Council on Foreign Relations

I suspect most people who read this blog are interested in the dollar, US interest rates, the trade balance, the “hard v. soft landing debate” (outsourced today to Kash at the Angry Bear), oil, even systemic risk in US financial markets.

Retrospective analysis of what went wrong in Argentina back in 2000 and 2001 is probably not so high on most reader’s list of interests.

But Argentina’s crisis was a searing experience for me.

In my no doubt biased view, the case studies are the real strengths of this just released IMF paper (fully disclosure: I contributed to the Argentine case study). Each case study shows how balance sheet analysis can be applied to better understand crisis dynamics — or the absence of crisis dynamics. All were written by some of the best (young) economists at the IMF (but again, I may be biased).

The Argentine cases study tries to show, concretely, why delay was costly, and specifically, how the balance sheet of Argentina’s banking system evolved during the course of 2001. The core thesis of the Argentine case study is simple: Argnetine’s banks were in far better positioned to survive a devaluation and a government debt restructuring at the end of 2000 than they were at the end of 2001. Consequently, waiting a year had real costs.

Interestingly, the deterioration of the banking system’s resilience was NOT primarily the result of new lending to the government. The banks extended far more credit to the government in 1999 and 2000 than they did in 2001. Indeed, that, in a sense, was a core cause of the government’s trouble: depositors were pulling funds out of the banking system, and a shrinking banking system could no longer extend credit to the government to help cover its ongoing deficits.

But even though the banking system’s absolute exposure to the government did not go up, its relative exposure did. Its credit to the government rose a bit, while its deposit base shrank massively. By the end of 2001, lending to the government made up a far larger share of the banking system’s assets than at the end of 2000.

Ironically, during the course of 2001, Argentine banks got rid of precisely those assets that would (potentially) have performed in the event of a devaluation and government debt restructuring. They ran down their best assets — their liquid offshore reserves — to pay off depositors (and to pay off maturing cross border credits). They also reduced their peso lending to Argentine firms dramatically. Peso deposits fell more rapidly than dollar deposits (that, incidentally, does not mean dollar depositors did not run: some peso depositors shifted into dollars, and some dollar depositors ran). To stay matched, currency wise, the banks had to reduce their peso lending commensurately.

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According to Andrew Samwick, the world’s central banks are too big to behave rashly. As he puts it:

“We’re too big an economy, and our creditors’ portfolio holdings are simply too large for them to behave rashly.”

That, according to Samwick, and I suspect Altig and Polley, is a key reason why the US will be able to reduce its large current account deficit gradually, without any major disruptions in financial markets or a sharp slowdown in US economic activity. Foreign central banks won’t sell their vast dollar holdings; hell, they might be willing to keep adding to them to keep the global financial system safe and sound.

I have one problem with the Samwick argument. It relies on a strange definition what constitutes prudent (assuming prudent is the opposite of rash) behavior by Asian central banks. Why exactly is it prudent for central banks to be issuing large quantities of local currency denominated debt (if they sterilize) to buy $500 billion of dollar denominated claims on a country that is running a current account deficit that looks set to approach 7% of GDP in 2005? Does the coupon on US dollar denominate debt — currently a bit over 4.5% for long-term Treasuries, and somewhat less at the short-end of the curve — really compensate them for the exchange rate risk that they are taking? You know, the currencies of countries with 7% of GDP current account deficits often do fall. See: Mexico, 1995; Thailand, 1997, Brazil, 1998. The dollar does not have to fall further against the euro to hurt the big reserve accumulaters either; what counts is what the dollar does against their own currencies.

And is China really behaving prudently and strengthening its financial system by forcing state-owned banks to absorb low-yielding sterilization paper to prevent huge reserve growth from leading to a huge increase in the money supply? Behaving prudentally by letting strong money growth continue even with all their efforts to find (cheap) ways to sterilize the reserve inflow?

Creditor countries usually do not extend credit in the currency of the debtor. Afterall, why should the creditor, rather than the debtor, take on the currency risk? So, at least to me, it is rather strange for the world’s major creditor countries (China is rapidly joining Japan as its current account surplus looks set to explodes) to be accumulating assets denominated in the currency of the world’s largest debtor country. China look sets to add at least $250 billion to its reserves in 2005, or around 15% of its GDP. That is a lot of money to spend propping up your biggest customer by lending on what amounts to quaisi-concessional terms.

