Do foreign holdings of US debt put the US economy at risk?
I am testifying later today (gulp) before the House budget committee — and the time that normally goes into writing blog posts has gone into preparing my written testimony.
That means I haven’t had time to fully explore a range of interesting topics:
- The Economist’s (continued) insistence that a 10% of GDP (and rising) current account surplus, 30% y/y export growth and $500b in intervention in the fx market is not a sign that a currency is (just perhaps) a wee bit undervalued.
- Larry Summers’ argument that the preeminent economic policy challenge right now is to find ways to address the unequal distribution of the gains from recent growth. No doubt his new paper with Jason Furman and Jason Bordoff is worth reading.
- Bear Stearns’ decision to back — i.e. to provide a loan that, best I can tell, allows the fund’s existing creditors off the hook — the least troubled of its two troubled hedge funds but not to back the other, more leveraged and thus more troubled, fund. Like Naked Capitalism, I wonder if that is viable — from the outside, Bear seems to be threatening to turn over the keys of its more troubled fund to that funds’ creditors and daring them to liquidate the more leveraged funds assets and set a market price that would make it hard to mark-to-model, no matter what the consequences are for Bear’s reputation. If I am reading this wrong, do tell …
The Budget Committee’s hearing is structured around the question of whether large foreign holdings of US debt put the US economy at risk? My answer is pretty simple: the United States’ ongoing need for a large increase in foreigners’ willingness to hold US assets in order to fund large ongoing deficits remains a potential economic vulnerability.
I try to lay out two different risks. One is that foreign investors fail to provide the US with enough financing, forcing too rapid adjustment. The other is that foreign investors provide the US with so much financing — at least in the short-term — that they prevent a necessary adjustment from happening, allowing the underlying disequilibrium to build.
I know my comparative advantage — I’ll be focusing on the US debt that foreign central banks hold as part of their reserves. The actions of central banks — and sovereign wealth funds — are central to both stories.
As Ted Truman and Fred Bergsten have argued, what matters most for the US — as for any country with a large deficit — is the total amount of financing that foreign investors are willing to provide, not the precise financial instruments that foreign investors want to hold. If total inflows are less than the current account deficit, something has to change — the dollar has to fall and interest rates have to rise to the point where foreigners are willing to lend and invest more, or the US would need to borrow and invest less.
But so long as central banks offset any fall off in private financing, this specific risk won’t materialize. That seems — at least to me — what has happened over the past few quarters.
There isn’t a great high frequency measure of central bank financing of the US, but the recent growth in the FRBNY’s custodial claims is certainly suggestive. I plotted the rolling three month sum change (annualized, so the change over any three month period is multiplied by four) — the resulting picture pretty much tells the story. Central banks have upped their financing of the US significantly over the past few months.
This graph doesn’t include the data for June. The June data will – barring a huge increase in custodial holdings this week — show something of a fall-off in the pace of growth in custodial holdings.
However, the change in the NY Fed’s custodial accounts aren’t entirely determinative. Central banks don’t hold all their reserves at the New York Fed. I actually think total central bank financing of the US has been running closer to $800b annual pace than to the $500b annual pace implied by the custodial accounts alone. Total central bank demand for US assets may have fallen a bit in June, but I suspect some of the flows that showed up in the New York Fed’s custodial data earlier this year will show up elsewhere in June. That is just a hunch though.
What is relatively clear is that the large increase in central bank financing of the US since last fall — other indicators tell a similar story to the Fed’s custodial data — has allowed the US to weather a fairly significant slowdown in private capital flows. When the US economy slowed and the global economy did not, private investors understandably became less willing to finance the US.
But the large increase in central bank purchases raises another risk: central banks may be thwarting all adjustment, not just thwarting disruptive adjustment.
Providing the US with enough financing to avoid any adjustment avoids problems in the near-term, but it is also allows the underlying problem — and in my view the large US external deficit associated with the United States low savings rate is still a problem — to build.
I also identify a third risk — well, perhaps a reality as much as a risk. Emerging market governments are likely to want to build up their holdings of US — and also European – equities, not just their holdings of US and European debt. China’s desire to shift its portfolio away from US debt is eminently understandable. But it still raises a host of complicated issues — issues that I fear I didn’t really have a chance to fully flesh out in my testimony.
It isn’t that hard to envision circumstances where China is neither willing to allow its exchange rate to adjust nor to invest all of its rapidly growing foreign assets in US debt, but the US also isn’t willing to sell the assets that China wants to buy …
55 Responses to “Do foreign holdings of US debt put the US economy at risk?”
i asked in the previous thread: ”’…if foreign CBs are holding the proverbial sword of damocles over the US economy and debt markets by effectively controling LT interest rates [...] does that mean hilary clinton is right?
”’ “Senator Hillary Clinton, a New York Democrat running for president, said in a Feb. 28 letter to Treasury Secretary Henry Paulson and Fed Chairman Ben S. Bernanke that foreign ownership of `nearly half’ the U.S. debt was `a source of great vulnerability.’ The economy `can too easily be held hostage to the economic decisions being made in Beijing, Shanghai and Tokyo.’
