Brad Setser

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Cross border flows, with a bit of macroeconomics

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The faster the rise, the bigger the fall?

by Brad Setser

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.


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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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 »

Near-record growth in the custodial holdings at the Fed; ongoing angst about the dollar’s role as a reserve currency …

by Brad Setser

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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No green shoots in Korea’s May trade data

by Brad Setser

Korea reports its trade data faster than anyone. Korea also exports a lot. That makes it a useful – though imperfect — indicator of the state of global demand.

The strong bounce-back in Korea’s April exports suggested that the sharp contraction in global trade that followed Lehman’s collapse had come to an end. Alas, the May data isn’t completely consistent with the current market narrative of global recovery.

Exports fell back a bit from their April levels.


Y/y, exports were down around 28%.


Taiwan also reports its data quickly. Year over year, its exports are still down more than Korea’s (31% v 28%). But May’s exports were a bit higher than April’s exports. That at least hints at a recovery.

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Not just emerging markets

by Brad Setser

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 … “

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Too much, or too little

by Brad Setser

Free exchange is worried that the Obama Administration wants to change too much:

WHEN asked my assessment of the government’s handling of the financial crisis, I usually say it is too soon to tell. But I am very concerned it is doing too much, too soon and too fast. Their current agenda (not even an exhaustive list): fix financial markets, boost aggregate demand, set up a new regulatory framework, decide how much bankers should be paid, create a market for green technology, repair infrastructure, repair schools, and fix entitlements. That would be ambitious for God to achieve, even given eight days, let alone mere mortals.

Simon Johnson is worried that the US is doing too little, and thus won’t make the kind of fundamental reforms that the United States needs:

“The financial crisis is abating – although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly, the lobbyists are out in force, they want what they always want, and it’s hard to see many of them as seriously weakened. How much progress have we made on any of [Rahm] Emanuel’s priority areas or, for that matter, along any other public policy dimension that was previously stuck? The charitable answer would be: this is still a work in progress and you cannot expect miracles overnight. True, but Rahm’s Doctrine .. says that you should implement irreversible change while you still have the chance. Tell me if I missed something, but has there been any breakthrough of any kind?”

A lot of current economic policy debates seem to have a similar character.

The debate over US monetary and fiscal policy, for example.

Is the US macroeconomic response to the crisis too modest (in part because nominal rates cannot go below zero), putting the US at risk of sustained deflation and a prolonged period of subpar growth? Or is it too aggressive, and thus creating a major risk of inflation?

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Russia’s waning appetite for dollars

by Brad Setser

If Russia were China — or if Russia’s reserves were growing at the same pace as in late 2007 or early 2008 – today’s revelation that Russia cut the dollar share of its reserves over the course of 2008 would be big news.

The dollar share of Russia’s reserves is now (or at least was in January) a lot closer to 40% than 50%. Reuters (via the Moscow Times, and other sources):

The euro’s share in Russia’s forex reserves, the world’s third-largest, overtook that of the dollar last year as the country pressed on with a gradual diversification, the Central Bank’s annual report showed. The euro’s share increased to 47.5 percent as of Jan. 1 from 42.4 percent a year ago, according to the report, which was submitted to the State Duma on Monday. The dollar’s share fell to 41.5 percent from 47 percent at the start of 2008 and 49 percent at the start of 2007.

It is often asserted that the dollar is the global reserve currency. It would be more accurate to say the dollar is the globe’s leading reserve currency.* The dollar is the dominant reserve currency in Northeast Asia. And the two big economies of Northeast Asia both happen to both hold far more reserves than either really needs. The dollar is also the reserve currency of the Gulf. And Latin America.**

But the dollar isn’t the dominant reserve currency along the periphery of the eurozone. Most European countries that aren’t part of the euro area now keep most of their reserves in euros. That makes sense. Most trade far more with Europe than the US – and some, especially in Eastern Europe, ultimately want to join the eurozone.

Russia has long traded far more with Europe than with the United States. By increasing the euro share of its reserves, Russia is in some sense just converging with the norm among other countries on the periphery of the eurozone.

Russia’s announcement also settles one mystery — or at least one little thing that I have spent a bit of time pondering. The following chart shows the Setser/ Pandey estimates of Russia’s dollar holdings relative to Russia’s foreign exchange reserves.

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Sovereign bailout funds, sovereign development funds, sovereign wealth funds, royal wealth funds …

by Brad Setser

The classic sovereign wealth fund was an institution that invested a country’s surplus foreign exchange (whether from the buildup of “spare” foreign exchange reserves at the central bank or from the proceeds of commodity exports) in a range of assets abroad. Sovereign funds invested in assets other than the Treasury bonds typically held as part of a country’s reserves. They generally were unleveraged, though they might invest in funds –private equity funds or hedge funds – that used leverage. And their goal, in theory, was to provide higher returns that offered on traditional reserve assets.

