Brad Setser

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Pot calling kettle black?

by Brad Setser

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

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

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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Two trillion and counting …

by Brad Setser

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

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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Chinese Handcuffs? No, Chinese trade deficit

by Mark Dow

This is Mark Dow. Brad is away.

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below. Read more »

One graph to rule them all …

by Brad Setser

If I had to pick a single graph to explain the evolution of the United States’ balance of payments – and thus, indirectly, the entire story of the world’s macroeconomic “imbalances” – this would be it.

cofer-v-us-thru-q1-09

All data is in dollar billions, and is presented as a rolling four quarter sum.*

The red line is the United States current account deficit.

The black line is the United States financing need – defined as the sum of the current account deficit plus US outward FDI and US purchases of foreign long-term securities.** The dip in the total US financing need from mid 2005 to mid 2006 isn’t real. It reflects the impact of the Homeland Investment Act, a holiday on the repatriation of the foreign profits of US multinationals that produced a sharp fall in outward FDI.*** The rise in the United States financing need over the course of 2007 by contrast is real; American investors bought the decoupling story and wanted to invest more abroad.

The shaded area represents official demand for US assets. The inflows from central banks that report data to the IMF and Norway are known. The inflows from central banks that don’t report and other sovereign funds are my own estimates. The key countries that do not report reserves are – in my judgment – China, Saudi Arabia and the other countries in the GCC. I have assumed that the dollar share of their reserves is closer to 70% than 60% (supporting evidence). I by contrast have assumed that the GCC’s sovereign funds have a diverse portfolio.

What does the graph tell us?

In my view, three things:

First, the rise in the US current account deficit from 2002 to 2006 is associated with a rise in official demand for US assets. The quarterly IMF data doesn’t extend back to the late 90s – or to the early 1980s. But trust me, that is a change from past periods when the US current account deficit expanded. To be sure, private investors abroad were also buying US assets. But the rise in the overall US financing need associated with the rise in the current account deficit wasn’t financed by a comparable rise in private demand for US assets.

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The savings glut. Controversy guaranteed.

by Brad Setser

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.

savings-glut-weo-09-6-1-redone

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

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Where is the spillover? China’s stimulus isn’t doing much to support Japanese demand

by Brad Setser

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.

The good and bad news in the World Bank’s China Quarterly

by Brad Setser

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:

china-world-bank-q2-09-1

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