Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

China, new financial superpower …

by Brad Setser Monday, August 3, 2009

One of the biggest economic and political stories of this decade has been China’s emergence as the world’s biggest creditor country. At least in a ‘flow” sense. China’s current account surplus is now the world’s largest – and its government easily tops a “reserve and sovereign wealth fund” growth league table. The growth in China’s foreign assets at the peak of the oil boom – back when oil was well above $100 a barrel – topped the growth in the foreign assets of all the oil-exporting governments. Things have tamed down a bit – but China still is adding more to its reserves than anyone else.

Yet China is in a lot of ways an unusual creditor, for three reasons:

One, China is still a very poor country. It isn’t obvious why it makes sense for China to be financing other countries’ development rather than its own. That I suspect is part of the reason why China’s government seems so concerned about the risk of losses on its foreign assets.

Two, almost all outflows from China come from China’s government. Private investors generally have wanted to move money into China at China’s current exchange rate. The large role of the state in managing China’s capital outflows differentiates China from many leading creditor countries, and especially the US and the UK. Of course, the US government organized large loans to help Europe reconstruct in the 1940s and early 1950s, and thus the US government played a key role recycling the United States current account surplus during this period. But later in the 1950s and in the 1960s, the capital outflows that offset the United States current account surplus (and reserve-related inflows) largely came from private US individuals and firms. And back in the nineteenth century, private British investors were the main financiers of places like Argentina, Australia and the United States. We now live in a market-based global financial system where the biggest single actor is a state.

Three, unlike many past creditors, China doesn’t lend to the world in its own currency. It rather lends in the currencies of the “borrowing” countries – whether the US dollar, the euro, the British pound or the Australian dollar. That too is a change from historical norms. Many creditor countries have wanted debtors to borrow in the currency of the creditor country. To be sure, that didn’t always work out: it makes outright default more likely (ask those who lent to Latin American countries back in the twentieth century … ). But it did offer creditors a measure of protection against depreciation of the debtor’s currency.

This system was basically stable for the past few years – though not with out its tensions. Now though there are growing voices calling for change.

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How much do the major Sovereign Wealth Funds manage?

by rziemba Sunday, August 2, 2009

This post is by Brad Setser and Rachel Ziemba of RGE Monitor

A score of recent reports have put the total assets managed by sovereign wealth funds at around $3 trillion. That seems high to us – at least if the estimate is limited to sovereign wealth funds external assets.

We don’t know the real total of course. Key institutions do not disclose their size – or enough information to allow definitive estimates of their size. But our latest tally would put the combined external assets of the major sovereign wealth funds roughly $1.5 trillion (as of June 2009) – rather less than many other estimates. This portfolio of $1.5 trillion does reflect an increase from the lows reached of late 2008. But it is well below the estimated $1.8 trillion in sovereign funds assets under management in mid 2008. Significant exposure to equities and alternative assets like property, hedge funds and private equity led to heavy losses by most funds in 2008 – a fact admitted by many of the managers.

$1.5 trillion is lot of money. But it is substantially less than $7 trillion or so held as traditional foreign exchange reserves.

There are three main reasons for our lower total.

First, we continue to believe that the foreign assets of Abu Dhabi’s two main sovereign funds – The Abu Dhabi Investment Authority (ADIA), and the smaller Abu Dhabi Investment Council (which was created out of ADIA and manages some of ADIA’s former assets) – are far smaller than many continue to claim.* Our latest estimate puts their total size at about $360 billion. That is roughly the same size as the $360 billion Norwegian government fund – and more than the estimated assets of the Kuwait Investment Authority (KIA) and the combined assets of Singapore’s GIC and Temasek. Our estimate for the GIC’s assets under management is also on the low side.

To be sure, Abu Dhabi’s total external assets exceed those managed by ADIA and the Abu Dhabi Investment Council. Abu Dhabi has another sovereign fund – Mubadala and a number of other government backed investors. Its mandate has long been to support Abu Dhabi’s internal development (“Mubadala [was] set up in 2002 with a mandate not only to seek a return on investment but also to attract businesses to Abu Dhabi and help diversify the emirate’s economy) but it now has a substantial external portfolio as well. Chalk up another $50 billion or so there. Sheik Mansour’s recent flurry of investments also has made it clear that not all of Abu Dhabi’s external wealth is managed by ADIA, the Council and Mubadala. The line between a sovereign wealth fund, a state company and the private investments of individual members of the ruling family isn’t always clear. Abu Dhabi as a whole likely has substantially more foreign assets than the $400 billion we estimate are held by ADIA, the Abu Dhabi Investment Council and Mubadala. And despite Dubai’s vulnerabilities, it still holds a good number of foreign assets, even if its highly leveraged portfolio has suffered greatly in the last year.