”’ “Clinton backed legislation proposed last year by North Dakota Senator Byron Dorgan and Benjamin L. Cardin, then in the House of Representatives, calling on the administration to respond when foreign ownership of Treasuries reaches the equivalent of 25 percent of gross domestic product. The $2.19 trillion of government debt held abroad was equivalent to 16 percent of the $13.6 trillion GDP as of March 31.” ”’
Hillary is at least partially right — though i would frame the vulnerability as stemming more from the ongoing need for flows (flows from beijing and moscow) as from foreign holdings of US treasury stocks. Decisions made by foreign governments though do have — in my view — an increasing impact on us markets.
if foreigners sold and drove up us rates, slowing the economy, the fed could respond by lowering rates — something Francis Warnock has noted. but that would put an awful lot of pressure on the $, and the financial equilibrium that allows the US to attract the financing needed to sustain a large current account deficit in the context where the $ is falling, the US is cutting rates and the usual buyers of US debt (foreign central banks) are selling isn’t totally obvious to me ….
Brad, what do you expect them to take away from your testimony and what action steps do you anticipate will follow? Your testimony would certainly be insightful but I am wondering other than an “improve our understanding” exercise, what specific steps congress will take in the following months, or for that matter, should take to address the facts and conclusions you bring to their attention.
It seems to me that the second of your two risks- that a surfeit of financing prevents overdue adjustments- is a pretty accurate description of the last three years.
Your assessment of the severity of the first risk almost certainly depends on your view of how Machiavellian the deficit recyclers wish to be.
yes, what policy recommendations would you submit to congress? clinton’s is one and graham-schumer-grassley-baucus is another; other than just muddling thru under the status quo, which so many seem content to do, including _explaining_ (ad nauseum) to PBoC and GCC that it’s in their ‘best interests’ to revalue more rapidly, i don’t see a lot of policy prescriptions presented… is it that they just can’t get thru paulson/bush so no one seriously bothers trying?
Since everyone is so concerned about Chinese holdings of US Treasury debt, I propose perhaps a radical solution to resolving global economic imbalances arising from the US trade deficit that no mainsteam economist has even considered. The solution is simply to live within your budget, and stop issuing debt securities. Dollar hegemony has permitted the US to live beyond its means for far too long without market discipline. It is imperative that the entire world moves to a multi-polar currency regime with the need for reserve currencies eliminated.
Cold War restrictions that prohibit civilian high-tech US exports to both China and Russia should also be reconsidered. As a high labor cost nation, the United States comparative advantage in world trade remains in high capital intensity, high technology products. With US high-tech product and service exports to the Chinese prohibited, the trade deficit will only swell further in size. Similar high-tech products are available from European competitors on the open market. Even military 4th generation NightVision goggles are exported to the Chinese by both British and Israeli defense contractors.
From Axel Merk,
The US dollar is dependent on inflows from abroad, as Americans import more than they export. If higher borrowing costs cause consumers to spend less, foreigners may redeploy more of their investments to other, more robust areas in the world. While Treasuries tend to be the first safe haven in times of increased volatility, the dollar no longer is the safe haven it used to be.
In summary, we expect volatility to pick up in all markets. As volatility picks up, speculators may sell assets to raise cash. Given the gains experienced in just about every asset class, there may be few places to hide. As bond prices may be under further pressure, the cost of borrowing goes up; this in turn may have implications for American consumers whose spending habits are interest-rate-sensitive because of their high levels of debt. This is where the circle to the trade deficit is closing.
The central question is whether foreign central banks really care if their loans to the US lose a significant part of their value–like 40%–in the event of a dollar devaluation. I would argue they don’t–it’s all just money to them, and they can issue as much of it as they want anytime they want, as long as it doesn’t infect their domestic markets with inflation.
What they do care about is whether their manufacturers can continue to export to the US and whether private investors holding dollars get stuck with massive losses. In the case of Japan, such investors include lots of retirees who have invested in dollar assets to get better returns than those available in Japan. So I would argue that the primary concern of these governments is maintaining the status quo.
So you have the confluence of two highly irresponsible sets of governments: one that is determined to maintain the value of its currency and international prestige at the cost of its domestic economic base, and the other that wants to develop its domestic economy and doesn’t care how much offshore money it has to issue to do it.
The question is what specific events will bring a tipping point to a situtaion that politicians views as virtuous cycle and economists view as an economic disaster?
i like DC’s suggestion but it is a bit like the US’ call for ‘energy independence’; it isn’t going to happen! just like the US relies upon foreign oil to keep its economy going, so too is the US reliant on foreign purchases of US debt!
I don’t get the impression that the US government is particularly committed to maintaining the dollar’s strength against the currencies of those countries who choose to participate in global goods and asset markets, but choose deny foreign participants access to their own domestic markets.
Indeed, a 40% dollar depreciation against the currencies of dirty float/pegged regime current account surplus countries would probably be welcomed. And if, in the context of such a depreciation, interest rates were to rise and consumption were to slow, as seems likely, then the external balance Calvinists would presumably be satisfied.
