Brad Setser

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Cross border flows, with a bit of macroeconomics

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Capital Is No Longer Flowing Uphill

by Brad Setser

So report Emine Boz, Luis Cubeddu, and Maurice Obstfeld of the IMF —the net financial outflow from emerging markets that characterized the pre-crisis global economy is no more. Capital isn’t exactly flowing downhill, e.g. from rich, advanced economies to poorer emerging economies. The aggregate current account of the emerging world is close to balance.

But the basic flow of funds is not from one set of advanced economies (Europe, Japan, the Asian NIEs) to another set of advanced economies (U.S., UK, Canada, Australia). It is no longer uphill.

In my view, there is both more and less than meets the eye here.

Less, because Asia’s surplus hasn’t actually changed much from the pre-crisis period. China’s surplus is a bit smaller after its 2016 stimulus. But the surplus of the NIEs is bigger than it was before the crisis (I do not quite understand how the NIEs can be considered advanced economies for discussions of the global flow of funds but be judged against the reserve adequacy standards for emerging economies—but that is a topic for another time). Japan’s surplus is back to roughly it pre-crisis level — and the rise in Japan’s surplus in 2016 has partially offset the fall in China’s surplus. The split within East Asia between “emerging” and “advanced” is a bit arbitrary. All the major east Asian economies are importers of resources and exporters of manufactures.

Emerging Asia is still in aggregate an exporter of savings to the world. Especially if India and others in South Asia are excluded, or if the NIEs are included.

More, because the relatively constant surplus in emerging Asia means there has been a giant swing in the aggregate current account balance of the commodity exporters. One proxy is the aggregate current account balance of the former Soviet Union, Latin America, the Middle East, and Africa. These regions of the world ran a surplus of $300-400 billion before the global crisis and a similar surplus in 2011 and 2012. They now run a deficit of similar size.

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On the Cost of Holding Reserves. Sometimes It Is Not That High

by Brad Setser

A few quick reactions to Tony Fratto’s argument that the cost of holding foreign exchange reserves acts as a natural limit on exchange rate manipulation. The cost of holding reserves is the cost of so-called sterilization—issuing short-term domestic currency debt to offset (in technical monetary policy sense) or to fund (in a financial sense) the purchase of a typical reserve portfolio of say 3 to 5 year Treasuries and similar euro-denominated assets.

1) The cost of holding reserves is often the highest in the countries that need reserves the most. They tend to have high domestic interest rates, so the “negative carry” on reserves is significant. Turkey for example. Or Brazil (though Brazil’s central bank has made money on the appreciation of the dollar against the real from 2014 on, with the capital gain on its dollar reserves offsetting some of the negative carry). The high apparent cost of reserves in countries with high nominal rates is one reason some countries—like Turkey—have found creative ways to limit the fiscal cost of reserves. Turkey allows its banks to borrow from abroad and place the borrowed foreign currency on deposit at the central to meet the banks domestic reserve requirement (the Reserve Option Mechanism).

2) The cost of holding reserves conversely isn’t much of a constraint in “savings glut” countries with low domestic interest rates. Taiwan for example. That is one reason why reserves are a ridiculously high level relative to GDP (about 80 percent of GDP). Or Switzerland. The Swiss National Bank is taking tremendous amounts of foreign exchange risk (so there would be large capital gains or losses from moves in the franc-euro exchange rate, or given the composition of its reserves, in the dollar-euro exchange rate), but its actual interest bill isn’t a constraint. Negative rates on sterilization instruments and positive rates on Treasuries should result in positive carry. The fiscal cost of holding reserves also isn’t a constraint in Japan, though Japan hasn’t been intervening recently. The Ministry of Finance funds its reserves with essentially zero rate notes. The “carry” on reserves is one reason why Japan’s government is actually, according to the IMF, receiving more in interest income than it pays out of interest on its debt.*

3) The cost of holdings reserves did not prove to be a constraint on China either, back in the pre-global crisis days when China really was intervening at a rapid clip to block appreciation of the yuan. China’s reserve to GDP ratio rose from around 15 percent of GDP (2000) to around 50 percent of GDP in 2007 (if you counted all of China’s shadow reserves in 2007 and 2008).

