The bad news: the US trade deficit hasn’t shrunk by as much as foreign demand for US long-term assets.

My graph only showed inward portfolio flows. That isn’t the entire balance balance of payments. But inward and outward FDI flows tend to offset each other. And in general Americans have been adding to their foreign portfolio, not reducing their foreign holdings. That means the (remaining) deficit is increasingly financed by short-term flows, which isn’t the most comfortable thing in the world.

All this is pretty clear if you look at the details of the last TIC data release (already covered in depth by Rachel). Over the last three months, private investors reduced their US holdings by over $100 billion (line 31). That total was offset by the repayment of the Fed’s swap lines — but the long-term flow picture isn’t great. Net portfolio inflows over the last 12ms totaled $188 billion (line 19). After adjusting for repayment of ABS, that total falls to zero (lines 20 and 21).

As the following graph shows, net private demand for long-term US assets — that is gross long-term private portfolio inflows net of US portfolio outflows — started to disappear in late 2006, and then took another down leg after the subprime crisis broke in August 2007. And over the last 9 months, official demand for US long-term bonds also disappeared — as reserve growth slowed (until recently) and central banks moved in mass toward short-term treasury bills.

The split between official and private flows in the chart reflects my adjustments to the TIC data – but my adjustments basically just make the TIC data match the US survey data and the revised BEA data on official flows.* My adjustments change the official/ private split, but not the total.

The usual narrative would argue that the fall in demand for US long-term assets is a reflection of foreigners concerns about the scale of the US fiscal deficit. That though isn’t really the case. Demand for long-term Treasuries has held up better than demand for almost all other kinds of US assets. The reality is that the rest of the world has lost confidence in claims on the US private sector, not in claims on the US government. Consider the following chart …

The higher frequency data tells a similar story. Net (private) demand for US long-term financial assets (private demand for US long-term assets from the rest of the world, net of US purchases of long-term foreign assets) hasn’t been strong for some time. It picked up in the crisis, as flows contracted in a way that favored the US. Americans sold their foreign portfolio faster than the rest of the world sold their US portfolio. But as the crisis has abated, net private demand for US assets has fallen off. Foreign demand for long-term US assets remains weak – and over the last few months Americans resumed buying foreign assets.

Incidentally, this chart is one of many that suggests, at least to me, that the US could not have sustained large deficits over the past few years if the US had been forced to finance its deficits in the private markets. The demand wasn’t there. Not on the scale that was needed. **

For a while, official purchases of long-term assets offset weakness in private demand. But after the crisis, risk-adverse reserve managers have preferred short-term bills – so demand for long-term US assets from central bankers largely disappeared.

There are some tentative signs that central banks are once again buying Treasury notes, at least short-dated ones. My estimates suggest that official purchases of long-term US financial assets are trending up again — largely because of purchases of Treasuries through London.***

Even so, there was — at least in the three months to May — still a sizable gap between net demand for US long-term financial assets and the US trade deficit. The (much reduced) trade deficit is being financed by short-term inflows, and specifically short-term official inflows.

That isn’t ideal. The “quality” of the financing of the US deficit has gone down.

The fall in the trade deficit has, in my view, reduced the risk of a disruptive dollar adjustment — at least relative to the pre-crisis world where the slow growing US was running 6% of GDP or so current account deficits, deficits that private investors showed little sign of wanting to finance. Analysts who emphasize the rise in the fiscal deficit tend to ignore the (even bigger) fall in private sector borrowing and corresponding fall in the United States total external financing need. But finding the financing to cover a period of adjustment is never easy; the US isn’t yet out of the woods.