Hopefully some of you will remember my policy suggestion for the US:
That is, if Congress insists on restricting the Chinese in some way (rather than the US consumer), the best approach would be to impose limits on the amount of US debt that the Chinese are allowed to buy.
Given that the Chinese peg their currency mainly by buying dollar debt, I suggest that to block this represents an efficiently targeted measure, in the spirit of Mundell’s Principle of Effective Market Classification. It is then up to the Chinese as to how they want to respond – to turn to buying other assets, to find ways of encouraging Chinese purchases of goods and services that the US is prepared to sell them, or to give up the peg. This would be better than targeted tariffs, because it would not discriminate between US businesses.
Of course, I doubt whether the politicians would like such a solution, because it would impact most directly on US debt prices and hence long term interest rates, and because they actually want to be seen to help specific businesses hurting in their constituencies.
RE, perhaps a mixture of your remedy and mine- that the US Treasury issue RMB debt (in essence, a bond which pays an RMB-level coupon in dollars, and whose principal accrues value in line with the USD/RMB exchange rate) would work.
From Robert Kiyosaki,
Today, I’m predicting the next crash, what I believe will cause it, and why it’ll be a severe blow to the global economy. The signs are already here.
The coming bust started in 1971. That was the year Richard Nixon took the United States off the gold standard, thus converting the U.S. dollar from money to currency — that is, from an asset to a liability, and an instrument of debt. That was the year the dollar died.
The world has never been in this position before — and the whole world is involved. That’s because Nixon’s actions in 1971 made the United States into a virtual empire. As an empire, we began dictating the terms of world trade: If you wanted to do business with us, you had to accept our new dollar as gold. Unfortunately, the world complied.
Today, China ships us products and we ship them dollars. The problem is that the Chinese can’t spend those dollars. If they do, the price of their currency, the yuan, would go up. Why? It’s simply a matter of supply and demand.
So instead of spending their U.S. dollars in China, the Chinese buy our assets, especially U.S. bonds, with them. Because they buy our bonds, interest rates in the U.S. remain low, and low interest rates encourage Americans to borrow more money. This causes bubbles in real estate and the stock market.
While it’s tough to predict the future, one thing is for certain: The U.S. dollar will continue to go down in value, and savers will be losers. With people all over the world piling debt upon debt and spending like fools, it might be best to follow the Chinese.
…or private equity Fissures Appear in Junk-Bond Pipeline: “It is a potentially ominous sign, because so much money needs to be raised to finance leveraged buyouts in the months ahead. Private-equity firms and bankers plan to seek buyers for more than nearly $300 billion in bonds and loans through early 2008.” markets finally appear to be choking on corporate loans (packaged into CLOs) cf. http://www.nakedcapitalism.com/2007/06/more-on-rating-agencies-and-risk-in.html
[q]That is, if Congress insists on restricting the Chinese in some way (rather than the US consumer), the best approach would be to impose limits on the amount of US debt that the Chinese are allowed to buy.[/q]
Pretty much impossible to do in practice. You sell me a T-bill. I sell it to the Chinese government. For you to be able to prevent the transaction means keeping track of the owner of every T-bill out there.
Treasury bonds are almost like cash. The attraction is that you can buy and sell them quickly and easily.
[q]The economy `can too easily be held hostage to the economic decisions being made in Beijing, Shanghai and Tokyo.[/q]
Funny they didn’t mention London and Frankfurt. Genie already out of the bottle.
I must admit Macro Man, I do not really understand your proposal. You seem to be suggesting that the US effectively shorts renminbi debt. Isn’t that diametrically the opposite of what is required, and what the US could do if China’s capital account was open to them – ie buy yuan and invest them in renminbi bonds, to offset Chinese intervention? But perhaps I have got your idea wrong.
I would expect that because the US authorities have expertise in preventing money laundering and because the Chinese debt purchases need to be so large, it would be impossible for the Chinese to evade such regulations.
In that case PBoC could just buy these RMB bonds from Treasury and xfer all the exchange risk back to Treasury. Now it gets to set the exchange rate and now even get to xfer RMB liability, sounds ideal for the PBoC!
The Soviets managed to own dollars and get paid without owning Treasuries. There should be plenty of middlemen who’d love to make a fee. Vanguard Treasury Fund Admiralty shares charge only a 0.1% annual fee if you have more than 50k opening balance.
The Soviet Union collapsed a long time ago now, and I expect that money laundering surveillance has developed since then. Anyway, I wonder how hostile the US really were to being lent money by the Soviet Union. I would like to see China try today to buy, hide, and receive income on, $1.3tn worth of secret assets!
Dontcha mean “mark-to-market” instead of “mark-to-model”? The latter has rather negative connotations.
http://www.frontlinethoughts.com/pdf/mwo062207.pdf – Blame It On Stability
http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF-+June+2007.htm – What Can Go Wrong: China
Wake Up And Smell The Inflation
Why are the inflation numbers understated? Why would government officials cook the books? The answer is simple: money. Most government-employed people are on cost-of-living adjusted pay packages. Social security programs, retirement programs and pension contributions are all inflation-adjusted.
