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Today’s balance of payments release was overshadowed …

by Brad Setser
June 18, 2009

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.

current-account-q1-09-1

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.

The same data can be examined as a quarterly series. Central bank and sovereign fund purchases of US financial assets exceeded the current account deficit from q4 2007 to q2 2008.*

current-account-q1-09-1b

True maestros of reserve tracking know that the sharp fall in central bank demand for US assets in q3 2007 (the first quarter of the crisis) is a bit puzzling, as the IMF’s data doesn’t show any fall off in reserve growth in that quarter.** The big fall in q4 2008 though is no mystery, as it matches the IMF’s data showing a sharp fall in global reserves.

The details of the balance of payments data are also interesting. Take table 5, for example. It provides a regional breakdown of central bank and sovereign fund purchases of US assets. And by playing with the data on China (from Table 12), I can estimate of the US assets purchased by China’s central bank (I subtract clearly private purchases from the total). And by subtracting China’s estimated purchases from Asia’s total purchases of US assets, I can get a number for the rest of Asia as well. This methodology isn’t perfect. But it leaves ittle doubt that China drove the rise in overall reserve growth in late 2007 and early 2008.

current-account-q1-09-3

And what are central banks buying? Right now, just Treasuries. There was a huge flight out of bank deposits in q4 08 and q1 09, and a big fall in demand for Agencies and risk assets as well.

current-account-q1-09-4

China’s hand — I suspect — can be seen in the changing composition of central bank purchase. The sharp rise in demand for Agencies in 2005 and 2006? That is largely a function of China’s attempt to get a bit more yield out of its reserve portfolio. The rise in purchases of corporate bonds and equities (other assets in the US data) from mid 07 to mid 08? That is also China. The Gulf was also buying a lot of equity then, but its purchases don’t really appear in the US data. The Gulf’s sovereign funds makes extensive use of external fund managers; SAFE opted to manage its equity portfolio “in-house.”

One other point is worth emphasizing. To my mind, China isn’t taking on any more risk (at the margin) financing the fiscal deficit now than it took financing the household deficit back in 2005, 2006, 2007 and the first part of 2008. Ultimately China is really covering only the portion of both deficits that spills over to the rest of the world — and the total US external deficit was (obviously) far larger back then.

But the politics have changed.

Why? Part of it, I suspect, is a fairly systematic tendency to underestimate the risks associated with large current account deficits that stem from excesses in the private sector. The fiscal deficit — and China’s current Treasury purchases — are a lot more visible than the complex chain of risk taking that allowed Chinese financing to help sustain the excess of the United States’ housing boom. But part of it is that the over the past year or so China has been providing the US with more financing and in some sense getting less in return. For a long-time, the rise in Chinese official financing of the US coincided with a rise in US purchases of Chinese goods.

current-account-q1-09-2

Vendor financing yields obvious benefits, helping to offset its hidden costs. However, over the past year Chinese purchases of US financial assets have far exceeded US purchases of Chinese goods. That may have something to do with the shift in China’s tone. To many in China, the risks associated with financing the US seem to have gone up even as the benefits that China gets in return have gone down.

I didn’t do a graph of the quarterly data. But China can at least take comfort from the fact that Chinese official financing of the US — according to my estimate derived from the US data — peaked at $137 billion in q3 2008. By q1 2009, it was more like $75 billion. Annualized that is around $300 billion — a big number, to be sure, but not quite as big a number as $500 billion. Sustaining that slide, though, ultimately will require a sustained reduction in China’s trade surplus.

* Ted Truman of the Peterson Institute argues — correctly — that official inflows really should be compared to the sum of the current account deficit and long-term private outflows, as central bank inflows can finance a capital outflow just as easily as a current account deficit. This important caveat matters a bit less now, though, as the crisis has reduced the scale of private capital outflows.
** The US data shows a shift out of Agencies and Treasuries toward bank deposits — and my guess is that something similar happened globally. Their also may have been large flows into money market funds. Both flows are ironic in light of subsequent events: in late 2008 central banks moved huge amounts back into Treasuries as they pulled funds out of banks and money market funds.

