Brad Setser

Brad Setser: Follow the Money

Geoeconomics, in pictures

by Friday, July 31, 2009

This post is by Brad Setser and Paul Swartz of the Council on Foreign Relations.

No doubt today’s GDP release will attract the lion’s share of the econoblogosphere’s attention. But sometimes it is a good idea to counter-program.

Paul Swartz, I and others at the Council’s Center for Geoeconomic Studies have been – at the prodding of our boss – trying to come up with indicators that capture “Geoeconomic” risk. Or at least to develop measures some key “geoeconomic” concepts, with geoeconomics defined as anything that touches on both the economy and geopolitics. An example might be the gapminder chart we did for the Council’s multimedia spectacular on the financial crisis that touches on the question of whether the G-7 still brings together the world’s most economically powerful countries.

I am not sure that we have succeeded, though I do think we have come up with some interesting ideas – ideas, though, that need to be stress tested with a bit of external scrutiny. Call this a very rough working draft.

One idea has been to look at what share of the world’s total economic output is produced by democratic countries. To do this, we weighted output by a measure of a country’s political openness (from the Polity IV project). A low score implies that all of the world’s output is produced in countries that are not democracies. A high score means all the output is produced by countries that are well-functioning democracies. And a score in the middle means something in the middle – either there are a lot of economically large democracies and a lot of economically large autocracies, or that a lot of global output is produced by countries that aren’t total autocracies nor perfect democracies.

The results are interesting; the end of the Cold war increased the share of output produced by the world’s democracies. But China’s ability to grow rapidly with significantly democraticizing has made the global economy a bit less “democratic” (in the sense that less of the world’s output is produced by democracies).

gdpbygoveranceforms

That implies that if current economic trends – meaning the gap between the rate of growth between autocratic and more democratic countries — continue, the share of global output produced by democracies will decline over time.

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The (almost) dollar crisis of 2007 …

by Brad Setser Thursday, July 30, 2009

It is now rather common to argue that those economists who anticipated the crisis anticipated the wrong crisis – a dollar crisis, not a banking crisis. Robin Harding of the FT writes:

“If economists try to predict crises they will get it wrong, and that will reduce their credibility when they try to warn of risks. It was in their warnings that economists failed: plenty talked of ‘global imbalances’ or ‘excessive credit growth’; few followed that through to the proximate sources of danger in the financial system, and then forcibly argued for something to be done about it.”

Free exchange made a similar point last week.

“It’s interesting that he [Krugman] mentions Nouriel Roubini, who is one of several international economists who famously saw some sort of crisis on the horizon but who very much erred in guessing the precipitating factor. I think international macroeconomists have been looking for a dollar crisis for quite some time, and they believed that such a crisis would bring on the meltdown. Instead, the meltdown occurred for other reasons and paradoxically reinforced the position of the dollar (and, for the moment, many of the structural imbalances that have troubled international economists).”

Actually, the crisis has — at least temporarily — reduced those structural imbalances. The US trade deficit is much smaller now than before. And, be honest, the criticism directed at Dr. Roubini should have been directed at me: after 2005, the locus of Nouriel’s concerns shifted to the housing market and the financial sector, while I continued to focus on the risks associated directly with the US external deficit. But it is hard to argue against the conclusion that the current crisis stems, fundamentally, from the collapse in the financial sector’s ability to intermediate the US household deficit – not a collapse in the rest of the world’s willingness to accumulate dollars. The chain of risk intermediation broke down in New York and London before it broke down in Beijing, Moscow or Riyadh.

At the same time, I also think the argument that warnings about “imbalances” (meaning the US trade deficit) were wrong neglects one important thing: there was something of a balance of payments crisis in 2007, although it took a very unusual form. When US growth slowed and global growth did not, private investors (limited) willingness to finance the US deficit disappeared. Consider the following graph, which plots (net) private demand for US long-term financial assets (it is based on the TIC data, but I have adjusted the TIC data for “hidden” official inflows that show up in the Treasury’s annual survey of foreign portfolio investment) against the US trade deficit.

almost-a-dollar-crisis-4

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Pot calling kettle black?

by Brad Setser Wednesday, July 29, 2009

One thing that has puzzled me is that some of the countries that have — implicitly at least — been most critical of the expansion of the Fed’s balance sheet during the crisis long have had much larger balance sheets than the US Federal Reserve.

