The Practical Difficulties of Weaning America Off Foreign Capital

Brad Setser, who is normally an upbeat counterpoint to permabear Nouriel Roubini at RGE Monitor has an unusually worried post on what the end game might look like for foreign purchases of the US dollar (the central element of the oft-discussed global imbalances). We found this post courtesy Brad DeLong.

Setser focuses in on a core, and largely neglected problem: the Chinese, Japanese, et alia aren’t simply funding the trade deficit. They are also continuing to fund all our past trade deficits. And as the cumulative deficit gets bigger and bigger, they aren’t just funding the trade deficit (that is, their current exports), but the required return on the past lending, meaning in effect, they are also lending us the interest. And as the debt gets bigger and bigger, the productivity of this activity to the Chinese etc. gets lower, because more and more of their dough goes to funding old funding, and less to new exports.

It’s just like having a deadbeat customer who buys on store credit, except in this case, the stores keeps extending him credit because they think they need his purchases and don’t want to change their growth plan. They also labor under the delusion that the deadbeat will change his priorities, since he could trim other expenses to make his payments. But the numbers are getting so large that the deadbeat’s prospects are looking pretty hopeless, and the stores are starting to think about cutting him off.

We’ve quoted Mohamed El-Erian, the head of Harvard Management Corporation, and Nobel Prize winner Michael Spence, who described a scenario under which the imbalances would gradually correct. But they also noted that other forces could come into play, producing disruptive outcomes. Setser, by contrast, doesn’t see an easy way out. He tells us that central banks don’t want more dollars (although they still are buying them).

This may be the beginning of the loss of our right of seigniorage, that is, being able to fund debt to other countries in our own currency, and the beginning of end of the dollar hegemony. Eurobond outstandings already surpass the value of US bonds in circulation. The Euro is on the cusp of being a viable competitor to the dollar.

From Setser:

It is hard for the world to diversify away from the dollar when the world’s holdings of dollars need to rise by about a trillion a year
OK, I probably should strike “world” and insert “the world’s governments” instead. It is pretty clear that central banks and oil investment funds provided the bulk of the financing the US needed in 2006….

However, at least one important government doesn’t think that it makes sense to add to its existing dollar holdings. Xia Bin (an economist with China’s Development Research Center), a few days ago:

Everyone knows that they should try to cut their US dollar assets. But, of course, if China wanted to make such a move, a big cut, our losses would be large as well. That would be very difficult to do,’ he said…[T]he key point Xia Bin raises is the first sentence – the idea that “everyone” knows that they want to hold fewer, not more, dollars.

Bin’s statement is also hard to square with the fact that China’s reserves increased by $135.7b in the first quarter alone. Only about $5b of that likely came from the rising dollar value of China’s existing euros and pounds. A a $130b quarterly increase (on a flow basis) is a $520b annual pace of increase — a truly stunning sum. China almost certainly added about $100b, if not more, to its dollar holdings in the first quarter alone.

Two trends seem to be to be in tension.

Trend one: The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves….

Trend two: A slowing US economy may well need to rely more – not less – on central banks to finance its deficit. The available data suggests that private investors are willing to finance a US current account deficit of $400-500 billion when times are good and US financial assets offer a bit of a yield pickup (and, for that matter, when the US offers a tax break that encourages US firms to bring their foreign assets home).

In 2006, net private flows were more like $200-250b by my calculations — which infers net private flows from the gap between the US current account deficit and estimated official asset growth rather than relying on the US data. The net point is important — private actors bought a lot of US corporate bonds, but US investors also bought a lot of foreign securities. Moreover, I am effectively assuming some private purchases of US debt were indirectly financed by the growing offshore dollar deposits of the world’s central banks — the accounting can get a bit messy.

However, if US should ever start to cut rates — and that seems a bit less likely now than a few weeks ago — and the dollar lose its “carry” over the other big currencies, net private inflows might well fall. Back in 2003 and 2004 they fell to $100b or so by some measures.

