S. asset for U.S. bonds.

    Ownership of financial assets in the U.S. can only grow by selling goods and services to the U.S.

    So, focus on the trade deficit, reduce the trade deficit, and soon all these other issues will be resolved. The Net International Investment Position will be improved and net borrowing will be reduced.

  • Posted by bsetser

    Csco — I’ll do post on this after the q2 bop data revises official and private inflows for the mid 07 to mid 08 period to reflect the last survey. broadly speaking, all foreign purchases of treasuries and agencies since 03 have come from central banks, with the exception of some recent tbill purchases. that isn’t quite true for the -07 to 08 period, but i suspect some “private” purchases of treasuries then should be attributed to gulf oil exporters (esp the Saudis) who use outside fund managers for even fairly simple things.

    i would compare official purchases of all long-term us assets to total purchases. some foreign purchases of long-term corp bonds during the boom were financed by s-term borrowing, so it is an imperfect measure if you want to net out roundtripping. official flows can also be compared to the current account deficit, as can my estimates of dollar reserve growth.

  • Posted by ReformerRay

    Opps – my mistake – Please add the word “Net” at the beginning of the sentence in the above post that says “Ownership of financial assets in the U.S. can only grow by selling goods and services to the U.S”.

  • Posted by FollowTheMoney

    The world needs Regional Central Banks, not nation state central banks to deal with our imbalances.

    as the world integrates and becomes more globalized all these imbalances can only be shifted by dismantling the current framework.

    my proposal, over the next 20 years would be to have the following major central banks.

    S.A.CB=Central Bank of South America
    N.A. CB=Central Bank of North America
    ECB=Central Bank of Europe
    ASIA CB=Central Bank of Asia
    CB-India=Central Bank of India
    CBME=Central Bank of the Middle East
    CBA=Central Bank of Africa

    Perhaps this structure would be better in the long run to avoid the imbalances or nation state central banks?

    This will take a very long time, but it is a suggestion. The world would need some major currency consolidation, perhaps starting with regional monetary currencies.

    The global reserve could then be unit made up of the 7 Regional Currencies, where the percent of the currency would be based on the regions GDP.

    Is this a dream? Perhaps? But it would help solve many problems.

  • Posted by L

    This is a really interesting idea that you are pointing out. Essentially before the crisis the other governments buying the US debt balanced the deficit outflows from investors, imports,etc.

    When the crisis hit, we all know the outflows reversed and thus the US dollar went up, the US debt yields went down.

    What has changed? Currently world governments no longer have the ability to buy the US debt at the levels of once before.

    Is this why we are seeing that when the money flows to riskier assets as in a mild recovery, it is amplified especially in emerging markets?

    There is no longer other governments countering the outflows to balance the deficit as once before. Should be a way to confirm this.

  • Posted by ReformerRay

    Follow the money says: “The world needs Regional Central Banks, not nation state central banks to deal with our imbalances”.

    Unnecessary. The way to deal with our imbalances is for trade deficit countries to impose tariffs on all imports from those countries that maintain large trade balances (surpluses) with them.

  • Posted by DJC

    Former Treasury Secretary Robert Rubin initiated the economic policy of “US Dollar hegemony”. The petrodollar recycling of oil revenue from US military projection power backed Gulf Arab Oil State regimes artifically overvalues the US Dollar versus every major traded currencies. The US current account deficit is offset by the capital account surplus with petrodollars recycled through Citicorp and other Wall Street banks. Including the Chinese, everyone needs US Dollars because only US Dollars can be used for the purchase of the strategic commodity oil. The petrodollar reserve currency status of the US Dollar is the issue that needs to be addressed.

  • Posted by DJC

    To be sure, China is still piling up those dollar-denominated bonds. Deutsche Bank recently predicted that Chinese reserves will rise by only $100 billion this year, compared with $418 billion last year. You don’t need a Nobel prize in economics to know that $100 billion won’t finance much of a $1.84 trillion deficit.

    We know pretty much what Treasury Secretary Timothy Geithner is hearing in Beijing this week because the Chinese have been grumbling about American profligacy for months. “We have lent a huge amount of money to the United States,” Wen declared in March. “Of course we are concerned about the safety of our assets. To be honest, I am a little bit worried.” Soon after that, on the eve of the G20 Summit in London, the Chinese central bank governor Zhou Xiaochun proposed that the US dollar might eventually be replaced as the world’s main reserve currency.

    “The United States is making policy decisions purely according to domestic considerations and is giving little thought to the outside world,” complained Zhang Ming, an economist at the Chinese Academy of Social Sciences, in April. “This being so, the Chinese government should prepare its defences. We can keep buying US debt but we have to attach some conditions.”

  • Posted by DJC

    Quote of the Week from Luo Ping:

    Luo Ping, a director-general at the China Banking Regulatory Commission, put it nicely in an interview back in February: “Except for US Treasuries, what can you hold? US Treasuries are the safe haven. For everyone, including China, it is the only option. We hate you guys. Once you start issuing $1 trillion to $2 trillion [of bonds] we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.”

    “We hate you guys?” Now that really does have the ring of marital breakdown. Let’s hope Mr Geithner is good at ducking crockery. Like divorces, major shifts in the balance of power are seldom amicable.

  • Posted by Rien Huizer

    If the US were a natural person, he/she would be borrowing from the emerging gvts/cbs and using the money for his/her consumption and to invest in the emerging stock markets. It does make sense, but you have to work on it.

  • Posted by Rien Huizer

    If the emerging governments would ban US investors from their markets, they would have to lend less to the US and more to spend in their own stock markets, right?