Before the crisis, the Fed’s balance sheet was around 6% of US GDP. Right now, it is around 15% of US GDP. A big increase no doubt. But the balance sheet of the People’s Bank of China (PBoC) is around 70% of China’s GDP. Foreign assets make up about 80% of the PBoC’s balance sheet — or around 55% of China’s GDP. And the PBoC’s estimated holdings of US treasuries and agencies are about equal to 30% of China’s GDP — a level that is far higher, relative to China’s GDP, than the US Fed is ever likely to achieve. The Fed expects its balance sheet to peak at roughly $2.5 trillion, or between 15% and 20% of US GDP.

pboc-v-fed-11

China consequently presumably knows a thing or two about how to prevent rapid expansion of the central banks balance sheet — including rapid expansion from purchases of long-term US Treasuries and Agencies — from producing unwanted inflation.

The key, of course, is to sterilize the expansion of the central bank’s balance sheet. That means to offset the increase in the banks’ financial assets with an increase in the central banks’ financial liabilities, rather than increase in base money.*

Paul Swartz and Peter Tillman — my colleagues at the Council’s Center for Geoeconomic Studies — have plotted the growth in the balance sheet of the PBoC (relative to China’s GDP) and the growth in the Fed’s balance sheet (relative to US GDP). By China’s recent standards, the expansion of the Fed’s balance sheet isn’t particularly unusual.

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Doesn’t a smaller (external) deficit mean less dependence on (external) creditors, including China?

by Brad Setser Tuesday, July 28, 2009

There is a common argument that the US depends more on China now than before because the US needs to issue so many Treasury bonds to finance its fiscal deficit.

I disagree, for two reasons:

First, the trade deficit is down significantly, so the amount that the US needs to borrow from the rest of the world has fallen. That means less dependence on external creditors. The fiscal deficit — obviously — is much bigger now than it was a year ago. But inflows from the rest of the world can finance a private sector deficit as well as a public sector deficit. Private borrowing in the US is way down – and that has pulled total US borrowing from the rest of the world down even as the fiscal deficit rose. After crises in Asia in the 1990s and in Eastern Europe and the US in this decade, there should be little doubt that external deficits that have their roots in excessive private borrowing are also risky.

In my view, the US was more dependent on central banks in general and China in particular for financing back in 2006, 2007 and the first part of 2008 — when the US trade deficit was larger than it is now and emerging market reserve growth was higher than it is now.

more-vulnerable-question-reserves-v-trade

Second, the majority of the fiscal deficit isn’t being financed by foreign central banks. That’s a key change. Indeed, the rise in the Treasury’s issuance of long-term debt has come even as central bank demand for long-term debt has fallen. That key fact gets lost amid the general sense that the US must be relying more on China now than in the past because the US government is borrowing more.

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The problem with relying on the dollar to produce a real appreciation in China …

by Brad Setser Monday, July 27, 2009

Is now rather obvious. The dollar goes down as well as up.

Last fall, demand for dollars rose — in part because Americans pulled funds out of the rest of the world faster than foreigners pulled funds out of the US. The dollar soared. As the crisis abated though, demand for US financial assets fell and Americans regained their appetite for the world’s financial assets. Not surprising, over the last few months, the dollar has depreciated.

And since — at least for now — China’s currency is tightly pegged to the dollar, the RMB also has depreciated. Fairly significantly.

The real exchange rate index produced by the BIS suggests that, in real terms, the RMB is back where it was last June. That is when China more or less gave up on its policy of letting the RMB appreciate against the dollar and went back to something that looks like a simple dollar peg.

china-rer-11

Does the RMB’s recent depreciation matter? I think so.

To start, China looks to be leading the world out of the current slump. That normally would result in an appreciating, not a depreciating, currency.