* Using the methodology described in my work with Arpana Pandey, I attributed some of long-term Treasury and Agency purchases through the UK (and for Agencies, Hong Kong) to official buyers on an ongoing basis. This avoids the jumps characteristic of the annual survey revisions. I also adjusted official equity purchases for Chinese purchases through Hong Kong from 2005 on, using a similar methodology. There was a big jump in Hong Kong’s equity purchases in early 2007, and the survey data subsequently attributed those purchases to China. The overall data should be fairly close to the BEA’s revised data series – though I didn’t adjust official purchases of corporate bonds down to reflect the survey revisions (apparently central banks do not use US custodians for this exposure), as I suspect that the data actually understates the official sector’s true exposure to corporate credit. Private fund managers did a lot of things to get a bit of extra yield, and some central banks made increasingly use of private fund managers when they themselves were reaching for a bit of yield.
**A counter argument is that official demand displaced private demand, but didn’t change the overall equilibrium. This has two components. First, if say China’s government hadn’t been building up claims on the US and Europe, private Chinese investors would have bought the same amount of US and European assets (something I don’t believe). And second, if say China had bought more European assets and fewer US assets, private investors in Europe would have shifted funds from Europe to the US – keeping the US deficit up. That argument has a grain of truth, but it assumes a bit more substitutability between US and European assets (including a willingness to take unhedged currency risk) than I suspect is present in the market.
*** The UK’s Treasury holdings rose by about $30 billion over the last three months.

On a y/y basis, the fall in exports does seem to have stabilized. Moreover, the y/y fall in exports seems to have stabilized with a bit before the fall in imports stabilized, and the percentage fall in non-oil imports (around 25% y/y) is a bit larger than the percentage fall in non-oil exports (around 20% y/y).

But y/y changes don’t tell us all that much. Levels are what count.

Real (goods) exports and especially imports have been essentially flat for the last three months or so. The Los Angeles and Long Beach port data suggests nothing much changed in June. That is progress. Exports, imports and indeed activity were all in free fall for a while in q4 and q1. But the trade data – backward looking data, to be sure – still fits comfortably with Jan Hatzius’ argument that final demand is going sidewise more than recovering.

But exports have stabilized after a smaller fall than imports. Real exports are at their late 2005 levels. Real imports are at their late 2003 levels. That means the non-oil trade deficit has fallen significantly.

The non-oil deficit over the last three months was only $40 billion — about 1/3 of its level in late 2005 and early 2006. The non-oil deficit actually isn’t that far from the levels typical of most of the pre-boom 1990s.

Of course, oil prices aren’t likely – unless you believe Philip Verleger – to return to their 1990s (or 2002) levels, so the overall deficit is still a bit bigger than it was in most of the 1990s.

Still, there has been a major adjustment. The question is whether it will be sustained when the US recovers and US demand picks up.

That depends on the course of the dollar, to be sure. And of the course of the dollar depends on whether private demand for US assets picks up, as well as whether countries like China maintain dollar pegs. But it also depends on the nature of the global recovery – and the strength of stimulus policies other countries adopt. And their at least there is a bit of hope, at least so long as China sustains its current highly stimulative policies. China’s June surplus was lower than expected, in part because China’s imports picked up before China’s exports. That’s goods news for global adjustment.

There sometimes is a tendency to speak about the world’s macroeconomic imbalances as if nothing has changed. That increasingly strikes me as a mistake. The world’s imbalances haven’t gone away, but they have shrunk dramatically.

Japan is now running an external deficit. China’s surplus shrank, at least in q2. The US deficit is much smaller now than in the past. Europe’s internal imbalances also have shrunk.

The adjustment came the painful way – with sharp falls in exports and imports. But it was still adjustment. The trade deficit fell sharply. The rise in the public borrowing buffered an enormous fall in private borrowing, and private demand. It cushioned rather than stopped the adjustment. The challenge now is try to make sure the recovery doesn’t undo the adjustments that happened during the crisis.

One last point: the lion’s share of the US deficit now comes from the United States petroleum import bill. Discussions about the policies that gave rise to imbalances typically focus on macroeconomic policy choices. That increasingly strikes me as incomplete. Energy policy should enter the calculus too. The US isn’t going to start exporting petrol – not on a net basis — anytime soon. But it certainly could do more to reduce its demand for imported energy.