China’s fiscal cost though was limited by China’s relatively large stock of base money. Base money is a zero interest rate loan to the central bank, it is very cheap funding. And it was further limited by China’s ability to shift the costs onto the backing system: China stopped selling expensive sterilization bills, and instead sterilized by raising the required reserve ratio in the banks. And the rate of remuneration on the reserves was kept low. Other countries no doubt have used the same trick.

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Getting Puerto Rico’s Fiscal Baseline Right

by Brad Setser

Developments in Puerto Rico are accelerating. The long-run fiscal plan is really a critical component of PROMESA—as it is intended to be a guide both for Puerto Rico’s annual budget and for any debt restructuring. I want to offer a few quick comments on the Ernst & Young report, and the most recent letter Puerto Rico’s oversight board sent the governor:

1) Puerto Rico probably isn’t going into (over?) its pension cliff and the health care cliff with a $1 billion primary fiscal surplus (the primary fiscal balance is the revenues minus non-debt expenditures). The Ernst and Young report suggests that spending is likely understated (unlike in past years, when the standard problem was that tax revenues were typically overstated). The oversight board seems to agree: “the Board has concluded that the Government’s FY17 expenditures could be understated by an amount ranging from $60 to $510 million, with a cumulative impact much greater over the next ten years. The Government’s liquidity projection is further understated by $300 million in FY17.” The implication alas, is that when Puerto Rico loses $1 billion in pension financing (as its pension assets will soon be depleted) and $1.5 billion in health care financing (as the Affordable Care Act grant will soon run out), it will face substantial fiscal deficits even in the absence of any debt service. The fiscal math I walked through on Monday still I hope works, but the likely starting point is worse.*

2) The oversight board recommends lowering the nominal growth forecast for the next few years, and being more cautious in the medium-term. The implied real economic contraction is now over 3 percent in both 2018 and 2019. That I fear is the unfortunate reality: one clear lesson from Greece is not to imagine away near-term pain. I would though be interested in seeing more explicit treatment of how the magnitude of the proposed near-term fiscal adjustment is contributing to the fall in growth.

3) In standard macroeconomics, a fiscal consolidation only depresses short-term growth. The economy eventually bounces back to potential. I worry though that in Puerto Rico near-term consolidation will reduce long-run potential (hysteresis) for one simple reason: lots of Puerto Ricans will respond to the ongoing contraction by migrating off-island, permanently weakening Puerto Rico’s economy.

4) The enormous uncertainty around Puerto Rico’s future fiscal bargain with the federal government (Medical funding is the most significant aspect of this, but in my view the interaction between Puerto Rico’s system of tax and the federal corporate income tax is also part of the bargain) impedes any quick restructuring agreement. Any deal that Puerto Rico strikes with its creditors before its future Medicaid funding and corporate income tax treatment is settled leaves the downside risk with the residents of Puerto Rico.

One last point: The oversight board’s web site has become an essential source of information on Puerto Rico remarkably fast.

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Offshore Profits and U.S. Exports

by Brad Setser

One important result of my theory about the sources of “dark matter” in the U.S. balance of payments is a concern that “border adjustment” might not generate the expected revenues. American multinationals would have a strong incentive to shift their offshore income on intellectual property rights that are now located in subsidiaries offshore back to the U.S..

A lot depends on the details of any proposed tax reform, but I think a firm with U.S. expenses and export revenues would generate a tax loss on its exports (export revenues are excluded from calculation of revenues for the purpose of the tax, and domestic expenses can be deducted). If that tax loss is refundable, exporters essentially get a check back from the government for a sum equal to their domestic labor costs (see Chad Bown on the “subsidy” component of a border tax adjustment).* Profits that now show up in subsidiaries in Ireland, Puerto Rico, Singapore, and the like** based on intellectual property that is held in the Caribbean, thanks to the low price headquarters charges for the global rights on their intellectual property, might show up back in the U.S.—and I suspect the royalties their offshore subsidiaries pay headquarters for research and design and engineering (e.g. exports) would soar.