30 Comments

  • Posted by guest

    I fully concur,no other countries than the USA supply as many information on,current account flows, banking through various Fed websites,on banking FDIC, Comptroller of currency….
    When Europe,financial and banking information flows is still at the dark age of the popes in Avignon and their pontifical bubbles.

  • Posted by guest

    Hallo

    0. guest it totally right.

    1. The behaviour of europe political elite shows: they take the citizens as what they are: a bunch (something like an penguin or a salad) of emotions, that are understanding the reality entirely through the stomach.

    2. The behaviour of europe economic media (incl. blogs, forums, ..) shows the same picture: they proof all days:
    a. the writers are unable to bring an adequate picture
    b. the readers are idiots and are satisfied with consolation.

    3. The behaviour of the europe finance elites shows, that they have totally corrupted the politic elites.
    (I had the opportunity, to follow the special-hour (UBS) in the swiss lower house: 200 (all of them) had no clue; really not a single comprehension of what is going on: theirs speeches were centred around bonus…

    Take it like this: a representative from the rural area, who has the chocolate-cow in his head: what do you expect, what the guy knows about international rivers of credits, real finance, alphabetical soup, … You can expect: each of them is very convinced about the desert and the gulag in his head. And you can expect, that the media is the same: applauds or condemns according to their political favourites.)

    4. The behaviour of the europe economic academia: that part, that is not in the heaven of a totally corrupted mind, had their best part, when they fell on the knees, saying, that they had instructed the scholars for the last twenty years with scientology-stile-dogmas.

    5. All, what europe humans, who are interested in the economic reality, had learned, they have taken it from the GB and US writers and their discussions: the Johnsons, Setsers, Pettis, Buiters, Smithes, Kwaques, …, the commentators in forums and blogs of US and GB.

    6. Make the distinction for Europe: fact based judgments or dogmatic based judgments or phenomenon of “Hilton-girly” judgment.

    The europe citizens and the politics do the “Hilton-girly” dance – the academia does the clerical dogmatic twist – and facts you will only find with Hubble telescope.

    7. It is all a relative game. But the transparency of release of the United States’ balance of payments data makes a difference.

    8. The europe elites like to make their business in the dark. Like in the early 20 century (when they drove Europe in the wall with total-damage) they are doing the same in the early 21 century. And they would do it in the same darkness, if there would be no internet.
    The elites survived the former “catastrophe” and they will survive the ongoing “crisis”. The guard of the sheeps will survive even though 25% of the sheeps are falling over the cliff. That is live.

    globumedes

  • Posted by Rien Huizer

    Brad: Vendor financing yields obvious benefits, helping to offset its hidden costs. However, over the past year China purchases of US financial assets have far exceeded US purchases of Chinese goods. That may have something to do with the shift in China’s tone. To many in China, the risks associated with financing the US seem to have gone up even as the benefits that China gets in return have gone down.”

    Right. I guess in Guangdong that is exactly how they feel.

  • Posted by Rien Huizer

    Swiss guest: cheer up, at least your politicians are sincere.

  • Posted by Glen M

    Rien,

    I’m guessing that if the total of China’s trade surplus was measured, IIRC while the US was portion was shrinking the European portion was growing, the offsets might look clearer. The Yuan peg is US dollar based but the trade surplus has many participants.

  • Posted by Rien Huizer

    Glen,

    You are partially right, but China’s EU export growth is slowing down, from 15% annually. European FDI in China is also slowing down. Acting responsibly (from a world economy point of view) is going to cause a lot of pain here and there. Interesting to see how the losers will react, especially if, as I expect, the “recovery” (that is the OECD economies minus the economy that existed purely as a result of irrational finance reverting to a quiet pace of growth, say 0% per capita on average after stabilization, with 2007 levels in 2010) wil be slow and shallow.

  • Posted by D Gross

    Great charts and very interesting analysis.