But I first wanted to offer my enormous thanks to Mark Dow of Pharo and Rachel Ziemba of RGEMonitor for filling in here when I was away. They set a standard that I will have a hard time matching.

Two weeks is a long time in blog land. I though needed a true break – and thanks to their efforts, this blog didn’t miss a beat. I can not thank them enough.

These days, the TIC data released monthly by the US Treasury and detailing the capital flows to and from the U.S. often seems anti-climactic given sharp moves in the fx and treasuries market. Despite the lag, data released yesterday and detailing May purchases tells a few interesting stories.

Most importantly, it illustrates the fact, that in the face of capital inflows to overheating emerging market economies in May, the central banks of these countries kept buying U.S. dollar assets. Q2 has been the first quarter of significant reserve accumulation of the last year. Preliminary estimates we’ve done at RGE Monitor suggest that reserve accumulation was around $180 billion in the quarter (adjusted for valuation), the first significant increase since mid 2008. As in 2008, China accounts for the bulk of the accumulation.

Despite supra-national reserve currency rhetoric given the reluctance for currency appreciation, there was little choice to buy dollars. China added $38 billion in U.S. short and long-term treasuries - a net increase of $26 billion in U.S. short and long-term assets. The discrepancy can be explained by China’s reduction in its USD deposits and continued reduction in agency bonds.

However, they shunned the long-term assets. The major foreign buyers of US assets went back to the short-end of the curve, buying T-bills and adding other short term claims. Total purchases of T-bills by foreign official investors were $53.1 billion.

This move could help explain why long-term treasury yields rose in May. With concerns about the U.S. fiscal position, worries expressed by major U.S. creditors about the dollar’s value, perhaps the move to the short-end of the curve is little surprise. It also suggests that the U.S. government is again becoming more reliant on bills financing as it was towards the end of 2008. This may not be sustainable in the longer-term.

While the decrease in the US current account deficit means that the U.S. may be less reliant on foreign finance in 2009, the U.S. has become even more reliant on China as a share of its foreign finance. China has been the largest reported holder of U.S. treasuries for some months now. But as of May China now accounts for 20% of total outstanding foreign holdings and almost equals the combined holdings of Russia and Japan.

Since last fall, China dramatically scaled up its purchases of the shortest term, most liquid U.S. assets. It has purchased $196 billion in treasuries of less than 1 year maturity from July 2008 to May 2009. In part this might reflect a shift last fall within China’s US dollar portfolio. It also vastly decreased its holdings of US agency bonds, while slightly adding long-term treasuries.

However, as the chart below shows China’s purchases of long-term US assets fell sharply in the last year and continue to fall.

12 month rolling sums of Chinese purchases of U.S. assets

So why short-term assets? Investing the most liquid assets could keep funds freer for other purchases, including the extension of dollar denominated loans to resource countries. In theory, with shorter maturities, China could allow these assets to expire and not re-purchase them. However, in an environment where Chinese growth is re-accelerating, Q2 is unlikely to be the last with hot money inflows. As a result, expect further dollar purchases. No wonder Chinese officials were worried about USD holdings this spring given how many US assets they were buying.

Like China, Brazil also added short-term claims in May, with $12 billion in short-term claims offsetting net sales of $9 billion in treasury bonds. Short-term treasury holdings rose by almost $10 billion. Brazil has also been wanting to diversify its reserve holdings.

What of the Gulf, the major creditor region, visited by the Treasury secretary this week? Asian oil exporters likewise added to short-term holdings in May, prompted likely by local liquidity needs even more than dollar value worries. Given lower oil prices, the regions sovereign wealth funds have fewer new funds at their disposal. That may be changing slightly, yet, the increase in domestic spending and reduction in oil output limit new funds available. Meanwhile with the shifting from the dollar peg off the table as a policy option reserve diversification is limited. Moreover, given the pegs, their need for dollar liquidity and dollar financing remains high.