Interest payments on national debt (which is very high in both the U.S.) would go up dramatically if inflation was reported closer to its real level. In other words, there are billions to be saved if you can keep the official inflation figures down. Manipulating the numbers is surprisingly simple.
If you were to apply the same calculation methodology as in 1980, current U.S. consumer inflation is running close to 10% per annum–very similar to the levels reached around 1980 with the only difference being that the bond market was on high alert then whereas now it appears more relaxed.
that’s been john williams’ supposition for awhile now; but noone listens to his assertions…
Why is it secret asset? Is there something illicit about how the Chinese got hold of the USD? Don’t see what you can achieve other than causing a USD collapse, or maybe that is what you wanted.
Chinese reserves are not secret now, but if the US set a limit on the amount of US debt that the Chinese could buy, then any excess would have to be secret.
Naturally, if this prevented China supporting the dollar, the dollar would fall, but the Americans say they want China to stop intervening.
As I say, I do not seriously expect the Americans to adopt my proposal, because the politicians are looking for way out that does not involve pain. The trouble is that pain is unavoidable, not just for the US, but most of the rest of the developed world too, because the ultimate source of the pain is the competition coming from an awakened China, India, Eastern Europe etc, and that cat is not going back into the bag. Basically, we are going to have to take a smaller share of the cake, and even if globalisation allows the world to make a bigger cake, our portion is likely to be smaller in absolute terms.
from a new book by PIMCO’s McCulley: “…Americans operate on the theory that consumption comes first; hearses don’t come with Uhaul trailers, and, therefore, Americans spend accordingly. In Asia, consumption is an afterthought in the pursuit of ever-greater stores of international wealth.
Neither the Asian model nor the Anglo-Saxon model is inherently right or wrong. People’s utility functions are not homogeneous: different strokes for different folks. And because people’s utility functions are different, there is scope for win-win international trade: We can help each other out, whether willingly or unwillingly, as China has helped us on our current account deficit and we have helped China on its economic development.
Ultimately, though, China will graduate from the American University for the Study of Capitalism… Our belief that this secession can be deliberate and orderly is based on the fact that China cannot leave its mercantilist path or opt out of its currency tie too early because that would destroy its developmental model…
There is the threat that protectionism could force China to untie from its dollar anchor a lot faster …because it is an attractive strategy for a politician from a vote-getting point of view. The cost of protectionism can often be spread very lightly among millions of American consumers. For example, consumers pay more for sugar because of protectionism, but that is not making them single-issue voters against the politicians who support the quotas. Only the sugar worker is going to be a single-issue voter for that politician.”
The problem is that dollar is fungible. Let’s just for argument’s sake say that PBoC is hellbent on owning USD denominated asset it can still make Eurodollar deposits if it is prevented from buying Treasuries. There is nothing preventing European banks from buying Treasuries in your scheme, or is there? But really, now that CNY is not pegged anymore the value of having large reserves is quickly diminishing for the PBoC. China is expected to issue around $200B worth of special treasury bond to fund the SIC. You can bet that those won’t go towards buying treasuries. Some say (see yesterday’s NYT) that PE funding market is tightening a bit, well it is smart of BX to sell a stake to SIC. One can assume its funding source won’t tighten as much.
i agree w/ HZ and Twofish that limiting china’s (or anyone else’s) US debt purchases would be problematic and hard to implement (even w/ anti-money laundering surveilance in place) like just look at the trouble BS has trying to track petrodollar flows (not that he has the resources of treasury, but if even treasury gets it wrong…); and w/ SWFs forget about it. what i’ve sorta been toying w/ in my mind tho, is the possibility of _selective default_, but i think for the very same reasons that HZ and Twofish bring up wouldn’t that be just as hard? or is it just like freezing some dictator’s offshore bank account in macao or someplace?
Why not just stop US trading with China? That is much easier to achieve, at least on the operational level. The effect is the same any way. Which country does US trade with yet with sovereign assets frozen by the US?
To Idiots Bush and Cheney,
Study: Brazil, Russia, India, China Overtake U.S. in Dominating Global Energy Industry
UNITED NATIONS (AP) — The main challengers to U.S. economic power — Brazil, Russia, India and China — have overtaken the United States in dominating the global energy industry, according to a new study by Goldman Sachs.
In 2007, 35 percent of the 20 largest energy companies are from BRIC countries, about 35 percent are European, and about 30 percent are American, the study said.
“The U.S. is now lagging with the smallest percentage number of energy companies worldwide,” Ling said.
Irving, Texas-based Exxon Mobil Corp. is still the No. 1 energy company by market capitalization today, as it was in 1991, Ling said.
But he said it is now followed by the likes of PetroChina Co., a unit of state-owned China National Petroleum Corp.; OAO Gazprom, the Russian state-controlled gas monopoly; Petroleo Brasileiro SA, or Petrobras, Brazil’s government-run oil company; Sinopec, also known as China Petroleum & Chemical Co.; Russian oil producers OAO Rosneft and OAO Lukoil; China National Offshore Oil Corp.; and Oil & Natural Gas Corp., India’s state-owned oil company.