    I am very surprised to see the level of “excess” Dollar financing the Chinese engaged in.

    The actual level of Dollar financing needed is actually less than China’s net exports to the US (should be well below the green line on the last chart)> This is because so many of China’s commodity and material imports are priced in Dollars. Hence, China should only need to hold or lend (or transfer to other international investors) the difference between its net Dollar exports and imports (not its net US exports/imports).

    I suspect the huge difference (at least up until 2008) was to absorb hot money flows and capital investment. This should be less of an issue going forward given the weakness in private consumption and investment in China at present. There was a similar story in the Brazil. The Brazilians not only held Dollars related to their trade surplus but saw huge repatriation of offshore Dollars held by expatriates (offshore money in Miami and NY that used to be in USD came flooding back to BRL to play the carry trade and local markets- essentially private Brazilian investors turned their Dollars over to the central bank) plus a large amount of carry trade and local markets investment by hedge funds and international speculators.
    The GCC countries also had a similar experience.

    What happens now? Certainly there is plenty of international demand for treasuries still, even with the diminished need to absorb “hot money” inflows. Treasuries are liquid and secure. Will international demand for agencies or corporates ever come back? And what of household borrowing? I could see a scenario where massive Treasury borrowing requirements absorb international demand, leaving precious little international interest in non-government Dollar debt. Right now US households are saving, but what if they want to borrow again? Sounds like we could see permanently wide credit spreads.

    Or maybe, rather than the US government being forced to borrow in SDR or Yuan or other foreign currencies it will be US government agencies and private corporations that
    will be forced to borrow in foreign currency.

  • Posted by bsetser

    i guess there are two scenarios if us household demand comes back — one is low treasury rates (thanks to int. reserve demand) and high us credit spreads, the other is high rates as well as low credit spreads, as the usg ends up having to pay more to pull funds into the treasury market. i doubt we get back to the low rates/ low spreads equilibrium of the pre-crisis period.

    hot inflows are clearly part of the story — they show up in the us data with a bit of a lag (likely b/c china was using intermediaries so some of its USD purchases didn’t show up until the post lehman flight to quality but they definitely showed up then). i wouldn’t rule out a scenario where such hot flows resume tho. that seemed to be the case in may, when “green shoots” were seen everywhere and there was a ton of interest in EMs.

  • Posted by HZ

    “To my mind, China isn’t taking on any more risk (at the margin) financing the fiscal deficit now than it took financing the household deficit back in 2005, 2006, 2007 and the first part of 2008.”

    Maybe they think the household deficit does not generate as much inflation expectation as the fiscal deficit. Though US domestic inflation isn’t a great measure of the value of USD to Chinese consumers.

    “Sustaining that slide, though, ultimately will require a sustained reduction in China’s trade surplus.”

    China is also more willing to take on credit risk to the rest of the world directly. In addition to direct investment, it may also open up fund raising to foreign enterprises.

    FDI into China is also slowing down significantly.

  • Posted by Movie Guy

    Very good, Brad.

  • Posted by Dave G

    I’d just like to thank Brad and what I assume is the large team backing him up for providing such an amazing stream of clear information and analysis on such a regular basis. Although complete understanding of global finance is beyond my means, Brad gives nice clearly reasoned windows into the incredibly complex and opaque topic.

    Keep up the great work, Brad.

  • Posted by Cedric Regula

    We have a one week study in what is driving treasury rates. End of last week we began a big rally in treasuries across the curve because of apparent market relief that the 10 and 30 year auctions went well($31B of new supply).

    This rally gained steam in the earlier part of this week on better than expected PPI and CPI numbers(tho they were + numbers, not deflation numbers, and the expectation was for rather high inflation numbers).

    Highlights in the wholesale price numbers was a 27% decrease in the price of eggs, which apparently went a long way towards offsetting a 13% increase in the price of gasoline. So good news for Egg McMuffin fans there. Also a Green Shoot, to my thinking, because this means the massive amount of USG stimulus so far has seemed to work on both roosters and Arabs.