Based on the reported data, the GCC has a reported dollar portfolio of about $400 billion - $140 billion in U.S. equities, which hasn’t budged much in the last 2 years. Holdings of long-term treasuries increased from by about $30 billion from June 2008 to May 2009 to almost $200 billion despite a slight decrease in May. Holdings of Agency bonds fell by about $10 billion though.

The GCC total dollar portfolio is likely significantly bigger – over half of the estimated $2 trillion managed by public and private sector GCC investors. The discrepancy can be explained by the GCC tendency to buy through intermediaries. However, it seems likely that the use of local intermediaries has increased. The flows from the GCC have been higher in the last year. But again, the currency pegs may constrain the GCC to dollar purchases.

Japan, Russia and Canada, had notable net sales of U.S. assets in May. Japan’s shrinking current account surplus could reduce the amount of US assets it buys.

Canada’s sales may reflect the shift away from government bonds to equities outside of the U.S. in the midst of the rally.

Russia’s net sales, mostly of short-term assets, seem to be a bit more puzzling. Russia has been reducing its U.S. dollar assets from some time but given the inflows Russia received, one would have expected dollar purchases. In fact Russia’s central bank data on its fx interventions suggests that it bought $18 billion in US dollars in the month of May. Russia could be adding to offshore dollar deposits that would not be captured in U.S. data.

]]> http://blogs.cfr.org/setser/2009/07/17/may-tic-data-still-buying-us-assets-but-just-the-liquid-ones/feed/ http://blogs.cfr.org/setser/2009/07/17/may-tic-data-still-buying-us-assets-but-just-the-liquid-ones/ http://feedproxy.google.com/~r/CFR_BradSetserBlog/~3/L96f9F_V3eY/ http://blogs.cfr.org/setser/2009/07/15/nothing-brings-out-buyers-like-higher-prices-and-other-short-stories/#comments Wed, 15 Jul 2009 16:28:50 +0000 Mark Dow http://blogs.cfr.org/setser/?p=5912 This post is by Mark Dow

DXY, a dollar index, looks like it has started to break down. At my firm, Pharo, we have been whispering on the trading desk over the last two days that this was looking increasingly likely. The implications are positive for risky assets. Markets play a lot of tricks on investors, and you can’t be too certain of anything in times as unprecedented as these, but, to us, it looks like the short dollar trade is “on”.

Is there a fundamental reason for this? Not clear. However, I am pretty confident that if the dollar continues to sell off the way it has started to overnight and this morning, and Treasuries continue to weaken the way they have started to, the stories of debasing the currency and Chinese diversification and the like will bob right back up to the surface. So, there will at least be a fundamental ‘story’ behind it.

Personally, I always find it hard to put too much faith in these predominately bearish dollar stories when risky assets are doing well. And, almost inevitably, risky assets do well when the dollar sells off. The correlation between the dollar and risky assets continues to be very high. Here is a correlation matrix of some proxies, using daily observations over the past year.

In the first row and column of the table you’ll see DXY, the dollar index comprising a handful of G10 currencies. The other rows represent various and sundry risky assets—mostly EM currencies, the S&P, and EEM, the ETF for emerging market equities. CCN+ is the 12 month forward for the Chinese Rinminbi, since the forward moves much more in response to market impulses than does the spot rate, which, as all of you know, is tightly managed.

For the dollar to be negatively correlated to risky assets, DXY should be positively correlated the CCN+, negatively related to SPX, AUD (since the Australian dollar is quoted in terms of dollars per Aussie dollar), and EEM. DXY should be positively correlated to TRY (Turkish Lira), BRL (Brazilian Real), and JPY (Japanese Yen).