“So you have major state energy companies that have entered the market capitalization ranks,” he said. “I think it’s a combination of the U.S. energy industry falling dramatically behind the rest of the world for a number of reasons.”
like ‘i’ said, i like DC’s suggestion, but like mcculley points out, “Americans operate on the theory that consumption comes first.” the selective default option, wouldn’t be preemptive — and i’m not an advocate of it anyhow; 1) i don’t think it would work and 2) i’d just heard it floated around as an option if/when china came calling in its ‘chits’ (trying to trade nominal for real assets) …iow, if/when the endogenous/exogenous shit hits the fan, would it be possible for the US to selectively default on creditors it doesn’t like (e.g. beijing, moscow, riyadh, etc.) while honoring debts to creditors it does (i.e. presumably london and frankfurt – not paris ? i highly doubt it, but i wouldn’t entirely dimiss treasury (and the ‘washington consensus’) from trying!
um, point being (to be clear), once you’re talking about selective default seriously as an option, you’ve prolly already lost… and i think the same goes for selectively limiting US debt issuance; and, yes, better not to have issued so much in the first place — it’s the level (of promises the US has no intention of keeping) more than the ownership breakdown (of IOUs) that’s the problem.
Not quite sure what you mean by “honoring debts”. For the US government it is as simple as issuing more debts (obligation of Treasury) or FRB notes (obligation of the Fed). The US never promised more or less. All the hand-wringing in conducting fiscal or monetary policy is about the response of the other participants of the economy. Whoever you selectively default on, which is akin to a major seizure of someone else’s asset, you would have to deal with the credibility issue of the whole monetary system and risk the whole house of cards crashing down.
well, there’s risk-free and there’s ‘risk-free’ (at what inflation and fx rate – again translating between nominal and ‘real’?) my question/rumination was whether the US can actively select who bears the ‘risk’; again (again), i agree w/ you that the whole edifice crumbles once credibility goes (money, afterall, is an agreement, as lietaer would say).
like if i say to one creditor, yes, and to another, no, then obviously even the one i say yes to would be suspicious (w/o assurances), esp in an iterative process; hence the advent of credit history and all the rest. but if the house of cards is crashing down _anyway_ what i was wondering is if the US could keep enough of its (‘select’) lenders together, while singling out a scapegoat (in DC’s terminology) as the sacrificial, well, goat, in order to minimze the carnage — to itself, and to it ‘allies’.
in effect, the US would be saying yes, yes, yes to most of its ‘well-behaved’ creditors, but no to a few (or one) of its ‘enablers’, essentially telling them they’re assholes and deserve it anyway and turning the neo-washington consensus (in the BWIII club) against them for the ‘good’ and the preservation of a reconstituted monetary system in a newly tiered world.
again^3, somehow i doubt this would work, if only because most of the productive and resource (and intellectual?) capacity lies outside washington and if BWI & II never worked, why would III? beyond a “multi-polar currency regime” as DC advocates, i’d submit a back-to-the-future buffer stock solution ala graham and keynes (the terra?) perhaps coupled w/ non-national local/private currencies…
not that gov’t (tax-payer) backed fiat currencies are inherently unstable, it’s just that they’d work better when they’re not the only choice around; the right currency for the right niche, a currency ecosystem as it were (similar to all the different software licenses that abound) that would better reflect the system of values of its constituents… only the ‘right of kings’ — to coin money — is zealously held.
i am a little late to this discussion, but one question for macro-man: why should the US — from a narrow US self interest point of view — issue debt linked to the RMB (and take the $ depreciation risk) when China is willing to buy $ denominated debt and take that risk itself? The “price” China pays for its export subsidy/ development model is a capital loss on its foreign assets when the RMB appreciates. So long as China takes the currency risk itself voluntarily (and w/o insisting on high int. rates to offset the risk), why should the US offer to take on the currency risk itself? Generally, you want to avoid balance sheet mismatches if you can …
my policy recommendations are pretty standard — fiscal consolidation = easiest route to higher national savings, XR flexibility elsewhere. the only non-standard parts are that I don’t really think Europe needs to do more (it is already doing its part) in global adjustment and i think the US might consider some steps to reduce its petroleum deficit.
China’s Central Bank Asks for Patience on Currency: China’s central bank said it will take time for China to achieve foreign-exchange flexibility.
Chinese-Currency Bonds To Hit Hong Kong Market: China Development Bank said it will sell up to $656 million of yuan-denominated bonds in Hong Kong, the first such issue outside mainland China.
Your prescription sounds good.
Haven’t seen your reaction to the VAT rebate reduction recently announced by China — could be worh 1-2 percentage points in the USD/CNY exchange rate.
I’m pleased that you mention pertoleum deficit (and all your posts are free lessons for most of us).
You know I’m not an economist, but I want to bring here a humble explanation of a banker about the Anglo-disease, derived from Dutch disease, and affecting more to macroman’s empire than to your “naked empire”.
It seems to be an old economic subjet of the seventies, but as it goes to resources and imbalances of expending, although a bit out of topic, it fits OK to our actual world:
Good night you all.