The stability of the world economy hinges on the central banks of major emerging economies not doing anything that would shake up the status quo too much, anything “rash.” But not shaking up the status quo requires that they rashly put their balance sheets at risk and keep on extending large amounts of credit at low rates to the world’s biggest net debtor …

In a recent discussion at the Council of Foreign Relations that touched on a lot of the themes of this blog, and the Roubini-Altig debate, Ethan Harris of Lehman Brothers noted:

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Zhou Xiaochuang, China’s central bank governor, ruled out a revaluation to “to rectify bilateral trade imbalances.”

Fine. But China’s overall trade and current account surplus looks set to explode. A $30 billion global trade surplus can be argued away, but not a $100 billion plus surplus. Is he also willing to rule out a revaluation to address a broader set of imbalances?

Zhou, of course, can not say that China is planning to revalue. If China changes its policy, it wants to surprise the market.

However, I don’t quite get China’s emphasis on “flexibility” rather than a “revaluation.” I presume the formulation was initially meant to buy China a bit of time: we cannot move towards more exchange rate flexibility safely until we fix the financial system and create a functioning fx market that allows our firms to hedge, and that will take time, so back off …

But I increasingly suspect that time, rather than making China’s financial system stronger, is making it weaker. Sterilizing $200 b plus of reserves ain’t easy. Check out the PBOC’s balance sheet, and note the huge increase in sterilization paper in 2004. China’s keeps the costs of sterilization down by forcing the (state-owned) banking system to buy low-yielding central bank paper. But how exactly does that make the banking system stronger?

The only reason I can come up with is that China’s banks will ultimately be better off lending to the government at their cost of funds rather than lending to fuel China’s various domestic bubbles, where they ultimately will lose money …

One other (technical) thought: many emerging economies have gotten into financial trouble by borrowing in dollars to finance domestic projects. If the local currency falls in value, the real value of these dollar debts does up, causing trouble for borrowers and lenders alike. China obviously does not face that risk. But what about the opposite risk, namely borrowing in local currency against dollar or euro export revenues. 35% y/y export growth cannot continue indefinitely, and firms that borrow in renminbi to build export capacity potentially face trouble in the event of a renminbi revaluation. In the short-run, that may argue against any revaluation. But letting the current system run means that the domestic financial system’s renminbi exposure to firms with dollar (and euro) revenue will continue to climb. I am not sure this is a real risk, but I am starting to wonder.

So why shouldn’t the People’s Bank of China finance about a quarter of the US monthly trade deficit?

China reported (informally) is January-February reserve accumulation — $32.7 billion — yesterday, bringing its total reserves to $642.7 billion. That works out to about $16.5 billion a month in reserve accumulation, or enough to finance about 1/4 the United States’s roughly $60 billion a month trade deficit.

Actually, China’s underlying reserve accumulation is no doubt a bit stronger that this, as valuation losses associated with the fall in the euro v. the dollar between the end of December and the end of February masked a faster underlying pace of new reserve accumulation. If China keeps about a quarter of its reserves in currencies other than the dollar and movements in the euro/dollar are a good proxy for moves in the basket of currencies represented in China’s non-dollar reserve portfolio, valuation losses subtracted about $3 billion from China’s reserves between the end of December and the End of February (the losses would have been bigger but for the fact that the Euro happened to be fairly strong on February 28).

That impliues an underlying reserve accumulation of around $18 billion a month. China’s current reserve accumulation is a bit slower than it was in the fourth quarter, when China added about $90 billion to its reserves (a $360 billion annual pace). But $15 billion a month, let alone $18 billion a month, is not slow, by any measure. In one month, China adds enough reserves to say finance a decent sized IMF bailout package for a major emerging economy (Argentina got $15 billion in 2000); in two months, enough to finance a really large IMF bailout (Brazil got around $30 billion, Turkey about $25 billion).My point: $15 billion is still large relative to economy of China’s size, let alone a typical emerging economy.