You’ll notice that all of the correlations have the expected sign with the exception of JPY. This is due to the residual influence of the carry trade and deleveraging process. Since the yen was the other heavily borrowed currency during the levering up phase that led to the crisis (though nowhere near as abused as the dollar in this regard), the yen is the only currency apart from the dollar that is regularly negatively correlated to risky assets. It is also worth pointing out that the yen is a significant component of DXY, and, were it not there the correlations between DXY and these assets would even be meaningfully stronger.

Why is the correlation high? The simple, stylized answer is that most investment funds, irrespective of where they are domiciled, are denominated in dollars. This will change over time, and will contribute to the unwind of the dollar overhang that I wrote about here last week, but until it does, when investors reduce risk they buy dollars and “bring their assets home”, and when they increase risk they sell dollars and put their money back to work across the globe. There is more to it than that of course, but, over short spans, this is the main driver.

Okay. So, where does the dollar go? The market intelligence that we have put together here at Pharo tells us that market positioning—especially amongst large hedge funds—is light. The choppy markets frustrated a lot of investors, and there is very little belief in any positive economic scenario from here (true or not, this is the consensus view). In response, hedge funds reduced their longs, cut their shorts and headed for the beach, protecting the gains that they have had this year. Prop desks on the street are also protective of the profits they have generated so far this year. After an experience like last year, people really seem afraid of “doing something stupid”. The implication here is that if markets do move up, cell phones on the beach will ring and performance anxiety will start. Traders will chase. If, by any set of miracles, the fiscal stimulus or whatever starts to throw off better-than-expected news, traders would catch themselves really wrong footed, and things could get ‘ugly’ to the upside. In short, people would be much more surprised with good news than bad at this juncture. This would lead the DXY meaningfully lower, probably back to the lows of last year.

Chinese reserves data released today seem to be one more sign that the Chinese stimulus might be working a bit too well. China’s reserves stood at $2.13 trillion up from $1.95 trillion at the end of March 2009. Although reserve accumulation was likely lower than the headline $178 billion, it implies that hot money is back in China. Adjusting for valuation, Chinese reserve growth was likely about $140 billion, much higher $60-70 billion of China’s trade surplus, FDI and interest income in this period. This accumulation also suggests that China continues to have a hard time diversifying its holdings away from the U.S. dollar.

Adjusting for valuation – the changes in value of the non-dollar holdings in China’s reserves — would imply reserve growth of around $135-140 billion. This accumulation rivals that of Q2 and Q3 2008 for the highest quarterly level.

It is one indicator that suggests that parts of China’s economy may be overheating as China tries all measures to stoke growth. It seems well in line with almost 40% y/y urban fixed investment in May 2009, and loan growth equivalent to 25% of 2008 GDP. However, it just underscores some of the difficulties in both stoking growth and avoiding future distortions.

China’s rapid reserve growth is but one of many indicators that might be worrying monetary policy makers. While consumer prices are still falling on a y/y basis, as companies can not pass on higher costs to consumers, the current lending growth and money supply growth could lead to inflationary pressures ahead. China is again trying to ease and tighten its monetary policy at the same time. It recently began issuing sterilization bills again to try to mop up the liquidity generated by buying the foreign exchange. And investors anxious to get a part of the new IPOs and worried about inflation have been reluctant to buy some recent low-yielding bond issues. Despite the risk of overheating, other parts of China’s economy continue to be weak, suggesting that tightening could be politically difficult especially if it contributes to asset market correction

The potential risks stemming from the Chinese monetary (mostly lending) and fiscal stimulus is one of the reasons that we at RGE are still somewhat cautious about the mid-term outlook for Chinese growth (as summarized in this excerpt today). There is a risk that China might be forced to use rather blunt policy measures to try to cool the overheating in some parts of the economy and, especially, its asset markets before the real economy gets on to a sustainable growth path. Or, they might not reign in the spending and it could contribute to asset bubbles and inflation that could lead to a double-dip, if as RGE fears, the U.S. and global recovery is sluggish.

