Brad Setser

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The (almost) dollar crisis of 2007 …

by Brad Setser

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.


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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 »

2007 all over again? The dollar, central bank reserves and US bonds

by Brad Setser

Lower interest rates in the US than in much of Europe and most emerging economies

Slower expected growth in the US than in the emerging world

Rising oil prices

Falling dollar.

That describes the past week.

But it also describes most of 2007 and the first part of 2008.

In the last WEO (Box 1.4), the IMF argued that the world’s imbalances weren’t at the heart of the recent crisis, as the trigger for the crisis wasn’t a withdrawal of foreign financing to the US. The credit crisis, in other words, wasn’t a dollar crisis.

That argument was a bit overstated. The Bretton Woods 2 system was central to the ability of the United States to sustain a large deficit in the household sector – just as the expansion of the US household deficit was central to the ability of many emerging economies to grow their exports. Absent central bank demand for dollars, the natural circuit breakers would have kicked in earlier, before so much risk accumulated in the financial sector.

Moreover, it ignores the fact that there was something of a dollar crisis from the end of 2006 to early 2008.

When the US slowed and the global economy (and the European economy) didn’t, private money moved from the slow growing US to the fast growing emerging world in a big way. The IMF’s data suggests that capital flows to the emerging world more than doubled in 2007 – and 2006 wasn’t a shabby year. Net private inflows to emerging economies went from around $200b in 2006* to $600b in 2007. Private investors wanted to finance deficits in the emerging world, not the US – especially when US rates were below rates globally. Normally, that would force the US to adjust – i.e. reduce its (large) current account deficit. That didn’t really happen. Why?

Simple: The money flooding the emerging world was recycled back into the US by emerging market central banks. European countries generally let their currencies float against the dollar. But many emerging economies didn’t let their currencies float freely. A rise in demand for their currency leads to a rise in reserves, not a rise in price. As a result, there has been a strong correlation between a rise in the euro (i.e. a fall in the dollar) and a rise in the reserves of the world’s emerging economies. Consider this chart – which plots emerging market dollar reserve growth from the IMF’s quarterly COFER data against the euro … **


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The US doesn’t name China a currency manipulator

by Brad Setser

This wasn’t exactly a surprise, despite Secretary Geithner’s comments in January. The US made a large global stimulus — and a larger IMF — its priority in the G20, not exchange rate reform.

Moreover, this isn’t the right time to force resolution of this issue.

China’s exports to world and US imports from China are both falling. Chinese reserve growth — read the amount of dollars China has to buy to keep its currency from appreciating — has fallen sharply. And perhaps most importantly, the RMB was one of the few emerging market currencies that appreciated during the crisis in real terms.

According to the (recently rebased) BIS real effective exchange rate index, the RMB has appreciated by over 10% since June 2008 — and by almost 18% since December 2007. Other indexes show sligtly smaller real appreciation. But there is little doubt that China appreciated in real terms when many other emerging economies depreciated in real terms. This seems to have been been an important factor in the Administration’s decision. The Treasury noted that the RMB was basically stable when most other emerging currencies fell (“As the crisis intensified, the currency appreciated slightly against the dollar when most other emerging market and other currencies fell sharply against the dollar.”)*

Make no mistake, China’s currency still looks undervalued. It is only a bit higher — according to the BIS index– than it was in 2001 or 2002, back when China was exporting a fraction of what it does now. In other words, the rise in the productivity of China’s economy hasn’t been mirrored by a rise in the external purchasing power of its currency. That is a big reason why China’s current account surplus remains large.

And the underlying issue remains: the biggest driver of moves in China’s real exchange rate remains moves in the dollar. History suggests that China cannot count on dollar appreciation to bring about the real appreciation it and the global economy need if China’s surplus — and thus China’s accumulation of money-losing foreign assets — is going to come down. It will be hard — in my view — to have a stable international monetary system if the currencies of all the major economies but one float against each other. And China is now a major economy by any measure.

But it makes far more sense to have a fight over China’s exchange rate regime when China’s currency is depreciating in real terms and Chinese intervention in the foreign exchange market is rising — not when China’s currency is rising in real terms and Chinese intervention in the foreign exchange market is falling.