China may have a quarter of the world’s population, but it does not (yet) account for anything like a quarter of the world’s GDP. At market exchange rates, China’s GDP (heading toward $1.75 trillion at the end of 2005, according to the IMF) is not even close to a quarter of the United States’ GDP (around $12 trillion).Even though reserve accumulation has slowed a bit from the torrid pace of q4, China’s reserves look set to expand more rapidly in 2005 than in 2004, unless something changes.

Given the seasonality in China’s trade, the roughly $5 billion a month trade surplus that China posted in January and February works out to annual surplus of around $120 billion, v. $30 billion in 2004 (See analysis from UBS, or this article in Business Week). China’s exports grew by 36-37% y/y in January and February, while import growth slowed significantly, to around 8% y/y. It seems like rapid increases in China’s production of chemicals and steel have reduced its need to import these goods, dramatically slowing overall import growth. Imports are now growing more slowly than China’s GDP while exports are growing much, much faster.

A $120 billion trade surplus translates into a $150 billion current account surplus. Add in $60 billion in FDI flows ($5 billion a month), and China’s reserves ought to go up by $210 billion. And remember that even at the relatively subdued pace of January and February, China’s reserves grew by between $15-$20 billion a month (net of valuation changes) — implying hot money flows of $5-10 billion a month ($60-$120 billion a year). China could be looking at reserve accumulation in 2005 of well over $250 billion, and perhaps well over $300 billion, if something does not change.

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I suspect most people who read this blog also read Nouriel Roubini’s blog, and probably David Altig’s blog as well. So the Roubini/ Altig debate over the risks associated with foreign central bank financing of the US twin deficits in this week’s edition of the Wall Street Journal’s Econoblog is probably old news to most of you.

Nouriel certainly generated the more colorful metaphors. “Hot rotting potatoes” = the dollar-denominated debt that the US needs to sell abroad to finance its ongoing deficits.

Check it out.

2004 Current account deficit: $666 billion

2004 Net FDI outflow: $133 billion

2004 Net portfolio equity outflow: $63 billion (TIC data); $37 billion (BEA) data. The difference seems to stem from different treatment of equity purchases related to mergers and acquisitions.

Is the US an attractive destination for foreign investment? Well, not for equity investors. American citizens invested more outside the US than foreigners invested in the US, and American citizens bought more foreign stocks than foreigners bought American stocks. Equity outflows added to the amount of debt that the US needed to issue to finance its current account deficit.

In broad terms, roughly $890 billion in net external debt issuance by the US financed the $666 billion current account deficit, $170 billion in equity outflows, and $57 billion in net outflows from banks and non-bank financial firms.

The outflow from “banks and non-bank financial firms” probably is linked to hedge fund activity in Caribbean: US banks and broker-dealers extend credit to a Caribbean based hedge fund to buy US securities. That does not generate any net financing for the US.

The sums add up a bit too well, in part because I cheated. The net debt issuance data comes from the TIC, other data from the BEA. If I just used the BEA data, there would have been a decent error term. Errors and omissions are a fact of life in the balance of payments.

But the basic point is pretty clear: Equity investors, on net, prefer to invest elsewhere, so the US relies on debt, big time, to finance its current account deficit.

Warning: the remainder of this post is long and wonky.

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If you think that speculation on real estate has replaced the stock market as the US national pastime, try visiting China.

I expected Beijing to be one large construction sites, and was not disappointed. Shanghai is being built up even faster. But I was surprised by all the real estate froth around Chongqing. New apartments are going up everywhere. Chongqing may not be a typical inland city, but, at least in some instances, China’s real estate boom clearly extends well beyond the coast.

I do not agree with all of Andy Xie’s analysis of China. I think he overstates, for example, the risk a renminbi revaluation will push China into a Japanese-style deflationary spiral — and understates the risks associated with maintaining the current peg.

But he is no doubt right that low US interest rates have helped to fuel China’s real estate boom.

Last week, he laid out how rising property prices in the US have supported US consumption (a theme Calculated Risk also has explored). US consumption supports Chinese exports, and that, in turn, also helps to fuel China’s real estate boom.