But back to the reserves. Given the size of China’s reserve growth in Q2 — in the face of a shrinking trade surplus and lower foreign direct investment than in 2008 — the country is likely experiencing short term capital inflows “hot money” again. Economists tend to sum the trade surplus (the largest component of the current account) and FDI. What is unexplained by these inflows is often deemed to be hot money - short-term capital inflows. China’s trade surplus fell to $35 billion in Q2, about half that of Q1. FDI was about $21 billion taking the total to $55 billion.

Income on China’s past investments could explain part of the increase. Given the stock of China’s assets, even low yielding assets could garner a significant absolute figure, but it seems insufficient to make up the difference. Moreover, despite the mid-Q2 increase in bond yields, income on bonds remains relatively low. China’s stock of equities likely saw a bounce from Q1 levels. Yet, it is thought that China does not mark its portfolio to market. Moreover, much of the $100 billion in U.S. equities China holds were acquired between June 2007 and June 2008.

Remittances also might account for another part. These are only reported with a significant lag making comparability difficult. However, given the scale of Chinese reserve growth and adding up all the “explained capital inflows”, it seems likely that China has received hot money inflows of around $60-$70 billion. A reversal from the approximately $70 billion in outflows in Q1!

Unlike many other emerging economies, China remains quite closed to foreign equity investment. Thus, it seems likely that Chinese (including Hong Kong-based Chinese) may be trying to get money back into China again. Foreign investors may be contributing to the property market revival. Although currency appreciation is not expected in the short term given weak exports, consensus expects a stronger RMB over the course of the next few years. 12 month non-deliverable forwards, albeit not necessarily the best indicator of future levels, are barely pricing in an increase. However, there is general agreement that the RMB will have to appreciate.

In the short term this means China’s reserve diversification may have stalled. By putting pressure on the U.S. dollar, Chinese rhetoric about moving away from the U.S. dollar as a reserve currency earlier this year might have added to pressure on the renminbi and actually delayed the Chinese diversification path. China doesn’t release the currency composition of its reserves, but the dollar is thought to make up around 65% of the portfolio. That share could actually have increased slightly in Q2.

Euro assets make up most of the rest, along with a small amount of pound sterling, yen, and likely even a small amount of Canadian and Australian dollars. China has also increased its gold holdings. Despite the increase, gold makes up a less-than 2% share in Chinese reserves, much smaller than its share in U.S. or European reserves.

The U.S. data reflects the fact that China has yet to diversify much from the dollar. In fact as Brad Setser has noted, in Q1, China’s holdings of U.S. dollar assets as reported by the U.S. Treasury rose more than China’s reserves. One explanation - China was shifting within its dollar assets and asset managers, with the net result that more of its assets were captured in the U.S. data. But the data suggests China is still adding to dollar assets. Overall, China increased its short-term holdings immensely at the end of 2008 and early 2009. However, as of March and April it was paring back on its holdings of T-bills and increasing its holdings of U.S. treasuries.

The trend may still be visible in the May data which should be released at the end of this week. The scope of reserve accumulation suggests that, for now at least, China is still buying U.S. assets and helping meet funding needs. In the longer term, much will depend on China’s willingness for a stronger currency.

Given these trends, it may not be surprising that Chinese statements on new reserve currencies grew somewhat quieter in early May. Given the scope of capital inflows, these diversification statements may have seemed, as analysts for the Bank of New York have noted, to be counterproductive.

Given the increase in China’s reserve holdings, perhaps it is no surprise the Chinese investment corporation (CIC) is again becoming active, restarting its investment program. In recent weeks, the CIC announced plans to increase its stake in Morgan Stanley to avoid dilution, took a 17% stake in Canadian metals producer Teck Cominco, and announced a board of economic advisors. Further investments may follow as China continues to try to diversify its holdings.

