Those were Robert Rubin’s words to describe the US current account deficit.   They apply equally well to the amount of dollars the world’s central banks lent to the US in 2006.   

Press coverage of the IMF COFER data has tended to focus on the fall in the dollar’s share of global reserves in the fourth quarter of 2006, something that seems largely to be the product of central banks in the world’s advanced economies.  Blame Switzerland, Sweden and Italy – though I wouldn’t be completely surprised if the Japanese were slowly reducing the dollar’s share of their reserves as well.   

The real story in my view, though, isn’t the small slide in the dollar’s share in q4.   It is the huge overall growth in the world’s stock of reserves – something that continued in q4.    As a result, the world’s central banks supplied an unprecedented amount of financing to the United States — close to $600b by my estimates, which include some things that aren't in the COFER data.

The COFER data has a few important limitations (noted by Reuters).  The COFER data only provides data on the currency composition of about 2/3s of the world’s reserves.   And because the reserves of countries that don’t report data to the IMF (China) are growing faster than the reserves of countries that do report data to the IMF, the COFER data only tells us the currency composition of about ½ the current flow.    That is a big gap.    

Moreover, the COFER data doesn’t include the Saudis non-reserve foreign assets (which increased by $70b in 2006) or what might be called China’s missing reserves – the funds China has used to recapitalize the state banks and a life insurer, along with the dollars China likely has moved off the PBoC’s balance sheet with currency swaps.   Those missing reserves – by my estimate – increased by about $45b in 2006.   

The COFER data does tell us that the world’s central banks stock of reserves increased by $853b or so in 2006, rising to above $5 trillion.     About $508 of that increase came from countries that report data on the currency composition of their reserves to the IMF, and $345 came from countries that do not.      By my estimates, about $150b of the $850 increase came from the increase in the dollar value of the world’s existing euro, pound and yen reserves, and $700b came from actual “flows.”     

$700b is a new record.   And almost all of the growth came from emerging markets.   

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The phrase the “uphill flow of capital” seems to have caught on.  It is a vivid way of describing a world where poor countries finance rich countries.   Or, a bit more accurately, China and some no-longer-all-that-poor oil exporting countries finance the US.     

I wonder if the term “reverse globalization” will also catch on.  Nasser al-Shaali, chief executive of the Dubai International Financial Center (DIFC) Authority, recently used the term "reverse globalization" to describe one likely long-term consequence of the uphill flow of capital: Emerging markets will be buying companies – not just bonds – in the developed world. 

"Reverse globalization – when you have emerging market players going out and acquiring developed institutions – is a tide that no matter how you try to swing against it, will be very very prevalent in the years to come," he [Shaali] said. 

You can quibble about the term.  Globalization as a term could easily describe a two-way flow of funds around the globe.  Call it financial integration.    That is basically how the transatlantic economy works.  US firms invest in Europe.  European firms invest in the US.  Their respective positions basically balance each other out.   

But “globalization” has not been perceived as a two-way flow of equity investment between the developed and the emerging world, either in the developed or the emerging world.  In the emerging world, globalization meant opening up to US and European and sometimes Japanese firms and capital.  It didn’t mean buying up US or European firms.   It meant letting local firms (including local banks) be bought by US and European firms. 

And in the US and Europe and Japan, globalization often meant the export of US and European and Japanese capital and know-how to the emerging world.  Globalization was often interpreted a process that would lead the rest to adopt US-style market capitalism.    

For example, Frank Lavin – the US under secretary of commerce – recently indicated that China would benefit if it imported more of  the know-how and management savvy of US private equity firms.    

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Folks have been worrying about the current account deficit for so long that “Wall Street is downright bored with it.”    Trust me, I know.

But just because the world’s central banks have financed an expanding US deficit – at least the fraction of the US deficit that private market don't want to finance – up until now is no guarantee that they will finance large US deficits forever.    Indeed, rumblings about excessive dollar exposure (and low dollar returns) are growing just as the US economy is slowing.   If the Fed started to cut and the dollar lost its interest rate edge over say the euro, the odds are that sustaining the status quo would require more, not less, dollar reserve growth.    

The Peterson Institute, Bruegel and the Korean Institute for International Economic Policy recently sponsored a workshop on global adjustment.   Alan Ahearne, Bill Cline, Kyung Tae Lee, Yung Chul Park, Jean-Pisani Ferry and John Williamson then joined forces to outline a set of policies that would facilitate global adjustment.   

They argue that waiting until the markets “conclude the present situation is unsustainable” to take action to reduce the world's imbalances is risky.   I agree, though I might also have said that unless something changes, the real risk is that market pressures will grow to the point where even the most determined central banks give in.  The moment central banks stop making up for shortfalls in private flows to the US, watch out.     