I haven’t started to figure out how European companies that now report very little income on their direct investment in the U.S. might try to game the system. I suspect that they have an incentive to try to lower their reported intra-firm imports—e.g. reduce the transfer prices they charge their U.S. subsidiaries to lower their “border adjustment”. Auerbach, Devereux, Keen and Vella have emphasized that introducing a destination based cash flow tax in one country would have quite different effects than introducing a destination based cash flow tax in all countries.

But I also wanted to draw out the implications of the rapid growth in the offshore profits of American companies for the broader debate on globalization.

Consider the following chart: normalized versus GDP, the “reinvested” (tax-deferred, or less politely, largely untaxed as of now) profits of U.S. multinationals have more than doubled over the past twenty years, while U.S. exports of capital goods, consumer goods, and autos (my measure for “core” manufacturing exports) have stayed constant as a share of GDP. Imports of that set of goods have increased by roughly 25 percent on this measure.

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Imports Normally Would Have Subtracted More From 2016 U.S. Growth

by Brad Setser

I follow the news, some would say obsessively. I know there are far more important things afoot than backward looking analysis of the United States’ 2016 economic performance.

But I do think in some ways the U.S. was lucky not to have slowed more in 2016.

Why? Because import growth stalled, and imports did not subtract as much from U.S. growth as normally would be expected (and yes, that obviously wasn’t the dominant narrative of the 2016 election).

Plus the U.S. essentially got a small GDP boost as a result of a bad harvest in Brazil that raised U.S. soybeans exports in q3 (a rise that was only partially reversed in q4). The U.S. isn’t (yet) a commodity-driven economy, but it also isn’t (yet) a robot-based intellectual property rights (IPR) royalty-driven economy totally divorced from natural sources of economic volatility.

Imports are essentially a function of domestic demand growth and the exchange rate. More domestic demand than the exchange rate: the exchange rate in nearly all careful studies tends to have a stronger impact on U.S. exports than on U.S. imports. In the Fed’s U.S. international transactions model, for example: “The equations for goods and services exports predict that a 10 percent appreciation of the real dollar would reduce the level of overall real exports by about 7 percent after three years. After three years, the model predicts that real imports would be almost 4 percent higher.”

Over the last twenty years the negative contribution of imports to growth—think of it as U.S. demand that is shared with the world—has been about 25 percent of U.S. domestic demand growth. So typically 75 percent of any increase in U.S. demand goes toward domestic output, and 25 percent goes to the rest of the world (the U.S. of course also benefits from demand growth elsewhere, as growth outside the U.S. pulls up exports).

That is somewhat higher than that import share of GDP—as one would expect, if, over time, the import share of GDP is rising.

But something strange happened in 2016. From mid-2015 to mid-2016 (I like to look at the change over four quarters, a typical year-over-year comparison is the average over the last four quarters versus the average over the preceding four quarters so it uses eight quarters of data rather than four) U.S. imports were essentially flat (the negative contribution over four quarters was only 5-10 basis points of GDP) while U.S. demand growth—even counting inventories—contributed 1.5 to 2 percentage points to GDP growth.

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East Asia’s (Goods) Trade Surplus

by Brad Setser

European and U.S. politics have gotten a lot of attention this summer.

But one of the biggest shifts in the global economy over the past two years has been the powerful return of Asia’s trade surplus. A $50 billion monthly (goods) surplus in China is quite big. China’s annual goods surplus is $600 billion, more than it has ever been as a share of world GDP.*

Other major economies in northeast Asia are also running significant surpluses. Korea and Taiwan have large surpluses in goods trade, and Japan has swung back into surplus as well. The combined surplus of all of Asia now tops $700 billion.


One note: In the graph, I netted Hong Kong’s deficit from China’s surplus. I suspect some goods sold to Hong Kong end up in China.

If you think this is all because of lower oil prices, think again. Northeast Asia’s non-oil goods surplus is also up. The timing of the rise though is a bit different. The non-oil surplus rose in 2014, before the big move in global commodity prices.