I think the most significant risk is that the US consumer carries too much debt. Tighter lending standards, falling housing prices and rising interest rates will simply stifle borrowing demand. This is an ongoing process that will accelerate and cause the dollar and economic activity to plunge.
Thanks koteli for theoildrum link — I can really “relate” to what Jerome A Paris is saying about “Anglo Disease”. In the end, what matters is about advancing societies and balancing resource consumptions with population control (economic and financial variables are just “man-made tools” measurements and instruments used by the greedy hoarders to exploit us little guys — very meaningless and pointless to even worry about).
Developed countries like Britain and US need to start rolling up their sleeves and do their own “dirty” manufacturing works and stop being the casinos of creating/selling “global financial tradings” — thus, churning out ever more “what goes up must come down” cycles.
BTW, I would like to emphasize Asians love to gamble and China is surely to start their own global casino anytime soon, thereby competing with both Britain and US (not just in 10 years time as one British commenter has posted in another blog — it seems he forgot about Hong Kong and Singapore).
Your presentation is fundamentally about risk. I have a suggestion on how the risk analysis might be enhanced in one specific dimension. This has to do with the role of the international banking system in current and capital account flows.
All US dollar outflows from the US on either current or capital account end up clearing back to the nostro accounts of foreign banks in the US. This is the first point of the return trip on all accounts. It is the default point and it is critical to understanding the full routing and risk of the flows. For example, in the first stage, if Wal-mart buys from China, the proceeds will first land in the Chinese exporter’s bank account at a bank branch resident in China. This branch will clear up to its regional or head office, which will then clear its US dollars, directly or indirectly through other (offshore) banks, and ultimately to a dollar nostro account domiciled at a US bank in the US. – e.g. Citibank New York. As US dollars are moved around in China, they have a dual representation in nostro accounts back in the US. (China may be an unusual example here for a few reasons. But the logic of the connecting flows must hold.)
The dollar increase in the foreign bank nostro account in New York is the initial form of the capital inflow that offsets Wal-Marts contribution to the current account deficit at the margin. It is the initial form of the US external liability that results from this capital inflow. This inflow is automatic, in the sense that international banking system mechanics ensure it must happen. In this sense the US current account deficit is self-financing, because these return flows must happen as a result of banking mechanics.
Back in China, assume the commercial bank sells its dollars to the PBOC. PBOC now has the dollars that again will be ultimately represented as nostro funds in the US, through whatever chain of banking connections. Suppose PBOC then buys US treasuries, and that the ultimate seller is a US resident. PBOC may buy through London, or anywhere, but the eventual effect is that corresponding nostro funds in the US will be transferred to the US bank account of the bond seller. And the recorded form of the same capital inflow will switch from bank nostro funds to US treasuries.
To summarize, the US current account is self-financing through the international banking system. The default financing form is bank deposits. The ultimate form of financing results from bank deposit holders switching into other assets such as bonds, equities, and direct investment (This includes the case where dollars have flowed through the FX market, which only changes the foreign ownership of the ‘default’ dollar bank balances.) Surplus entities must proactively choose their asset mix in order to diversify out of their default capital outflow.
And this is where the risk is. The risk is not in the required capital inflows, which are automatic. The risk is the subsequent asset mix choice (including the case where the dollars have new owners through FX). The choice is the risk. Consider a ‘catastrophe’ scenario, for example, where the choice is to remain in default bank deposits. Suppose foreigners accumulate $ 1 trillion in additional bank deposits over the next year, without any marginal bond, equity, or FDI additions. (Worse yet, suppose the $ 1 trillion had also been shifted to new owners via the FX market). The deficit is still financed by a shift of Wal-Mart type domestic deposits into foreign bank deposits. But the result in this case would likely amount to a deflationary liquidity trap, since both asset prices and monetary velocity (i.e. the trapped money) would plummet. The risk is not that of the failure of the required capital inflows to materialize. That’s a given. The risk is the asset mix choice and resulting asset pricing.
The way to win a debate is to destroy an opponent’s argument with logic. The opponent here is any school of thought that thinks the current account deficit is a yawn. By integrating the role of the banking system into your arguments, I believe they will be more powerful and evidently true.
re: “The risk is the asset mix choice and resulting asset pricing.”
agreed, although if I understand your point, perhaps the more important issue of how controlling interests are established and retained. Just looking at that past couple of day’s headlines, owning is not necessarily the same as controlling – and of course, different assets provide different avenues for control. But with all the concern about natural resources, perhaps your other point may allude to a greater concern about controlling interests in the banking system?