Especially when there are a few tentative signs that China’s stimulus may be gaining some traction.

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China’s reserves are still growing, but at a slower pace than before

by Brad Setser

If China’s euros, pounds, yen and other non-dollar reserves were managed as a separate portfolio, China’s non-dollar portfolio would be bigger than the total reserves of all countries other than Japan. It would also, in my view, be bigger than the portfolio of the world’s largest sovereign fund. That is just one sign of how large China’s reserves really are.

Roughly a third ($650 billion) of China’s $1954 billion in reported foreign exchange reserves at the end of March aren’t invested in dollar-denominated assets. That means, among other things, that a 5% move in the dollar one way or another can have a big impact on reported dollar value of China’s euros, yen, pound and other currencies. China’s headline reserves fell in January. But the euro also fell in January. After adjusting for changes in the dollar value of China’s non-dollar portfolio, I find that China’s reserve actually increased a bit in January. Indeed, after adjusting for changes in the valuation of China’s existing euros, pounds and yen, I estimate that China’s reserves increased by $40-45b in the first quarter — far more than the $8 billion headline increase.

That though hinges on an assumption that China’s various hidden reserves — the PBoC’s other foreign assets, the CIC’s foreign portfolio, the state banks’ foreign portfolio – didn’t move around too much.*

The foreign assets that are not counted as part of China’s reserves are also quite large by now; they too would, if aggregated, rank among the world’s largest sovereign portfolios. They are roughly equal in size to the funds managed by the world’s largest existing sovereign funds. That is another indication of the enormous size of China’s foreign portfolio.

Clearly, the pace of growth in China’s reserves clearly has slowed. Quite dramatically. Reserve growth — counting all of China’s hidden reserves — has gone from nearly $200 billion a quarter (if not a bit more) to less than $50 billion a quarter. Indeed, reserve growth over the last several months, after adjusting for valuation changes, has been smaller than China’s trade surplus.

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Creditors generally do like to lend in their own currency …

by Brad Setser

China may not be an exception after all.

A creditor than lends in its own currency doesn’t have to worry all that much about the risk that it its lending is denominated in a currency that will depreciate. The borrower assumes the risk its currency will depreciate against the currency of its creditor as a condition for getting financing.

That is good for the creditor, and not so good for the borrower.

Back its days as a large creditor, the US (both the US government and private US creditors) generally lent in dollars. That meant that if a Latin currency depreciated against the dollar, the borrower had to find the dollars it needed to repay the US – or default and accept the consequences. Latin countries couldn’t allow their currencies to fall against the dollar and, in the process, reduce the real value of their foreign debts.

China is now a major creditor. But its foreign assets though are denominated in dollars, euros and yen – not RMB. That means that if the dollar depreciates against the RMB, it is China’s problem, not the United States’ problem. The amount of dollars the US has to pay China doesn’t change. But the amount of RMB that China gets for each dollar will fall

China’s willingness to take on this risk in some sense part was a core part of the Bretton Woods 2 system where reserve growth in emerging countries like China financed the United States external deficit. Had the United States external debt not been denominated in dollars, Dr. Roubini and I would have been even more worried by the size of the United States external debt than we were back in 2004. If United States debt structure hadn’t been as favorable, the dollar’s slide from 2002 on would have generated much, much larger problems.

China seems to have woken up, belatedly, to the fact that lending to the United States – or any other country – in its borrowers currency is risky. It probably should have started to worry some time ago, before it had $1.6 trillion or so of dollar-denominated claims. As the FT noted in a recent leader, “The People’s Republic has, however, over-exposed itself to the US, piling up dollar-denominated securities.” China is currently struggling with a problem that is very much of its own making.

China could, in theory, address this problem by ending its accumulation of dollar and euro and yen denominated reserves and instead making RMB denominated loans to the rest of the world.