 It is rather hard to come up with a novel list of policy changes to support global adjustment.  Adjustment by definition means that US demand growth has to slow relative to income growth (a fancy way of saying the US needs to save more).   The most obvious way to increase national savings is to reduce the US fiscal deficit further.    Dollar depreciation – additional dollar depreciation – would help support income growth in the US as demand growth slows.   And it would certainly help if other countries – particularly China — took policy steps to support domestic demand growth.     

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Iran indicated that it plans to reduce the dollar share of its portfolio to below 20%..  Something tells me it might not want to shift into pounds – a fairly popular alternative to the dollar – right about now either.  And for that matter, if it has euros on deposit in London …

It also indicated that China is now paying for its Iranian oil in euros.    Interesting.   

That brings up a question that Steve Kyle raised sometime ago over at Angry Bear – one that I have been meaning to address for sometime.   Does it matter that oil is priced in dollars?    

Steve’s answer is basically no.    And I don’t really disagree.   I certainly don’t think that the fact that most countries pay for their oil imports in dollars implies that either oil importers or oil exporters should keep their savings in dollars – and that is what really matters.  But I want to introduce one small nuance to his argument. 

First, though, does the fact that oil is settled in dollars imply that oil imports and oil exporters need to hold a lot more dollars than they otherwise would?    My answer is the same as Steve’s answer.  No.   Not really.     Sure oil importers probably need to keep some dollars on hand for transaction purposes.   But that fact alone doesn’t explain the huge dollar reserve holdings of many central banks.

Indeed, suppose an oil-importer wanted to set aside some funds back in 2002 to pay for its 2007 oil imports.   Should it have kept those funds in dollars?  Or in Euros?   The answer is pretty clear.  A euro buys less oil now than it did in 2002.   But a dollar buys far less oil now than in 2002.   Oil rose relative to both the dollar and euro, but it rose by more v. the dollar.  An oil importer would be better off holding its saving in euro, and then converting its euros into dollars when it needed to settle its 2007 oil import bill. 

By the same token, should an oil-importer hold its savings in dollars just because it gets paid in dollars?   The answer is not necessarily.    An oil exporter may want to hold assets that match the currency composition of its future imports (if you import a lot from Europe, you can limit your exposure to exchange rate moves by holding euro-denominated assets), not the currency of payment for its exports.   Or an oil-exporter may want to hold assets whose value is expected to appreciate not depreciate.   Clearly, in a backward looking sense, any oil exporter that set aside some money in 2002 would be a lot better off it held its savings in euros rather than dollars.    And as Steve Kyle notes, the currency that oil exporters opt to hold matters a lot more than the currency that they get in exchange for their oil.

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Stephen Green of Standard Chartered has the best analysis I have seen of the bureaucratic politics behind the creation of China’s new state investment company, as well as the best analysis of the constraints on its operations.  

As Green notes, the management of a country’s reserves — especially a large country's reserves — is fundamentally about supporting a country’s exchange rate regime (“Running FX reserves is not like running an investment or hedge or even pension fund. It should not be about maximizing returns, but first about supporting the chosen exchange rate regime”).  A large state investment company probably faces similar constraints.  

Green writes in Business Week:

There are other issues which will complicate Beijing's pursuit of happiness. ….  First, with the dollar. Premier Wen Jiabao, answering questions at the National People's Congress, went out of his way to make this point, saying the new fund would not have any impact upon the dollar. And for its own part, China is still caught in what former U.S. Treasury Secretary Larry Summers once called "the balance of financial terror", since if they sell their dollar holdings, the value of their residual U.S. holdings will fall. If the markets ever caught wind of China diversifying its holdings, dollar-selling pressure would be immense—and Washington would have something to say, too. But this raises the question why start a new fund if you don't want to do anything differently? That creates incentives to be extremely conservative, diversifying quietly and gradually.

Second, consider the possible impact on the region. How would people react if Beijing bought large quantities of the equities and debt traded in Taipei? Or of those traded in Tokyo? If the fund does indeed turn out to be active in Asian equities, China's relationship with the region will get a lot more complicated. How would other investors feel if China FX Fund owned 5% of their company? Would they be assured that China was only holding a position for financial reasons?

There are also big operational questions. If the new fund went into buying control of ventures overseas—an Indonesian gas field, a failing U.S. corporate, a high-end German engineering venture—how would that entity be operated? Would it be handed over to a Chinese corporate with some experience in that area or would managers and/or directors be sent from the fund? These are immense challenges, and the potential for generating nothing more than dissatisfaction at home and unease overseas are significant. Money, in short, will likely not buy Beijing happiness, at least not easily.

Exactly.