To borrow slightly from my friend Anna Gelpern, sovereign wealth funds argued that they were institutions that claimed to invest public money as if it was private money, and thus that they should be viewed as another private actor in the market place. Hence phrases like “private investors such as sovereign wealth funds”

This characterization of sovereign funds was always a bit of an ideal type. It fit some sovereign funds relatively well but the fit with many funds was never perfect. Norway’s fund generally fits the model for example, except that it seeks to invest in ways that reflect Norway’s values, and thus explicitly seeks to promote non-financial goals.

And over time, the fit seems to be getting worse not better.

Governments with foreign assets have often turned to their sovereign wealth fund to help finance their domestic bailouts – and thus investing in ways that appear to be driven by policy rather than returns. Bailouts are driven by a desire to avoid a cascading financial collapse – or a default by an important company – rather than a quest for risk-adjusted returns. That is natural: Foreign exchange reserves are meant to help stabilize the domestic economy and it certainly makes sense for a country that has stashed some of its foreign exchange in a sovereign fund rather than at the central bank to draw on its (non-reserve) foreign assets rather than run down its reserves or increase its external borrowing.

Of course, a country doesn’t need foreign exchange reserves to finance a domestic bailout. Look at the US.

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Greenish shoots in East Asia

by Brad Setser

In early January, data showing a sharp fall in Asian exports — a couple of Asian countries, led by Korea, tend to report trade data faster than anyone else — signaled a much broader slump in global trade.

The trade data for q1 is now in for most of the world, and it is (predictably) grim. China’s exports were up close to 20% y/y in q3 2008. They were down 20% y/y in q1 2008. Japan’s exports are now, stunningly, down close to 50% y/y. Germany isn’t doing much better. In February — the last monthly data point — exports were down by 23%, but in April German auto exports were down 48%. Turkey’s exports are down 33%.

Trade contracted exceptionally sharply almost everywhere. A sudden deceleration global demand growth — probably augmented by an inventory correction and in some case a shortfall of trade finance — is undoubtedly the main reason for the very sudden fall in global trade.

On the other hand, there is now some evidence that the contraction has ended, at least in Asia. Korea’s April exports, for example, topped its March exports. A chart showing Korea’s monthly exports and imports isn’t as scary now as it was a few months ago.

Korea’s April 2009 exports are about equal to its April 2007 exports. The y/y fall in Korea’s exports is now similar to the fall in 2001 — when the tech bust hit Korea hard. That counts as good news these days, as for a while it looked like the current fall would be far larger.

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How much “capital flow reversal” insurance should the world offer?

by Brad Setser

That isn’t a question that is usually asked in the debate about the “right” size of the IMF. But it strikes me as a question worth asking.

Back in 2006, US growth slowed relative to growth in the world. Private demand for US assets fell.* But the US didn’t have to “adjust” — that is to say bring its trade deficit down to reflect the reduced availability of private financing. Why not? Emerging economies, who received most of the influx of private money not going to the US, generally used this influx to build up their reserves. A rise in financing from central banks and sovereign funds offset the fall in (net) private demand for US assets.** The US trade deficit fell a bit relative to US GDP, but not by all that much.

Thanks to a generous supply of credit from the emerging world’s central banks, the party kept going long after private investors ceased to be willing to finance it.

Suffice to say that when emerging economies running comparable deficits to the US encounter a comparable fall off in private financial flows, the amount of financing that gets recycled back their way by the US and EU (through institutions like the IMF) is far smaller. Between 1997 and 1999, “volatile” private capital flows (bank loans and portfolio flows, I left FDI out) swung from a $100 billion inflow to a $100 billion outflow. The net increase in IMF’s lending over this time by contrast was only around $30b — not all that much relative to the $200 billion swing.

The current crisis isn’t all that different. Between 2007 and 2009, volatile capital flows are expected to fall from a positive $250 billion to a negative $400 billion — a swing over over $650 billion. IMF lending — based on all existing programs — will increase by close to $120 billion (see this chart by my colleague Paul Swartz). That is more than in the past, but not enough to offset the fall in capital flows, and certainly not enough to offset the combined impact of lower capital flows and lower commodity prices on the commodity exporting region.

Scaled to world GDP, the current swing in private capital flows and the (projected) rise in official lending looks roughly similar to the swing back in 97-98.

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