You can see the underlying sources of China’s trade surplus when it is disaggregated by region. In dollar terms, China’s bilateral surplus with its main markets for manufactures in the advanced economies (I included Hong Kong here along with the United States and the European Union because of transshipment) increased after the global crisis. The rising surplus with the large advanced economies was offset by a rising deficit with the world’s commodity exporting economies.

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Puerto Rico Needs Tools to Help It Carry Out A Necessary Restructuring

by Brad Setser

Full disclosure: I worked on Puerto Rico while at the U.S. Treasury in 2015. All views here are my own.

The Hill has published my column on PROMESA (the bill that sets out a framework for fiscal oversight and territorial debt restructuring that passed the House earlier this month and that the Senate is taking up this week). I support the bill.

Puerto Rico cannot continue to rely on fiscal gymnastics to delay an inevitable default, and needs to start building its budgets around credible estimates of revenues. The game of passing budgets that balance thanks only to overestimating revenue—and then finding ever-more-creative ways to cover the cash flow gaps that inevitably arise—needs to end. Puerto Rico desperately needs legal tools to organize its incredibly complex debt stock into a vote, and ultimately reach agreement with its creditors, the oversight board, and the court on a new payment structure.

A few additional points:

Puerto Rico’s nominal GDP growth over the past years has averaged about 1 percent. The nominal interest rate on Puerto Rico’s tax supported debt is about 5 percent. The basic debt dynamics are bad.

Contractual debt service on the tax-revenue supported debt is about 5 percent of Puerto Rico’s GNP (counting amortization payments, which tend to be modest). There is no way Puerto Rico can, nor should, run a primary surplus sufficient to cover all these payments. The new oversight board isn’t just needed to increase the credibility of Puerto Rico’s budgeting. It also should use its powers over the restructuring process to help guide the needed adjustment of Puerto Rico’s debts so Puerto Rico can avoid Greek-style austerity.

Puerto Rico is not like a typical sovereign. And not just because it has a strange legal position as a territory, and not just because traditionally it has issued in the municipal bond market.

Most sovereign governments fund themselves by issuing unsecured bonds, which broadly speaking have the same legal rank (and yes, I am aware of the complexities here, and recognize that domestic-law domestic currency debt does differ in important ways from foreign-law foreign currency debt, even if both are typically unsecured).

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It Has Been a Long Time

by Brad Setser

I stopped blogging almost seven years ago.

My interests have not really changed too much since then. There was a time when I was far more focused on Europe than China. But right now, the uncertainty around China is more compelling to me than the questions that emerge from the euro area’s still-incomplete union.

Some of the crucial issues have not changed. The old imbalances are starting to reappear, at least on the manufacturing side. China’s trade surplus is big once again—even if the recent rise in the goods surplus (from less than $300 billion a couple years back to around $600 billion in 2015) has not been matched by a parallel rise in China’s current account surplus. The U.S. non-petrol deficit is also big, and rising quite fast.

But some big things have also changed.

The United States imports a lot less oil, and pays a lot less for the oil it does import. That has held down the overall U.S. trade deficit.

Oil exporters have been facing a gigantic shock over the last year and a half, one that is putting their (sometimes) considerable fiscal buffers to the test. Even if oil has rebounded a bit, at $50 a barrel the commodity exporting world is hurting.

Looking back to 2006, 2007, and 2008, one of the most surprising things is that Asia’s large surplus coincided with rising oil prices and a large surplus in the major oil exporters. High oil prices, all other things equal, should correlate with a small not a large surplus in Asia.

The global challenge now comes from the combination of large savings surpluses in both Asia and Europe rather than the combination of an Asian surplus and an oil surplus.

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Turning on a Paradigm

by Mark Dow

This post is by Mark Dow

Very few things rouse the rabble as much as an ideological debate. And over the past year it has been looking like we are having the beginnings of a nasty one in economics and finance. The current economic and financial crisis has shaken a few trees and made many go back and question first principles. Often, the answer is that the prevailing received economic and financial wisdom has fallen woefully short.

That said, those who are looking for a debate here may be disappointed. A narrow ideological debate is not the can I wanted to open up. Instead, I thought it would be useful to review from an historical perspective how we got here, and then address why this should matter.