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China's reserves are growing fast because, apparently, it is a resource rich-economy:

Third, foreign currency reserves have more than doubled in the past six years due to the commodities boom, which has increased the assets of resource-rich countries such as China, Brazil and the oil-producing nations of the Middle East.

Oops.  The actual article is pretty good, so I feel bad picking out the one little point that is a bit off.  The surge in global reserve growth is, in my view, an under-reported story.

I can see the source of the confusion.  If you plot the evolution of China's current account surplus against the evolution of say the surplus of any oil or commodity exporting region, it sure looks like China is a commodity exporter.    In reality, though, China's non-commodity exports — and the value-added inside China — have just grown faster than China's (quite rapidly rising) commodity import bill.  

And with the manufacture of high-end electronic components, not just the final assembly, migrating to China, well, that might well continue. 

I watch the data on global reserve growth rather closely.  But I was still surprised to see (via Global Liquidity Blog) the scale of the growth in the Fed's custodial holdings so far in the first quarter.   Since December 27, the securities the Fed holds on behalf of foreign central banks have increased by $123.8b.   That is only through March 22 – so it isn’t for the full quarter, and it still is quite an increase.  Annualized, it works out to a stronger increase than in 2004, back when Japan seemed to be buying every Treasury note the US government issued.

And the Fed data just covers the securities — the safe securities — held by the Fed.   Central banks also hold Treasuries and Agencies through private custodians.    They have dollars on deposit in the US.  They have dollars on deposit outside of the US.  They hold "private" mortgage backed securities (especially the PBoC).  They hold corporate bonds (though not very many) and so on.

Stephen Jen puts global reserve growth at $75-80b a month, which seems about right to me.  China has not reported data for January or February, which makes it hard to know.   But Brazil (reserves up $6.5b so far in March), Russia (reserves up $6b in the first two weeks of March) and India (reserves up a billion last week — which is nothing compared to February) are all set to add $20b or more to their reserves in the first quarter.  Japan's reserves should increase by $10b a quarter on interest payments alone.  China is probably good for $20-30b a month even in q1 – or $60-90b for the quarter, though a lot depends on what China decides should show up on the balance sheet of the PBoC and what will be placed elsewhere.   

Throw in the growth in the assets of the oil investment funds, and official institutions — central banks and oil investment funds — probably added $250b to their assets in q1.  That is roughly a $1 trillion annual pace, nearly all from the emerging world.    There shouldn't be much doubt left over who finances the US current account deficit.

Mohammed El-Erian and Michael Spence noted the uphill flow of capital in their Saturday Wall Street Journal oped as well (Hat tip, Mark Thoma).  They argue that the rise in US consumption is a natural consequence of the rapid increase in the value of US assets over the past few years — along with the emerging world's willingness to finance the resulting US deficit.   The uphill flow of capital, in turn, explains most recent asset market conundrums (“excessive compression in risk spreads, the unusual collapse in market volatility, the inverted shape of the U.S. yield curve”).  

I basically agree.  But I am not sure, though, that the story really starts with an increase in the value of US housing stock, which in turn leads US households to naturally want to consume more and thus borrow from the rest of the world – something that the rest of the world accommodated.  El-Erian and Spence write:

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The similarities between China and India have seized many (see Martin Wolf's column and the resulting discussion).   Both China and India have enormous populations — and enormous scope to increase their urban labor force as their absolutely enormous rural population migrates towards urban areas.   Both have grown very rapidly recently. Indian growth is now close to Chinese levels.   Both have grown on the back of strong investment.   Both have experienced strong credit growth.  Both have booming stock markets — though the timing of their respective booms hasn't always coincided perfectly.   Both have experienced rapid reserve growth.

And both have the potential to exert an enormous influence over the global economy.   China, for that matter, already does.

Still, I have been far more struck by the differences than the similarities.  And not just the obvious ones — China's modern infrastructure is often contrasted with India's crumbling infrastructure, China's supposedly efficient version of bureaucratic capitalism (and the absence of political reform) is often contrasted with India's democratic but sometimes more chaotic political institutions.    

No, what has struck me is that India's recent acceleration is having a lot of the effects that one conventionally would expect — rapid credit and investment growth have led to inflation and current account deficits — while China's recent strong growth hasn't had the effects one would expect.  Jon Anderson of UBS has argued that China is one massive economic puzzle for conventional macroeconomists.  He is right.   India isn't.  Or at least as big of a puzzle.

India has experienced a massive credit boom over the past few years, well detailed by in a highly recommend Global Economic Forum piece by Chetan Ahya of Morgan Stanley.  Bank credit has grown in relation to GDP — and relative to deposits.   The surge in credit has contributed to a boom in investment.  Indian household savings are comparable to Chinese household savings. Indeed, Louis Kuijs found that household savings are a higher share of India's GDP than China's GDP.  But India's government and private sector have far more need to borrow these savings than China's government and private sector.   As a result, Indian savings lag Indian investment, leading to a current account deficit.