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The faster the rise, the bigger the fall?

by Brad Setser Sunday, July 26, 2009

Cross-border bank claims – according to the Bank for International Settlement (BIS) — shrank in the first quarter, though at a slower pace than in the fourth quarter. That basic storyline also holds for the emerging world: the total amount the major international banks lent to the world’s emerging economies fell in the first quarter, but not at quite the same rate as in the fourth quarter.

The fall in cross-border flows is often presented as evidence of the dangers posed by financial protectionism – as governments that are now forced to backstop global banks aren’t inclined to backstop “their” banks global ambitions.

But there may be a simpler explanation for the fall in cross-border claims: the boom was unsustainable. Cross-border loans to the emerging world grew at an incredible clip from 2005 to mid 2008. Total lending more than doubled in less than three years, rising from a little under $1.4 trillion to $2.8 trillion.

bis-gross-claims-on-ems3

Some of that rise was offset by a rise in the funds emerging economies had on deposit in the international banking system. Emerging market central banks in particular were putting some of their rapidly growing reserves on deposit with the big international banks. But there was still a huge boom in lending — one that probably couldn’t have been sustained no matter what.

Bank loans to emerging economies did fall sharply in q4 2008 and q1 2009, as one would expect given the magnitude of the crisis. For all the talk about financial protectionism, I suspect that they would have fallen far faster if governments hadn’t stepped in to stabilize the international banks — and to mobilize a lot of money for the IMF so the IMF could lend more to emerging economies, reassuring their creditors.

Cross-border claims are falling at a bit faster rate than in the 1997-98 emerging market crisis. Claims on emerging economies are down by about 20% from their June 2008 peak. But cross-border claims also rose at a far faster rate in the run-up to the current crisis.

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Not necessarily always stabilizing …

by Brad Setser Thursday, July 23, 2009

One common argument — at least prior to the crisis — was that sovereign investors, because of their long-term focus, were generally a stabilizing presence in the market. Sovereign wealth funds in particular. And presumably central bank reserve managers as well. After all, in many cases, the line between a sovereign wealth fund and an aggressively managed central bank reserve portfolio is rather thin.*

These arguments were always a bit hard to assess. There isn’t enough data on the actual actions of sovereign funds to evaluate their true impact on the market. Did sovereign funds step up their purchases of equities when the markets went down? Or were they sellers then?

The available data does suggest that reserve managers have generally acted to stabilize the currency market. Central bank demand for dollars tends to rise when the dollar is going down. But the available evidence also suggests that reserve managers added to the instability in the credit markets during the recent crisis.

Central banks rather suddenly stopped buying Agency bonds, pushing Agency spreads up — at least until the Fed stepped in.

And, as the latest BIS bank data makes clear, they also withdrew large sums from the international banking system. The following chart comes table 5c in the BIS locational banking data; it shows the annual change in the deposits that the world’s reserve managers hold in the banking system.**

central-bank-deposits1

To be sure, central bank reserve managers weren’t the only ones pulling money out of big international banks. Money market funds were too. But the loss of $400 billion in deposits — $220 billion in q4, another $170 billion in q1 — from the world’s reserve managers added to the pressure a lot of banks faced. Including, I would guess, some European banks with large dollar balance sheets; that is one reason why there was “extraordinarily high demand for dollars from foreign financial institutions” during the crisis.

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Two trillion and counting …

by Brad Setser Wednesday, July 22, 2009

China’s latest surge in reserves – a surge that look its total holdings over two trillion dollars – didn’t really register in the financial media. China’s first trillion was a big story. The second trillion, not so much. It generated a few news stories and blog posts, but not the kind of big feature stories that accompanied China’s first trillion.*

The second trillion though came remarkably fast. It took a few millennium for China to get its first $1 trillion in reserves (Ok, more like a decade … ). The second trillion took less than three years. Reserves topped $1 trillion in late 2006. They topped $2 trillion in April 2009.