Guest on 2007-06-27 08:10:04
My basic point was purely technical, while more or less policy neutral. Perhaps policy risks flow from it as you suggest, although my own policy perspective would be more along the lines of Fed policy. To those who suggest capital inflows might not be forthcoming under certain circumstances, I would counter that this could not happen. But to the degree that it ‘nearly’ happens, it might show up as a money glut in the US domestic banking system (either a bulge in foreign nostros, or more likely/less unlikely, foreign inter bank short term fixed deposits). The problem with this scenario is that it constitutes a flight to commercial bank deposits rather than to treasury debt, which would be the more normal refuge. However, in the event of a severe capital inflow dislocation, I could see it doing strange things to the international bank liability component of the domestic banking system, with the type of glut and deflation risk I suggested. The policy implication might be a round of Fed suasion on money center and other banks (a la LTCM) to buy US treasuries, since their prices would have collapsed. This in itself would be a price rescue operation, not a bank liquidity glut utilization operation per se, since the funds would be sourced by bank activity rather than bank customer activity. But it would serve to re-prime the pump of an effectively broken domestic financial system at that point. That’s the policy implication I see first. The ownership issues you refer to I think remain as a function of the size of the deficit and the debt, and are widespread across all asset classes otherwise.
jkh — makes sense. but your account implicitly assumes that us trade is settled in us dollars. that is certainly true today — it is one aspect of exorbitant privilege. but i don’t think it is a necessary feature of trade; China also settles its accounts with third parties in dollars (supporting your argument even more) for example. in a lot of ways, your analysis here matches my analysis of oil payments in $. what really matters is the currency/ type of financial assets that the oil exporters decide they want to hold for savings purposes, not the fact that they are paid in $ — though inertia does probably imply the default is to hold $ assets if you are paid in $. and for the gulf, inertia is combined with a $ peg …
Brad – off the top, if there were a developed RMB banking market in the US, this could allow domestic bank RMB lending (which automatically spawns an RMB money supply in the US). This could facilitate Wal-mart domestic borrowing in RMB, with invoicing of and payment for US imports from China in RMB. It could also facilitate the issuance of RMB denominated debt from the US, as proposed elsewhere. But the latter stages require the former. Once the former and the latter are both in place, RMB return capital flows become automatic with RMB import payments and, once again, the issue becomes the choice of China as to what to do with its ultimate claim on RMB nostros in the US. Buying RMB denominated US debt would be one choice.
But the initial capital inflow would be RMB nostro balances, self-financing the marginal current account deficit flow, the same as the US dollar case (Wal-mart borrowing effectively funded by RMB nostro balances). From there, the issue of risk emanating from the asset mix choice of the capital supplier China is the same, including the choice to sell RMB (again this merely changes the ownership of an RMB capital inflow, not its initial appearance). There is also now a complex of micro risks, including Wal-mart’s exposure to the RMB, the US treasury’s exposure to the RMB, and how the domestic RMB banking network could deal with FX risk transfers desired by those players. (But it won’t be able to reverse the fundamental change in the macro FX risk, which is that with the invoicing change from US to RMB, China has shifted US FX risk out of its system and created RMB risk for the US system on a net change basis).
Perhaps most of this is consistent with what you’re saying also.
JKH – Is it correct to say that a rapid transition or state-change from “a” to “b” (as you’ve described) would be painfully similar in adjustment terms to an-Argentina-style shock and adjustment?
Guest on 2007-06-27 10:07:54
Many economists that read this blog, and the host especially, are far more qualified than myself to begin to answer that comparison question specifically.
But its an important question I think, because there seems to be a general tendency to recognize the nature of the risk in some sense, but without necessarily visualizing the way in which ‘the event’ would actually transpire. It’s hard to visualize a risk that implicitly is assumed to be abrupt, when the system seems to grind on through inertia. And the mammoth market size of the US financial system must be important in judging how the risk would play out.
The scenario I outlined was the closest thing I could conceive of to an effective ‘drying up’ of capital flows, which I think is technically impossible in fact, due to the inevitable ‘round trip’ of payments made on current account back into the US banking system through nostro accounts. Even the baton passing of dollar balances through the FX market in a major FX crisis could not cause capital inflows technically to ‘dry up’. The fact is that vast reservoirs of US dollars can’t really disappear from the system, except by repayment of bank lending, or by credit defaults and equity losses.
The urgency of the issue of the deficit is more a liquidity issue, at least initially, than a solvency issue (although solvency, including that of the US government, is obviously a longer term consideration). What would a ‘liquidity crisis’ look like in terms of the flows or the absence of flows and the corresponding stock of foreign held assets? Perhaps it could become a hoarding of bank balances as described, with a total retreat from risk assets. (If there is a retreat, there must be an offsetting ‘charge’ into something in order to balance flows on a net basis).
The adjustment described seems bizarre, but perhaps less bizarre than others. The bottom line for me is that foreign investors en masse must make a choice on their existing asset allocation and their allocation of new monies earned through current account surpluses.
They have no choice – i.e. they have no choice but to make a choice in terms of asset allocation.
‘Fleeing’ US assets for the entire foreign population of investors is simply not a technical option. So how do they come to terms with the inevitability of having funds to deploy somewhere in the middle of an asset price collapse from which they are retreating?
My view is that Fed Reserve involvement would be rather heavy, both directly, and in terms of moral suasion and liquidity commitment to the domestic financial system. Perhaps the Greenspan put will never die. In fact it is part of their job. Moreover, the put would likely be transferred to the broader financial system through some form of ‘moral suasion’. The Fed would dominate relative to the normal involvement of the IMF.
I don’t know. Does that sound like Argentina?
I think you are right to emphasise the fact that the banking system means that the US current account deficit is automatically financed (ie a dollar bank deposit is a liability of a US bank), but wrong to worry about a slump if the Chinese do not spend their deposits.