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Still growing …

by Brad Setser Saturday, August 1, 2009

The Fed’s custodial holdings of Treasuries just topped $2 trillion. Custodial holdings of Treasuries rose by $25 billion in July. The overall pace of growth in the Fed’s custodial holdings did slow a bit in July, as some of the rise in Treasuries was offset by a fall in Agency holdings. But in a world where the US trade deficit is running at about $30 billion a month, a $15 billion monthly increase in the Fed’s custodial holdings is significant.

I understand why the Treasury market is so focused on Chinese demand — China is a the largest player in the market, and a major shift in Chinese demand would almost certainly have an impact. Right now, the market is obsessing over the low level of indirect bids in last week’s 2 year auction. At the same time, concern that central banks are abandoning Treasuries should be muted so long as the rise in the Fed’s custodial holdings of Treasuries is running far above the US trade deficit. Barring a huge increase in the trade deficit after May, that is certainly will be case over the last three months of data.


It is also true on a 12m basis.


The Fed’s custodial holdings may exaggerate central bank purchases a bit, as central banks sought safety in the crisis and moved funds out of private accounts. But so long as the custodial holdings of Treasuries are rising so rapidly, it is a little hard to argue that central bank reserve managers aren’t willing to hold dollars.

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China linkfest

by Brad Setser Saturday, August 1, 2009

Qing Wang of Morgan Stanley: “Given China’s high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. …. We therefore think that from the perspective of the economy as a whole, the opportunity cost of domestic fixed asset investment, or formation of physical assets onshore, should be the total returns on US government bonds. Put in simple terms, in the debate about over-investment at the current juncture, it actually boils down to an investment decision on building railways in China versus buying US government bonds, given China’s high national savings.

David Pilling: “Far from a sign of strength, Beijing’s accumulation of vast foreign reserves is the side-effect of an economic model too reliant on exports. The enormous trade surplus is the product of an undervalued renminbi that has allowed others to consume Chinese goods at the expense of Chinese people themselves. Beijing cannot dream of selling down its Treasury holdings without triggering the very dollar collapse it purports to dread. Nor are its shrill calls for the US to close its twin deficits – which would inevitably involve buying fewer Chinese goods – entirely convincing. Rather than exposing the superiority of China’s state-led model, the global financial crisis has laid bare the compromising embrace in which the US and China find themselves. ”

Peter Garnham touches on similar themes for the FT.

Philip Bowring on the obstacles (mostly self-created) to internationalizing the renminbi: “China’s expressions of desire to reduce the role of the dollar are anyway contradicted by its actual policy of maintaining a de facto peg to the U.S. currency, meanwhile continuing to accumulate dollars in reserves now totaling $2 trillion. The modest yuan appreciation after 2005 came to a halt more than a year ago as China has sought to sustain exports in the face of the global slump. There is conflict between macro-economic stabilization goals and pressures from industries and employment creation not to put more pressure on exporters. … Nor has there been any significant move towards full convertibility as the financial crisis has, with good reason, made the authorities nervous of liberalization …. any significant use of yuan requires and significant offshore stock of the currency. That is incompatible with China’s expressed desire to reduce its dollar reserve dependence.”

Robert Pozen on the limits of the SDR.

Michael Pettis on his blog and in the Financial Times: ” If the Chinese economy was the biggest beneficiary of excess US consumption growth, it is likely also to be the biggest victim of a rising US savings rate. … Eventually, and maybe this is already happening, the decline in the US trade deficit must result in a decline in China’s ability to export the difference between its growth in production and consumption. When this happens, China’s economy will grow more slowly than Chinese consumption, just as the opposite is happening in the US. Put another way, rather than act as the lower constraint for GDP growth as it has for the past two decades growth in Chinese consumption will become the upper constraint, as for the next several years Chinese consumption necessarily rises as a share of GDP, just as US consumption must decline as a share of US GDP.

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Geoeconomics, in pictures

by Friday, July 31, 2009

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

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

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

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

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

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


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

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The (almost) dollar crisis of 2007 …

by Brad Setser Thursday, July 30, 2009

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

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

Free exchange made a similar point last week.

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

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

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


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Pot calling kettle black?

by Brad Setser Wednesday, July 29, 2009

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

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


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

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

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

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

by Brad Setser Tuesday, July 28, 2009

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

I disagree, for two reasons:

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

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


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

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

by Brad Setser Monday, July 27, 2009

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

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

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

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


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

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

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The faster the rise, the bigger the fall?

by Brad Setser Sunday, July 26, 2009

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

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

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


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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