    So the 10 year note yield was driven from last weeks high of 3.95% all the way down to a strong support level at 3.6% yesterday morning. It then soundly bounced off that level, and today the news is out that the auctions next week will total $104B in 2s,3s,and 7s. The 10 year has sold off a whopping 18 basis points so far today and is at 3.82% at the moment.

    So my read of this is that supply matters.

  • Posted by jonathan

    In response to your note about “spilled ink.” The making of history is imprecise. In the moment, we’re overwhelmed with data, much of it wrong, much misleading, much contradictory. In the long run, we’re left with tidbits, a mere sampling that may or may not correlate meaningfully to what actually happened. We see this in such recent but rapidly receding history as Reaganism and we see how people try to impose their views not only on the meaning of what happened but on the description of what actually occurred at the time. Now stretch that out over a hundred years and you see this problem – and this crisis – through a lens that shows how useless most speculation is.* Sorry for the digression.

    I also want to respond to your note in the comments section. I think the US is in the early stages of responding to a meaningful shift in dynamics in which our history is now becoming an inappropriate burden. We like to imagine ourselves as being the New World but we’re not. By dynamic, I mean the external world is imposing the need for efficient response to constraint on us.

    To be clearer – since I’m being a tad abstract – many in America believe we need to free ourselves and our companies from constraints to then let our skill in the market create innovation. That is in some quarters an ideal reminiscent of the American Western of the stolid individual on a horse or behind a plow or hacking a motorcycle into a chopper. But the world does not respond to our subjective wishes. It imposes its will on us.

    We are no longer competitive or even particularly competent lower cost providers but much of our system is set up to keep costs low as though the last 20 years had not happened and as though we cannot see the headlights of oncoming India, China et al. Germany shows that placing sensible policy constraints on companies enables them to become more efficient and more effective. As an example, their universal health system – which fits their culture and is, I think, the best model for us – provides a constraint that gives German companies certainty in a number of competitive areas. American companies and American regions are too busy competing with each other to offload costs onto employees while the Germans are able to focus on investment and other decisions knowing that constraint is essentially fixed.**

    Constraint in America has a negative cast of the government telling you what to do – a thing the right only wants to impose on us morally and not economically. But constraint is also freedom because it defines the space in which you operate. In this era of competition, we can’t win at being low cost but we can win at being very good at responding to constraint. This is why, in business terms, we need more not fewer environmental constraints and why we need universal care. Control these factors and we have a more powerful competitive mechanism.

    One hidden irony is that constraint in another context = constitution, meaning that constraint is actually a core American value.

    So my response to what will happen is that we’ll either adapt to constraint as a public policy or we’ll muddle through. I don’t know what muddling through would look like but it won’t be as well off.

    *And the long term meaninglessness of 99.9% of all pontification and 99.999999999999999999% of twitter. I could have added a few dozen more 9′s on the end.

    **Krugman’s old trade model fits this quite well.

  • Posted by Cedric Regula

    Brad:”The US data shows a shift out of Agencies and Treasuries toward bank deposits — and my guess is that something similar happened globally. There also may have been large flows into money market funds.”

    Don’t forget the USG did guarantee money market funds, post Lehman, and they also raised the 100k FDIC insurance level to 250k at banks. I think they also committed to guarantee that the treasury would back the FDIC, since the internal FDIC funds from fees has been drawn down to very low levels.

    This was of course done to head off the run on banks and money markets. Seems to have worked.

  • Posted by bsetser

    Cedric — that comment was in reference to q3 07, i.e. a long time ago, and well before the money market gurantee. in q3 and q4 08 (and q1 09) there was an enormous flow out of agencuies and bank deposits into treasuries …

  • Posted by Cedric Regula

    Brad
    OK. by the time I got down to the bottom of the article , I forgot where the ** comment was pointing to.

  • Posted by former journalist

    Jonathan: your comment above was stunning in its clear choice of words as well as its simple and yet profound framing of the choices that lie ahead for our nation. It’s one of the best that I’ve read anywhere in months. Thank you, whoever YOU are.