Property bubbles support demand in the US and China. Until property prices begin to decline in New York and Shanghai, the game is not over.

Household real estate values in the US increased by $2 trillion or 13.4% in 2004 compared to $1.4 trillion or 10.5% in 2003. US personal consumption rose by $505 billion in 2004. On the surface, the balance sheet of the US household sector is much stronger than one year ago due to asset inflation. As long as property prices keep appreciating at the current pace, why should the US consumer stop spending and start saving?

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Paul Wolfowitz looks to be heading toward the Presidency of the World Bank. He probably was not the first choice of anyone outside the US, not even the UK. But no one seems to see much of an upside in blocking his nomination.

Wednesday’s Wall Street Journal noted (accurately) that Europeans do not want to start Bush’s second term on the wrong foot. Why repeat the contentious UN debate on Iraq in the World Bank now?

Europeans also do not want the US to block their candidates to run other multilateral institutions.

I suspect there is a third reason as well. Europeans know that if they block Wolfowitz, they won’t get a Sachs, a Stiglitz, a Summers or a Birdsall. Nor will they end up with a credible candidate from a major emerging economy. They will likely end up with another pro-war, American conservative. Remember, that when the US vetoed one German candidate to head the IMF back in 2000, the only politically acceptable alternative was another German. Blocking Wolfowitz would antagonize Bush, convince the American right that both Europe and the World Bank are worthless, and likely result in the eventual appointment of someone Europeans (and developing countries) find no more palatable.

That said, Wolfowitz’s nomination is not exactly generating much enthusiasm in the development world. I suspect that the Brits are (quietly) rather upset, despite Jack Straw’s public support. Remember, development — and specifically helping Africa — is a big theme of the UK’s G-8 Presidency. It is also a politically charged issue inside the UK: Blair wants the votes of the UK’s development campaigners, and to show that his close partnership with Bush is delivering tangible results for Britain. Wolfowitz’s nomination certainly doesn’t help Blair make that case.

I have three more specific concerns.

One, despite Wolfowitz’s I-am-not-Rumsfeld diplomatic charm offensive, I am not convinced Wolfowitz will bring American conservatives around to backing the World Bank. Developing a vision for the Bank that the Bush Administration, the World Bank’s other board members (remember that the Europeans put up more money than the US, and unlike the US, they are willing to put up more) and the World Bank staff all buy into will not be easy. The battle over development policy that is not being fought out now may end up being fought out in the Bank’s board at a later date. The Bank could end up paralyzed.

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Because if the dollar was heading the other way, as the New York Times noted Wednesday morning, there is no one left at the Treasury to mind the store. Under Secretary for International Affairs John Taylor is now a lame duck. There is no Deputy Secretary. Secretary John Snow seems more of a salesman than a policy maker, and a lame duck too, for all intents and purposes.

The names of the expected nominees for Under Secretary of International Affairs and Under Secretary of Domestic Finance are well known (Tim Adams and Randal Quarles). But they have yet to be nominated, let alone confirmed.

[Update: Tim Adams' nomination was announced today, along with the appointment of Arnold Havens as acting Deputy Secretary. I hope that a Quarles announcement follows soon. Quarles was the star of the first term Bush Treasury: even those who don't always agree with his brief tend to think Quarles argues his case very well. Thanks to Praktike for the heads-up]

On the other hand, the absence of a confirmed Deputy Secretary or Under Secretary probably doesn’t matter much. The White House makes economic policy in the Bush Administration, not the Treasury. Tim Adams is unlikely to change that basic reality.

I confess to a bit of surprise at the strength of the dollar’s recent rally v. the euro. The (overdue) sell off in emerging markets, including some Eastern European emerging markets, seems to be playing a role, along with reassuring statements from the Hong Kong Monetary Authority. And, yes, higher US interest rates should support the dollar at the margin, particularly as weak European growth looks likely to keep European rates relatively low. But the roughly 90 bp yield pickup on 10 year Treasuries v. 10 year bunds does not strike me as all that big (the spread on two years is larger, a bit over 120 bp). The gains from the extra carry could easily be wiped out by any currency moves. Call me old fashioned, but I would want to see convincing evidence that at least the non-oil trade deficit has peaked and is heading down before making a big bet on the dollar. All the evidence, however, suggests the trade deficit is still rising.