If the Chinese wanted to keep holding dollars, but wanted to stop buying treasuries, say because they were concerned about the willingness of the US government to pay them back they could simply move the dollars to a time-deposit. The bank would then have to find an outlet for these funds. Normally they would lend the dollars, buy a security, which could be a US treasury, or ultimately, leave it in a settlement account at the Fed, earning no interest. The bank might pay them a poor return for this deposit, but that is what the Chinese would have to pay for the bank’s intermediation service, and for the Chinese, superior credit quality. The government may also have to pay more to get the bank to buy treasuries, but that would be a reflection of their deteriorating credit quality. The resulting rise in broad money supply and fall in velocity would hardly be meaningful.
RE – I agree almost entirely – although my example was a pullback of $ 1 trillion in 1 year for all assets other than bank deposits. Given the back and forth on this blog recently regarding the likely effect of the Chinese pullback from a single bond auction, I could see $ 1 trillion being of potential substance for asset pricing, particularly if correlated with similar domestic aversion to risk assets.
The road to Argentina goes via Britain in the 1970s. Foreigners lose their appetite for assets denominated in your currency, especially debt. There is a slow route, in which the lenders just get full up, and there is a fast track, in which the you repudiate your debt, either via high inflation or an outright default. Then the lenders demand a higher return, which increases your burden. With a bit of austerity and a windfall like North Sea oil, you might still be able to turn back. If instead, your response is another cycle of borrowing, default and even more expensive debt, you are well on the way to Argentina. Whether you turn back or proceed depends on whether you are willing to accept the reality of your situation. So far, the signs from America are not encouraging.
America is not Argentina
re: “no choice but to make a choice in terms of asset allocation”
fwiw, i think their choice is fundamentally whether they want to continue in nominal assets or (as they have expressly desired) move to ‘real’ assets — those assets that (more or less) maintain ‘value’ independent of the general price level.
re: “the Greenspan put will never die. In fact it is part of their job. Moreover, the put would likely be transferred to the broader financial system”
i thought this was kinda interesting http://www.portfolio.com/views/blogs/market-movers/2007/06/26/will-china-prevent-the-cdo-meltdown
– “Stability and growth remain China’s objectives, and a financial crisis beginning in New York is every bit as threatening as a stock market crash in Shanghai. China could not have acted fast, as the US Fed did during the LTCM crisis. But, so long as only a few funds are in crisis and the unwindings are ‘orderly’, I think China will find it in its interest to be a ‘bagholder of last resort’, purchasing a few assets at prices high enough to prevent cascading markdowns or defaults against margin lenders. Fund investors will still lose money, but that rarely has systemic implications.”
self preservation as uncoordinated intervention, esp in light of http://www.nakedcapitalism.com/2007/06/carry-trade-threatens-deflationary.html
– “Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK and the euro area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.”
re: “‘real’ assets — those assets that (more or less) maintain ‘value’ independent of the general price level”
along with the unique characteristics of each (relevant) nation’s currency, might we assume that asset mix, pricing and price stability is also more or less affected by any of the following:
-accounting standards and capacities for enforcement
-property rights and enforcement
-tax base and policies
-organizational and political/legal infrastructure
-’brand’ valuations (sentiment) as affected by media and data influenced perceptions of (evolving) political and economic strengths and risks
-capacity to use force (military and other)
if consideration of the above may serve in any way to better differentiate between nations and determine relative risks and probable outcomes.
It is interesting to think about the meaning of ‘foreign’ as applied to a nation like the U.S., which may be the, or at least one of the most integrated political economies in the world, as compared to others.
or the notion of ‘generous’ foreigners which include self-interested nations with the largest wealth gaps in the world.
perhaps more accurate to say self-interested elites in nations with the largest poor-rich gaps, and worst human rights records in the world.
The financial market is afloat on a sea of borrowed credit .when the owners come back for their money it is bad time.The recent volatality in the US is due to selling of bonds and shares by foreign managers to buy New zealand and Australian stocks and bonds.
untill recently USD/JPY was the trade that everyone wanted to be in. While the Federal Reserve, struggling to control inflation, increased the price of money sixteen consecutive times, the Bank of Japan was fighting deflation by holding interest rates near zero. Consequently during 2006, the interest rate differential between US and Japan made long USD/JPY a one way bet. Even though the US dollar still has a positive interest rate differential against the Japanese yen, interest rate expectations are visibly favoring the Japanese yen, what makes the USD/JPY a bad carry trade for 2007. Many traders are currently hunting high yielding currencies like the Aussie and the kiwi at the cost of the US dollar. Since the beginning of March, both the Australian and New Zealand dollars have surged over against the US dollar, .
Australia’s two year government bonds yield 5.48 percentage points more than similar Japanese bonds and have a 1.77 percent premium over U.S. As a result of this large differential, in just 12 months the Aussie climbed 15 percent against the Japanese yen, trading from a low of 82.07 on March 2006 to as high as 99.90 in April 2007, as Japanese investors bought Australia’s and newzealands higher yielding assets.