  • Posted by former journalist

    Jonathan: Your post above was stunning in its clear choice of words and its simple yet profound framing of the choices that lie ahead for our nation. It’s the best I’ve read in months. Thank you, whoever YOU are.

  • Posted by former journalist

    Jonathan: your post above is stunning in its clear choice of words and simple yet profound framing of the choices that lie ahead for our nation. It’s definitely one of the wisest I’ve read anywhere in months. Thank you, whoever YOU are.

  • Posted by Too Much Fed

    “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.”

    Could someone tell me the difference between central gov’t planning and central central bank planning?

    What’s wrong with the private markets in this particular situation?

  • Posted by former journalist

    I am so sorry Brad and everyone else about my triple posts. I don’t quite understand what happened.

  • Posted by Too Much Fed

    “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.”

    What about wealth/income inequality?

    Was it unfavorable for the lower and middle class in the USA (and probably other high wage countries) and now the USA gov’t?

    Was it favorable for the spoiled and rich in china, in the oil regimes, and in the USA?

    Is that actually “the plan”?

  • Posted by Too Much Fed

    “China’s hand — I suspect — can be seen in the changing composition of central bank purchase. The sharp rise in demand for Agencies in 2005 and 2006? That is largely a function of China’s attempt to get a bit more yield out of its reserve portfolio. The rise in purchases of corporate bonds and equities (other assets in the US data) from mid 07 to mid 08? That is also China. The Gulf was also buying a lot of equity then, but its purchases don’t really appear in the US data. The Gulf’s sovereign funds makes extensive use of external fund managers; SAFE opted to manage its equity portfolio “in-house.””

    Someone correct me if I am wrong here, but the way I understand it is that some of the dollar peg countries sell bonds to “sterilize” excess free currency from having a fixed (or near fixed) exchange rate and a trade surplus. To make interest payments on the bonds, the free currency needs to be invested in financial assets in the “other” (dollar here) currency.

    If the returns on financial assets in the “other” currency do NOT make the interest payments, will there be trouble?

    Is that why china invested in agencies then because interest rates on treasuries were not high enough?

  • Posted by Too Much Fed

    Here is a question from my example above.

    If china was paying 4% on its “sterilization” bonds and its currency was appreciating by 3%, does china need a 7% return to break even?

  • Posted by bsetser

    too much fed — yes, at the margin, if capital losses from fx moves are charged v the income statement. in practice though some of china’s reserves back cash in circulation, which pays no interest –

  • Posted by don

    “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”
    Once again, my time-worn response: The official flows from that smnall set of governments is causing the U.S. current account deficit.

  • Posted by Too Much Fed

    bsetser said: “too much fed — yes, at the margin, if capital losses from fx moves are charged v the income statement. in practice though some of china’s reserves back cash in circulation, which pays no interest –”

    So, what is the total value of sterilization bonds? Or, what amount of chinese currency has been “sterilized” via bonds?

  • Posted by Too Much Fed

    Need some more help.

    Assuming I’m remembering my numbers correctly, isn’t there something wrong when a current account deficit equals or almost equals currency in circulation in a year???

  • Posted by yoda

    why people from China and Japan think buying dollars or dollar denominated asset can help them to build wealth is beyond me. they have themselves to blame for their destruction of wealth as dollar and USA weaken due to massive debt.

  • Posted by Adam Leeds

    A question for everyone:

    I was reading this article in light of Andy Xie’s article here: Tight Spot for Fed, Blind Spot for Investors

    Xie writes that what we’re seeing or going to be seeing now is that Treasury demand will no longer be driven by central bank demand (and thus yields will go up). He says this because central bank demand is price insensitive, instead responding to the current account deficit (which is collapsing). But my question is, if the central banks are targeting an exchange rate, why is the current account deficit the relevant number to determine their US$ demand?

    I’m sure this is an elementary question that shows how little I’ve learned about these subjects, but if someone would enlighten me I’d be grateful.