Betting on the appreciation of the currency of a country with a growing current account deficit of more than 6% of GDP strikes me as intrinsically risky. Given the recent trajectory of oil prices, and indicators of strong US consumer demand in q1, anyone buying dollars should assume that the data releases for February and March will show an increase in the monthly trade deficit. And so long as non-oil import growth exceeds US export growth by a big margin, the deficit looks set to keep expanding during the course of the year. Slow growth in Europe may be good for US pride, but it is not good for US exports …

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A week in China certainly does not make me an expert. Like many, I see China through the filter of English-speaking Chinese economists, and, to more precise, through the filter of those economists and analysts that Nouriel Roubini and I spoke to during our visit.

Roubini’s basic views were pretty hard for any Chinese policy maker with a Bloomberg terminal (or subscription to the Herald Trib) to miss. That no doubt influenced the set of people willing who were willing to meet us.

Still, I came away thinking the odds of a major move in the renminbi — say a revaluation of more than 10% — are higher than I thought going in. Why? Because Chinese economists, including economists in research institutes with links to the People’s Bank of China, are very aware that the-oft discussed 3-5% revaluation in the renminbi would not do much. It is too small a move to have much of an impact on China’s (growing) global trade surplus. More importantly, such small move would leave investors expecting a further renminbi appreciation. Consequently, it would not significantly reduce the pace of China’s reserve accumulation.

I suspect that the People’s Bank of China is privately arguing for a significant revaluation. Of course, the People’s Bank of China is only one voice among many on exchange rate policy. The policy process in China remains opaque, at least to me — but it seems that any change in exchange rate regime would require a decision from a committee of the state council. That is no real surprise: the choice of exchange rate regime is usually a political, not a technical, decision and the renminbi has been pegged to the dollar at its current value that any move will be big news. China’s state council no doubt worries about a lot of things other than the difficulties China’s rapid pace reserve accumulation is creating for the central bank. China’s export sector is a lobby just like Walmart is a lobby here in the US. Committee policy making lends itself toward compromise and small steps — not bold moves. I certainly have no real idea how China’s internal debate will play out.

There clearly is a fair amount of concern in China about the dollar’s path. I guess that is only natural if you hold as many dollar reserves as China does. The Chinese are quite cognizant that the dollar’s value has slipped relative to the euro, and relative to oil. They certainly worry — rather publicly — that the US is not doing all that good of a job looking after the value of China’s existing investments in dollar-denominated securities. But they are also worry that Europe is perhaps not dynamic enough to be all that great an alternative; the Europeans have made it clear that they both don’t need and don’t want any more financing from China. The euro is quite strong enough already. All this is leading a decent of number of Chinese economists — including economists with links to China’s central bank — to conclude that China already may have as many (if not more) reserves than it really needs.

No doubt, there was a bit of selection bias in the voices Nouriel and I heard. We did not talk to any property developers enjoying the cheap financing made possible by rapid growth in bank credit fueled, in part, by rapid reserve growth, or to anyone with major investments in China’s export sector. We did hear a number of economists echo the themes Guo Shuqing, the outgoing head of China’s State Administration of Foreign Exchange, laid out in the China Daily last week — namely, that fast export growth and large FDI inflows are not necessarily good for China — and even that trade surpluses and large reserve increases are not always a sign of economic health.

There is growing concern about the impact rapid reserve growth is having on monetary policy. It is true that inflation subsided over the course of 2004, helped by a strong harvest that kept food prices tame and lots of steel and auto capacity. But there could well be a new round of inflationary pressure building: reserves grew rapidly in the fourth quarter, and fiscal policy may help control money growth less in 2005 than it did in most of 2004. China’s 2004 tax revenues wildly exceeded expectations in 04, and the surplus was kept on deposit until December, helping to limit overall money growth. It seems, tough, that there was a burst of spending at the very end of the year and reserves are likely still growing rapidly, even if they probably are not growing quite as fast as in q4.

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