For me, making the transition from economist to trader raised a lot of issues about efficient markets and animal spirits. It underscored the shortcomings of formal training and our incomplete understanding of the human element in finance and economics. As a result, the issue of paradigm shift has been simmering on my backburner for quite some time now.

One of the most important lessons I have learned as a trader is not just that emotions play an outsized role in market dynamics—that much became clear quite quickly—but that the emotions regularly swing, as if they were a pendulum, from one local extreme to the opposite. In other words, around any given trend there are oscillations above and below, moments of high bullishness and high bearishness. Time and time again we transition from moments when any positive statement is met with skepticism to moments when no one dares say anything negative. In short, we slowly change directions, see that the new direction starts to work and jump on, take the new direction too far so that it stops working, and then we start the whole process all over again.

These pendular swings in the market can take anywhere from a couple of weeks to numerous months, and they are marked by a distinct, three part psychological process: denial, migration, capitulation. In the first phase, participants deny that a change in market character is truly afoot. Markets rally on bad news (or sell off on good news) and traders look for others to blame for their trading losses (suggestion: when in doubt blame government; no one will ever disagree.) Then, little by little, traders begin to recognize ‘what is working’, start to question their previous beliefs, and then begin migrating from their old camp to the new. In the last phase, capitulation (or give-up phase), the final holdouts switch camps and jump on the new bandwagon—often in climatic fashion. This then completes the pendular swing.

This manifestation of human nature is not confined to intermediate term swings in the market. It also applies to ideological fashions in economics. At the time of the Great Depression the prevailing ideology was the Austrian Business Cycle School, a variant of the classical school of economics. (This school of thought was responsible for the useful term “creative destruction”). As the Depression took hold, the policy response was to allow the system to purge itself of its excesses. In retrospect, the mainstream view is that this policy response—or lack thereof—severely exacerbated the length and depth of the downturn.

Economists of every stripe have their own pet reasons as to what caused the Great Depression and what got us out of it. Leaving this debate aside, it is not controversial to say that Keynesian polices were perceived to have helped lift the US out of the Depression.

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May TIC Data: Still Buying US Assets But Just the Liquid Ones

by rziemba

This is Rachel Ziemba. Brad will I think be back soon but I figured I’d get in one last post going into some excessive details on the Treasury International Capital (TIC) data.

These days, the TIC data released monthly by the US Treasury and detailing the capital flows to and from the U.S. often seems anti-climactic given sharp moves in the fx and treasuries market. Despite the lag, data released yesterday and detailing May purchases tells a few interesting stories.

Most importantly, it illustrates the fact, that in the face of capital inflows to overheating emerging market economies in May, the central banks of these countries kept buying U.S. dollar assets. Q2 has been the first quarter of significant reserve accumulation of the last year. Preliminary estimates we’ve done at RGE Monitor suggest that reserve accumulation was around $180 billion in the quarter (adjusted for valuation), the first significant increase since mid 2008. As in 2008, China accounts for the bulk of the accumulation.

Despite supra-national reserve currency rhetoric given the reluctance for currency appreciation, there was little choice to buy dollars. China added $38 billion in U.S. short and long-term treasuries – a net increase of $26 billion in U.S. short and long-term assets. The discrepancy can be explained by China’s reduction in its USD deposits and continued reduction in agency bonds.

However, they shunned the long-term assets. The major foreign buyers of US assets went back to the short-end of the curve, buying T-bills and adding other short term claims. Total purchases of T-bills by foreign official investors were $53.1 billion.

This move could help explain why long-term treasury yields rose in May. With concerns about the U.S. fiscal position, worries expressed by major U.S. creditors about the dollar’s value, perhaps the move to the short-end of the curve is little surprise. It also suggests that the U.S. government is again becoming more reliant on bills financing as it was towards the end of 2008. This may not be sustainable in the longer-term.

While the decrease in the US current account deficit means that the U.S. may be less reliant on foreign finance in 2009, the U.S. has become even more reliant on China as a share of its foreign finance. China has been the largest reported holder of U.S. treasuries for some months now. But as of May China now accounts for 20% of total outstanding foreign holdings and almost equals the combined holdings of Russia and Japan.

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