Real diversification and liberalization of the capital account might be a longer-time in coming. Over time, some of the new capital management regulations – allowing companies to keep more of their foreign funds abroad, to use them to fund subsidiaries – might reduce inflows and funds purchased by the central bank.

So reserve accumulation is back. China is not the only country that added to its reserves again last quarter. Setting China and its estimated $140 billion in reserve growth aside, a group of over 30 countries that RGE tracks reported a valuation adjusted a net increase in reserves of about $40 billion. While not all of the countries have yet reported their June statistics, Q2 2009 is on track to be the first quarter in a year with reserve accumulation. The stocks of global reserves, are rising back towards $7 trillion again.

The pace of accumulation has slowed but the accumulators are the usual suspects –emerging economy exporters wary of currency appreciation. Many experienced sharp inflows into equity, bond and FX markets in the liquidity-fuelled rally in April, May, and early June. Russia, South Korea, Hong Kong and Taiwan account for much of the accumulation. A renewed flight from the U.S. dollar, expect these central banks to resume buying.

While some countries – like Russia -may have managed to slightly pare their dollar share in the face of capital outflows last year, the dollar still dominates reserve portfolios, particularly in Asia and the GCC. The amount of dollar liabilities in some emerging markets contributes to the need for U.S. dollars. Europe’s near abroad is similarly more partial to the euro. However, there continue to be obstacles to the euro as a reserve asset, including a fragmentation of the bond market — and the last thing European officials want is a stronger euro.

All this means Chinese reserve diversification is likely to be happening only at the margin and China (and other central banks) are likely buying U.S. assets

]]> http://blogs.cfr.org/setser/2009/07/15/chinese-reserves-boiling-over-again/feed/ http://blogs.cfr.org/setser/2009/07/15/chinese-reserves-boiling-over-again/ http://feedproxy.google.com/~r/CFR_BradSetserBlog/~3/L7LNDTheRng/ http://blogs.cfr.org/setser/2009/07/13/will-the-chinese-keep-saving/#comments Mon, 13 Jul 2009 22:20:01 +0000 rziemba http://blogs.cfr.org/setser/?p=5906 This is Rachel Ziemba of RGE Monitor where this post also appears.

In a recent post, Jeffrey Frankel asks will the U.S. Keep Saving? noting that despite the recent increase in the U.S. savings rate, the demographics of the U.S. (as well as those of Japan and Europe) will contribute to a reduction in savings. He argues that despite the fact that wealth losses will boost savings rates, the dis-saving of the retired population will keep the savings rate relatively low, if higher than the pitiful rates of recent years.

The companion question, whether the Chinese will keep saving is equally of importance. Whether the Chinese stimulus is able to boost private consumption ahead will be critical to global and Chinese demand. So far Chinese consumption has held up and even grown slightly from a weak base –as illustrated by retail and auto sales. Yet one reason that the Chinese economic reacceleration is fragile is because it is uncertain where the new production in China’s factories will be consumed. Chinese domestic demand still seems weak and overpowered by some structural incentives to save.

In the near term U.S. savings rates, which reached 6.9% in May, seem destined to keep climbing as U.S. consumers retrench. This could contribute to slower growth in the so-called export-led economies which had grown reliant on exporting demand.

One outcome of the financial crisis has been a narrowing of global economic imbalances, as illustrated by the reduction in the Chinese trade surplus and a reduction in the corresponding deficits of countries like the U.S.. The combination of a sharp fall in consumption across the globe and withdrawal of credit, partly accounted for swift reductions in some countries. I wrote last week about the narrowing of the surplus of oil-exporters. All in all, surpluses and deficits might be smaller given the reduction in credit available even as the increase in government borrowing leads to higher long-term interest rates. This narrowing is likely despite the fact that reserve accumulation seems to have restarted in Q2. Setting aside China which will report reserves data at some point over the next day or so and adjusting for valuation, reserve growth was about $40 billion in the quarter of 2009. While this is much smaller than in the heyday of 2007, it is the first quarter of positive reserve growth since Q3 2008. Yet, there are some signs that we will not return to the earlier pace.