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The PBoC’s call for a new global currency, the SDR, the US and the IMF

by Brad Setser

A $200 billion shared pool of reserves ($250 billion counting the IMF’s supplementary credit line) is tiny relative to the world’s $7000 billion in national reserves, or — more importantly — relative to the emerging world’s short-term external debt. The IMF currently lacks enough funds to be a lender of last resort for Eastern Europe, let alone the world. George Soros:

“capital is fleeing the periphery and it is difficult to rollover maturing loans. …. To stem the tide, the international financial institutions (IFIs) must be reinforced … the fact is that the IMF simply doesn’t have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and potential needs are much greater.”

A bigger IMF implies a somewhat larger role for the IMF’s unit of account: the Special Drawing Right (SDR), itself a basket of dollars, euros, pound and yen. When the IMF lends, its loans are denominated in SDR – not dollars, euros or yuan. China may argue that SDR-denominated lending is the first step toward creating a new “supranational” reserve currency. But that is a stretch. No one made such an argument back when the IMF was making a lot of SDR-denominated loans to Asia in the 1990s.

The IMF pools contributions from many countries, so denominating its accounts in a composite of the world’s main currencies make sense. Using the SDR inside the IMF isn’t a threat to the US dollar either. Last I checked, the dollar has somehow managed to maintain its position as the world’s leading reserve currency even though United States’ contribution to the IMF (its quota) is measured in SDR.

Indeed, the SDR – as the IMF explicitly recognizes on its website – isn’t actually a currency.

“The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.”

Countries intervene in the foreign exchange market with dollars and euros not SDR. An IMF loan is just denominated in SDR – so the amount a country has to repay doesn’t change all that dramatically when the dollar moves v the euro. In practice countries actually want to borrow “freely usable currencies” not SDR. In other words, they generally want dollars and euros.

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A bit more to worry about; foreign demand for long-term Treasuries has faded

by Brad Setser

I wanted to highlight one trend that I glossed over on Monday, namely that foreign demand for long-term Treasuries has disappeared over the last few months. Consider a chart showing foreign purchases of long-term Treasuries over the past 3 months. Incidentally, the split between private and official purchases in this data should largely be ignored. The revised (i.e. post-survey) data generally have attributed nearly all the flow from 2003 to the official sector.

The rolling 3m sum bounces around a bit, but foreign demand for long-term Treasuries in November, December and January was as subdued as it has been for a long-time. Among other things, that fall in foreign demand for long-term Treasuries after October suggests — at least to me — that the big Treasury rally late last year (and subsequent sell-off this year) doesn’t seem to have been driven by external flows. Foreigners weren’t big buyers of long-term Treasuries back when ten year Treasury yields fell to around 2%.

There also is at least a passing resemblance between a chart of foreign demand for US corporate bonds and foreign demand for Treasuries.

It is also striking that — for all the talk of safe haven flows to the US — foreign demand for all long-term US bonds has effectively disappeared.

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January’s TIC data …

by Brad Setser

John Jansen is right; today’s TIC January data was a disaster. $150 billion in (net) capital outflows (-148.9 billion to be precise) cannot sustain even a $40 billion trade deficit.

I also though have learned that the TIC data doesn’t necessarily match the trade deficit on a monthly basis — and on occasion it moves in ways that seem inconsistent with the market. If the big outflow had come in December (a month when the dollar slid) rather than January, the flow data and the market move would fit together. But a big outflow in January is hard to square with the dollar’s January rally.

Long-term inflows in January were weak — with net sales of long-term assets by both private and official investors. But that isn’t news. Setting December (when foreign private investors bought a bunch of US corporate bonds) aside, foreign investors haven’t been buying long-term US assets since the crisis hit.

The swing came from two sources:

1) US investors bought a bunch of foreign bonds. That is a change. US investors had been net sellers of foreign bonds and equities through out the fall.

2) Banks stopped piling into US assets. In October — at the peak of the crisis — private investors abroad bought $64 billion US t-bills and increased their dollar deposits by $196 billion (see line 29 of the TIC data; “change in banks own (net) dollar-denominated liabilities). In January, credit conditions eased a bit, and private investors reduced their t-bill holds by $44 billion and the banks reduced their (net) dollar deposits by $119 billion.

In some deep sense, the $150 billion outflow in January offsets the $273 billion inflow in October. Over time, the TIC flows do tend to converge with the trade balance.

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