Yet even a slowing US economy leads the US trade deficit starts to trend down, I suspect the US will need to borrow about $900, maybe a bit more, to cover its ongoing trade deficit and a rising income deficit. That works out to an “official” financing need of up to $800b in a really bad case scenario.

Trend 1 and trend 2 conflict with each other.

So far, the tension hasn’t produced any policy changes. All available data suggests that central banks – despite all the talk about tiring of dollars – actually increased their dollar reserve accumulation in the first quarter. Look at the growth in the Fed’s custodial holdings.

It takes a brave man (or woman) to forecast that this will change.

I rather clearly underestimated central bank’s willingness to finance the US back in early 2005. While central banks took advantage of the dollar’s strength in early 2005 to scale back on the their dollar purchases, all the available data suggests that emerging market central banks dollar reserve growth increased substantially in 2006. We know that emerging market central banks that report data to the IMF added about $230b to their dollar reserves in 2006, up from $130 in 05, $120 in 04, $95b in 03 and $35-40b back in 2002.

And the group that reports data to the IMF doesn’t include China or a lot of the oil exporters. Add in an estimate of Chinese and Saudi flows (which could well be off … ) and total emerging market inflows to the US – proxied by the growth in dollar reserves — have clearly remained on an upward trend

Actually, there is a third trend. OK, this isn’t yet a trend. It is more of a prediction.

Emerging markets increasingly will be financing not the expansion of the US trade deficit, but the expansion of the US income deficit. If the average interest rate on US debt rises from 4.3% to 5.2% over the next two years and returns on FDI and US lending abroad remain unchanged, the total deterioration in the US income balance over the next two years will be close $200b. The current account balance would consequently deteriorate by $200b even if the trade deficit stayed constant.

Exporters in emerging economies — and real estate developers who have benefited from the rapid money and credit growth that has often accompanied rapid reserve growth — have been the obvious “winners” from the current international monetary system. They are a strong constituency that supports the status quo. I have consistently underestimated the power of China’s export lobby. China too has its interest group politics.

But increasingly the emerging world will be financing a US whose imports from the emerging world aren’t growing. Remember, the trade deficit has to stabilize at some point. The costs associated with financing the US won’t shrink. But the obvious benefits will.

Rather than financing export growth emerging market central banks (and the Japanese Finance Ministry) will increasingly be financing interest payments to themselves. At the end of 2006, I estimate that the world’s central banks – counting SAMA’s foreign assets and China’s hidden reserves — held around $3.7 trillion in dollar reserves. On current trends, that easily could rise by another $1.3-1.4 trillion over the next two years. if the average interest rate on their dollar holdings rises to around 5%, they will receive a bit under $200b in interest from the US in 2007 – and that total will rise to around $250b in 2009.

By 2009, counting all its foreign assets (not just its reserves) and counting euro and pounds as well as dollars, China should get close to $100b a year in interest payments. By then its total foreign assets will top $2 trillion

I am starting to wonder what China’s exit strategy is. On current trends, China will, after all, account for a very large of the growth in the world’s dollar holdings over the next few years.

China is now as deeply entangled in the messy business of financing the US as the US is deeply entangled in the messy business of governing Iraq. And as a share of China’s GDP, China is spending more subsidizing US consumption than the US is spending in Iraq. The surplus in China’s basic balance (net FDI inflows + the current account surplus) is now close to 15% of China’s GDP (the IMF estimates China’s 2007 current account surplus will top 10% of its GDP, and their estimate looks low to me, given the q1 data). That finances the buildup of foreign assets by various parts of the Chinese state. And if the expected appreciation of the RMB against a dollar heavy basket of euros and dollars that replicates China’s reserve portfolio is about 33% (which seems reasonable), the expected capital loss on the incremental increase in China’s foreign assets – one measure of the implicit export subsidy – is around 5% of China’s GDP.

That is at least a rough estimate of the annual cost of China’s current policy: a full accounting would look at the interest differentials, which right now offset some of these costs.

I think I know what the People’s Bank of China’s exit strategy is. But a new People’s Investment Company just shifts the accumulation of dollars from one part of the Chinese government to another. That doesn’t eliminate the loss, only shifts the loss to another part of the government.

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