Strong credit growth has also been one factor pushing up inflation.   Higher rates of inflation, in turn, have led the RBI to push up interest rates.   Inflation is now in the 6.5% range — faster than in the US or Europe, so India's real exchange rate would appreciate even if the nominal exchange rate stayed stable.   And nominal interest rates are now 7.5%.   That is lower than nominal GDP growth — but I suspect the gap between India's nominal interest rates and India's nominal GDP growth isn't as big as the comparable gap in China.

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That at least is what the market seems to think.  The carry trade has bounced back. 

The Australian dollar — a high carry currency — is setting new highs (v. the US dollar at least).  The kiwi has recovered.   Iceland's krona has been fairly resilient in the face of a rating downgrade.  The Malaysian ringit and Thai baht are heading back toward their 1998 levels.  The Indian rupee — a new carry trade destination currency – has been doing well.   And, judging from the strong ongoing growth in Brazil's reserves, inflows in Brazil have continued.  Brazil's reserves are up $5.5b so far in March.  China's low interest rates (and capital controls) keep the RMB from being a destination currency, but its stock market has bounced back — hot money doesn't seem to be shying away from China, or perhaps Chinese money isn't heading out of China even with higher interest rates in the rest of the world.

The US dollar, by contrast, is once again rather weak.  Especially against the Euro.  1.34 is back to the dollar's lows of 2004 and early 2005.  The Fed may be on hold — and, if Dr. Roubini is right, about to cut.   But US rates are still higher than eurozone rates, let alone Japanese rates.  

So why — as Teis Knuthsen of Danske bank notes — has the dollar diverged from the high carry currencies?

After all, Australia, New Zealand, Iceland, India and Turkey all have current account deficits, and all but India have large current account deficits.  How can the Aussie dollar be strong and the US dollar weak when both offer a yield pickup over the euro and yen?

Two thoughts:

One, most of the currencies of other current account deficit countries offer a bit more carry than the US dollar.  So if you are going to finance a country with a big deficit, why not finance the country that offers the most yield?  That is the logic behind my Deutsche Bank friends' recent recommendation to go long Turkey v. South Africa.   The same logic may apply globally. And if you want carry and don't want to finance a current account deficit, there is always Brazil.

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China's formal reserves were a bit under $1.1 trillion – think $1.066 trillion – at the end of last year.  No doubt they are close to $1.1 trillion, if not above it, now.    No wonder China’s central bank government  just made it quite clear that the PBoC doesn’t really want any more reserves.   Zhou, quoted by Reuters:

“Many people say that foreign exchange reserves in China are (already) large enough … We do not intend to go further and accumulate reserves

Zhou’s statement is probably yet another sign that the growth in China’s reserves this year has been kind of fast — and that the PBoC doesn't really want to continue to absorb the lion's share of the all the dollars that are now piling up in China.

But even now, the PBoC (though SAFE) is not the only Chinese institutions that have been adding to their foreign assets.   James McCormack of Fitch just released a quite interesting new report (registration with Fitch required) that estimates that China now holds $1.55 trillion in foreign assets.    And by China, Fitch effectively means China, Inc.   Most foreign assets not held by SAFE are held by various state companies and state banks.   Especially the state banks – Fitch, drawing on data from IMF, estimated China’s banks hold $273b in foreign assets, a $50b increase last year.   And it isn’t clear if that total – or for that matter China’s balance of payments data – counts the funds the banks raised in their offshore IPOs.  What happens in Hong kong may stay in Hong Kong. 

McCormack estimates that China added $342b to its foreign assets last year.  And even before China created the “People’s Investment Company” nearly $100b of the increase was coming from outside the central bank and wasn’t taking the form of reserves.    That squares with my own estimates – Chinese reserve growth, as large as it was, has been well below what it should be, given China’s burgeoning current account surplus and ongoing net inflows of FDI.    Large hot money outflows could explain the difference, but, well, all the evidence suggested that private money wanted to get into China and its booming equity market, not get out.   The other explanation: the state banks, state insurance companies, state pension funds and state companies all helped the PBoC out.

That is what makes Zhou’s comment that the PBoC is through accumulating reserves so interesting.   I don't think that the pace of growth in China’s foreign assets has slowed from last year.  If anything it probably picked up on the back of the still growing trade surplus.   So keeping something like the status quo in place – and by status quo I mean the current  exchange rate regime and ongoing Chinese openness to greenfield FDI – requires that someone in China add $400b or more to their stock of foreign assets.

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