The second trillion would have taken even less time if China hadn’t shifted about $200 billion into the PBoC’s other foreign asset and another $100 billion or so to the CIC (after netting out the funds that flowed back into the PBoC when the CIC bought SAFE’s stakes in the Chinese state banks). If all of China’s foreign assets are counted, China’s foreign portfolio likely topped $ 2 trillion back in June 2008.

But there is another milestone that China is fast approaching — one that should be a big story. On current trends – and, to be sure, a lot could change, especially if China is serious about using its reserves to fuel the outward expansion of Chinese state firms, especially those state firms bidding for the world’s commodity supply – China’s holdings of Treasuries should top $ 1 trillion in about a year.

Chinese purchases of Treasuries, after taking account of China’s likely purchases through London, are once again growing in line with China’s reserve growth. Look at a chart of China’s total holdings of US assets.** Its Treasury holdings picked up in May.

china-june-09-14

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SAFE, state capitalist?

by Brad Setser Tuesday, July 21, 2009

One of the questions raised by the expansion of sovereign wealth funds – back when sovereign funds were growing rapidly on the back of high oil prices and Asian countries’ increased willingness to take risks with the reserves – was whether sovereign funds should best be understood as a special breed of private investors motivated by (financial) returns or as policy instruments that could be used to serve a broader set of state goals. Like promoting economic development in their home country by linking their investments abroad to foreign companies investment in their home country. Or promoting (and perhaps subsidizing) the outward expansion of their home countries’ firms.

Perhaps that debate should be extended to reserve managers?

Jamil Anderlini of the FT reports that China now intends to use its reserves to support the outward expansion of Chinese firms. Anderlini:

Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, Wen Jiabao, the country’s premier, said in comments published on Tuesday. “We should hasten the implementation of our ‘going out’ strategy and combine the utilisation of foreign exchange reserves with the ‘going out’ of our enterprises,” he told Chinese diplomats late on Monday.

A number of countries have used their reserves to bailout key domestic firms – and banks – facing difficulties repaying their external debts. Fair enough. It makes sense to finance bailouts with assets rather than debt if you have a lot of assets.

But China is going a bit beyond using its reserves to bailout troubled firms. It is trying to help its state firms expand abroad The CIC has invested in the Hong Kong shares of Chinese firms, helping them raise funds abroad (in some sense). And now China looks set to use SAFE’s huge pool of foreign assets to support Chinese firms’ outward investment.

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And now, the rest of the story: long-term portfolio flows have fallen by more than the trade deficit

by Brad Setser Monday, July 20, 2009

The goods news: the US trade deficit has shrunk. On a rolling 12m basis the trade deficit is down to around $500 billion, and the data from the last few months suggests that it should fall even further.

The bad news: the US trade deficit hasn’t shrunk by as much as foreign demand for US long-term assets.

trade-deficit-v-portfolio-flows-5

My graph only showed inward portfolio flows. That isn’t the entire balance balance of payments. But inward and outward FDI flows tend to offset each other. And in general Americans have been adding to their foreign portfolio, not reducing their foreign holdings. That means the (remaining) deficit is increasingly financed by short-term flows, which isn’t the most comfortable thing in the world.

All this is pretty clear if you look at the details of the last TIC data release (already covered in depth by Rachel). Over the last three months, private investors reduced their US holdings by over $100 billion (line 31). That total was offset by the repayment of the Fed’s swap lines — but the long-term flow picture isn’t great. Net portfolio inflows over the last 12ms totaled $188 billion (line 19). After adjusting for repayment of ABS, that total falls to zero (lines 20 and 21).

As the following graph shows, net private demand for long-term US assets — that is gross long-term private portfolio inflows net of US portfolio outflows — started to disappear in late 2006, and then took another down leg after the subprime crisis broke in August 2007. And over the last 9 months, official demand for US long-term bonds also disappeared — as reserve growth slowed (until recently) and central banks moved in mass toward short-term treasury bills.

trade-deficit-v-portfolio-flows-11

The split between official and private flows in the chart reflects my adjustments to the TIC data – but my adjustments basically just make the TIC data match the US survey data and the revised BEA data on official flows.* My adjustments change the official/ private split, but not the total.

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