The U.S. current account deficit has been narrowing for some time and has fallen from 6.6% of GDP at the end of 2005 to 3.7% at the end of 2008 and the IMF estimates that it will fall further to 2.8% of GDP over the course of 2009. With U.S. consumers buying less (the savings rate rose to 6.9% in May 2009), Chinese producers need to find new markets.

The Chinese current account surplus was $420 billion in 2008 and is likely to be smaller this year. The Chinese trade surplus (the largest component of the current account) was about $100 billion in H1, but one month (January) accounted for almost half. The absolute level of China’s trade surplus has shrunk, to about $13 billion in April and May and just over $8 billion in June. While the greater cost of China’s commodity imports (watch for more on this tomorrow) accounts for part of this narrowing surplus, it may reflect a sign of things to come should Chinese exports stabilize at a weak level in the absence of external demand.

Should export-oriented “surplus” countries like China keep saving and keep trying to export demand, the reduction in imbalances could actually exacerbate the global economic contraction or contribute to a more sluggish recovery. The high savings rate or rather artificially low cost of capital in China has contributed to misallocations of capital that will be difficult to reverse and will take some time.

However expansionary fiscal policies in these countries and a reallocation of capital within these countries, could in the long-term contribute to reducing internal and global imbalances. Chinese officials seem cognizant of the need to rebalance the domestic economy even as some of their policies seem to operate at cross-purposes.

While government incentives are contributing to an increase in some purchases, Chinese consumption (and that of other emerging economies) may find it very difficult to pick up the slack from a U.S. consumer that is spending less. However, Chinese fiscal stimulus does seem to be doing more to potentially boost domestic demand. Yet the effect of some of these incentives could diminish over time and there is of course a risk that Chinese production could add to global overcapacities in the absence of an increase in domestic demand.

In the Wilson Quarterly, Michael Pettis argues that whether or not the Chinese start consuming more, their savings rate will drop from the 50% marked in 2007. Either Chinese policies will contribute to more private consumption or the reduction in global demand will lead to reduced growth, limiting savings.

So what would be the package of consumption-led growth?

Eswar Prasad details how China and other Asian savers might rebalance their domestic economy through removal of the policies that suppressed domestic demand. These are largely long-term in nature including the development of China’s capital market to increase the return on domestic assets and patching holes in the social safety net.

The massive credit extension in China, which rebounded in June 2009 after slowing slightly in April and May suggests that the cost of capital in China remains well below global costs. This distortion raises the risk that non-economic projects are being financed to meet bank quotas. Thus there is a risk that even as Chinese officials try to take some steps to support domestic demand, other policies might add to the misallocation of capital, contribute to asset bubbles (especially property). Meanwhile, some Chinese investors are worried about future inflation. The blunt policy tools continue to be hard to manage.

The raft of Chinese data to be released over the next few days may give us some more clues as to the trajectory and possible risks ahead

This just hit my inbox, from the research team at Barclays. Since we’ve talked a fair amount of late about the Fed balance sheet, I thought I’d pass it on.

“Weekly Federal Reserve balance sheet update

Usage of the various Federal Reserve liquidity programs continues to erode as outstanding loan amounts mature and are not replaced with new borrowing. The overall size of the central bank’s balance sheet is now 9% smaller than it was at the start of the year.”

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below.

The chart shows China’s monthly trade balance. You will note that every year around March there is a big dip. It is a seasonal anomaly associated with the Chinese New Year. What you will observe is that the post-Chinese New Year rebound this year was much less pronounced, and, unlike in previous years, it soon rolled over. The trend now appears to be going the other way. This is despite Chinese government incentive to support exports and China increasingly taking market share from other Asian countries. It may well turn out that quite soon a Chinese trade deficit will have allowed us to slip out of—at least from a flow perspective—our Chinese handcuffs.