  • Posted by bsetser

    rien — they would have less to lend to the us, but no less to spend domestically (either in their own stock markets or on other things). Countries with current account surpluses could spend more at home (or invest more in the local stock market) by scaling back their reserve growth, running larger fiscal deficits/ smaller surpluses or borrowing to buy stocks and spurring more domestic investment.

    tis the difference between reserve growth financed by capital inflows and reserve growth financed by a current account surplus.

  • Posted by Alan Murdock

    Brad writes: “The unique feature of the United States’ foreign borrowing is that the United States was borrowing, in no small measure, from other countries governments.”

    Most of this post seems to address sovereign debt. I’m not sure to what extent flows are fungible and there was meaningful distinction between AAA-rated USD-denominated varieties of paper, whether Treasuries, Agencies or Hocus-Pocasies.

    Chris Whalen’s shop, IRA, put up an interview with a German bank analyst the other day. I think it’s fascinating with regard to interaction between “state” and “private” sectors. The whole thing is well worth a read, here are some teasers.

    Hans-Joachim (“Achim”) Dübel: “Individual banks, such as WestLB, LBBW, BayernLB, HSH Nordbank sit on high double-digit € billion exposure positions. Compare these pictures to peak outstandings of US high-risk markets in €, e.g. Subprime RMBS of € 575 billion in 2007, and you get an idea about to what extent the Landesbanken funded Wall Street. Take all high-risk securities markets at peak levels together – from leveraged loan CLOs to Alt-A RMBS, and I think we are looking at some 15% of the Buy Side demand.” (((I think it’s safe to assume what’s now called “high-risk” was originally marketed as AAA, no?-AM)))

    “The irony of the Landesbanks is that they did not lose a penny on investments and loans Germany. All of the losses were caused by investments in foreign assets, primarily from the US. The overhang of assets was caused by the failure of the EU Commission to limit debt issuance by the German banks. Thus the question came: where to put the money raised via the issuance of debt? The US was the choice. Had there been a capital markets boom in China, the Germans would have invested there instead. The choice of asset selection was completely opportunistic and engineered by Wall Street. Don’t forget that many other nations in Asia and the Middle East were given the same treatment by the American banks….

    “Everybody knows the Iceland story, but few know that, for example, basically all of the banks in Düsseldorf went bankrupt in the crisis. My suspicion is that they all talked to the same investment bankers on road shows….

    “The salient point is that there was only a time limit set in the agreement, but there was no volume limit, so the German state banks started to issue massive amounts of state-guaranteed debt after 2001. This money was not used to finance German or even European lending but simply to park funds in investment vehicles and make more money on it to boost their bottom lines.”

  • Posted by Rien Huizer


    Sounds like you think there is something unusual about Landesbanken making bad investment decisions. Not true, this is what they have been doing all along. There has not been a dumb way to lose “public” money that they have not been involved in. Real estate, various kinds of stupid bonds, derivatives, you name it. If you worked for an investment firm, these were ideal customers. Sophisticated and able to understand complex structures. Given the right introduction of course.

    But what is the relevance for this topic? Germany is neither an emerging market nor a deficit country. It is just full of financial people that are expected to perform miracles and regularly do, as you noticed.

  • Posted by guest

    Whilst departing from the core subject but remaining,within the boundaries of finance and society.
    The financial industry of yesterday, has been praised for its illusory contribution to the states coffers,as commandited by the states and the central banks to contribute to capital inflows and capital gains.The same industry is now thrown to the bonfires of debauchery,pilfrages, robberies and accused to be self indulgent and arrogant.

    On the subject of society, the templars military and religious orders 12/14 c were the messengers of Christianity and mandated to and distribute the spirit of religion to the heretics.They came back very rich and more arrogant at the time when the coffers of Philippe le Bel (king of France 12 Ce) were depleted.
    A failed between the order of the Hospitaliers and the Templars was the pretext given to Philippe le Bel to put 130 Templars in the bonfires and confiscate their wealth.
    If the finance industry is far from close to the templars and could be with merits of its own,thrown to the bonfires, the governments of today need to find late culprits (fiscal paradises, finance industry) and replenish their coffers. Civilisation may change but the spirit,will remain.

  • Posted by DJC

    Asian Economies and China to decouple from US Economy within 5 years

    No, I don’t have any inside information, but I believe that China and other Asian countries will decouple from the United States during the next five years, partly because the American economy will remain moribund, partly because American policy will continue to be incompetent, and partly because their own domestic market and financial systems will be able to bear the burden. Regional cooperation among Asian currencies passed a major milestone on May 3, as the Far East Economic Review reported yesterday.

    Less important than the specifics of the agreement is the fact that it includes all the countries of the region. This is a major challenge to the International Monetary Fund, which always objected to a regional Asian initiative outside its purview, as well as to the United States.

    The Asian exit from the dollar will be turtle-slow and gradual. China and Japan between them have nearly $2 trillion worth of US Treasury securities and will do nothing to jeapordize their existing investment. But the collapse of governance in the United States and the Obama administration’s response have turned the US into a zombie economy, and the dollar into a zombie currency.

  • Posted by Howard Richman


    Great quote from Rodrik at the top of your posting. You are correct that it applies just about as well to the United States as to developing countries.

    But I read the rest of Rodrik’s piece. Rodrik goes on to misdescribe China’s development strategy as being economic diversification, but that is only part of the story.

    The other part is mercantilism. The loans that they made to the United States suppressed Chinese consumption while enhancing Chinese investment in tradable goods production. At the same time, they enhanced American consumption while suprressing investment upon tradable goods production in the US.

    We called China’s strategy “Dollar Mercantilism” in our 2008 book Trading Away our Future.