Public Capital Flows into the U.S.

Mark Thoma finds Martin Feldstein in the Financial Times worrying about the state of the international economy:

Economist's View : Martin Feldstein: Uncle Sam’s bonanza might not be all that it seems, Commentary, Financial times: A major reason for the dollar’s current overvaluation is the widespread misunderstanding of the nature of capital flows to the US. The business press and many financial analysts provide the reassuring message that the flow of capital to the US substantially exceeds the amount needed to finance the US current account deficit, and that that inflow is coming primarily from private investors.... This... results from a misinterpretation of the data provided by the US Treasury.... The figures... while technically correct, are misleading for two reasons. First, the... [Treasury] release... excludes bank deposits... bank lending... foreign direct investment.... If the total net inflow were larger than the current account deficit, the US would be accumulating large reserves of foreign exchange....

A second source of confusion... is... the ... measure of inflows from “private” sources overstates the actual private investment... if the Chinese government purchases US bonds through... private bank[s], these funds will be recorded in the... data as a private purchase.... My own belief... is that the inflow of capital that now finances the US current account deficit is coming primarily, perhaps overwhelmingly, from governments and from institutions acting on behalf of those governments.... OPEC governments and other oil producers that are temporarily placing revenue in dollar bonds and bank deposits... Asian governments that wanted to accumulate foreign exchange to eliminate the risk of speculative attacks... China and other Asian governments to stop a falling dollar reducing their net exports....

The US current account deficit... is widely predicted to move much higher in 2006... equal to 6.4 per cent of US gross domestic product.... [T]he dollar must fall by at least 30 per cent just to shrink the trade deficit to a more sustainable level of 3 per cent of GDP. Much larger dollar declines are also possible....

The current small interest rate differences in favour of US bonds are not nearly enough to compensate investors for the fall in the dollar that is likely over the next few years.... The dollar must fall faster than these small interest differentials.... At some point, that will trigger a shift away from the dollar. Private investors and the governments... will inevitably shift at some time from dollars to euros or yen.... That that has not happened already reflects investors’ belief that it is still possible to benefit from the interest differentials before the dollar depreciates. That sanguine belief may, however, reflect a serious misunderstanding of the magnitude and nature of the capital flow to the US.

I am still looking for somebody who can tell me how China (and the rest of Pacific Asia) are financing their reserve accumulations. How much are they borrowing from the good burghers of Shanghai? How much are they raising by increasing the supply of high-powered money? How much is coming straight out of tax revenue? These are very important questions, and I don't know the answer to them.

Comments

[pgl]

Ah but the Dark Matter crowd will argue that the deepening of our indebtedness to the rest of the world is an accounting illusion. After all, the U.S. continues to have positive net income from abroad. So the Dark Matter crowd says the U.S. is creating intangible wealth not captured in the accounting as if we are truly saving a lot more than the NIPA accounts suggest. This may sound a bit familiar to the NRO crowd's devotion to nominal household wealth hitting a record but the Dark Matter argument is really on sounder footing. It is assuming that there is no transfer pricing manipulation distorting the figures used to present the accounting observation that US investment income from assets abroad has persistently exceeded foreign investment income from holding assets in the US. But then I've been arguing that this accounting of income may indeed itself be distorted by transfer pricing games.

[still working it out]

Anecdotally the source of the East Asian ability to finance these foreign reserve purchases could simply be an incredible propensity to save. My Chinese friends tell me that interest rates of effectively zero percent are no disincentive to Chinese citizens saving enormous proportions of their income.

They are keen for higher returns though. When the Chinese remove their capitol controls there are going to be an enormous number of private Chinese citizens very keen to move their money to overseas bank accounts to get rates of over 2%

[Bruce Wilder]

Fundamentally, I do not even understand Brad's questions. It's a Central Bank. Wal-Mart and J.C. Penney and Dell buy lots of stuff from Chinese manufacturers; the Chinese manufacturers take these dollars to the Bank; the Bank prints up Yuan to give to the Chinese; the Bank takes some of its dollars and buys U.S. securities. What in that sweet little circle requires "financing"?

If there's something to understand, it is how the People's Bank of China manages to keep its domestic inflation from running out of control. I expect that is where that legendary savings rate comes in handy.

[kharris]

Bruce,

Just a guess, but I'd guess what has Brad wondering is how a country with a current account balance pretty close to zero (ok, $33.8 bln estimate for 2005, $45.6 bln for 2006, OECD estimates) can manage to buy up a gazillion US Treasury notes. Only to the extent that China has US$s left over after paying its import bill does China have its own money to buy Treasuries. In October, TICs data show China holding $247.6 bln in US financial instruments, and Brad is arguing that indirect investment, through banks, boosts the tally by a lot.

[Arun Khanna]

Re: "I am still looking for somebody who can tell me how China (and the rest of Pacific Asia) are financing their reserve accumulations."
Asian countries especially China have opaque budgets that don't allow outsiders to understand finances of the country accurately. Remember China recently added previously unaccounted for GNI equal to Turkey's economy. That's one hell of a large Turkey to misplace in one's iron bowl!

[Winslow R.]

Brad, it is good to hear you sound coherent!

Bruce, Brad is saying the same thing, just using 'hot money' instead of 'printing the yuan'. Your 'legendary savings rate' is his 'burghers of Shanghai'. Your question on control of 'domestic inflation' can be tied to his 'tax' and 'borrowing' question.

Kharris wrote:

"Only to the extent that China has US$s left over after paying its import bill does China have its own money to buy Treasuries"

I do not think you mean to suggest a small C/A deficit/surplus makes it impossible for a Tsy to accumulate massive quantities of a foreign currency with no financing costs. I think inflation/ability to tax would be the limiting factor.

[anne]

Remarkably the increase in reserves is contianed enough that inflation seems to be less of a problem not more. Currency speculators have even seemed to turn away from the Chinese market, a credit to the selective monetary policy of the Chinese. We should be closely following China's impressive policy.

[gordon]

I wonder what will happen to the Chinese propensity to hold savings in $US if they strike oil in Sudan or elwhere - oil that they can buy for Yuan?

[nate]

Feldstein's article may (not sure) indicate that it might be time for some to put a little bit in a world bond fund.

http://biz.yahoo.com/p/tops/ib.html

[brad setser]

kharris -- China's 05 current account surplus will be more like $140 billion -- we have the data from the first half of the year, and the trade data from 5 of 6 months of the second half of the year. there is a debate about 06.

Dr. Delong -- I'll take a stab at answering your question. very ballpark, and assuming total reserve accumulation on a flow basis (i.e. net of valuation losses) of $250b or so, i suspect that roughly 1/2 the increase has been financed by an increase in the stock of high powered money (high-powered money to GDP is very high in China), and 1/2 has been sterilized. the recent data on broad money growth suggests that the chinese scaled back sterilization around the time of the revaluation. And about 1/2 is financed by selling sterilization bills to the banks at quite low rates (i.e. by shang hai burghers), something made possible by a set of controls on bank lending that have kept lending growth below deposit growth, making the banks very liquid.

I don't think the government is running a fiscal surplus, or building up the treasury's cash reserves held on deposit at the central bank, and thus helping the central bank out -- but i don't know for sure. Stephen Green of Standard Chartered is the person to ask for all questions on sterilization; he puts out a nice "Chinese money monitor."

[George J. Georganas]

How about the following story ?
Chinese people of the present generation have learnt to live by spending far less than they now manage to earn. It is only natural that they should be saving much. The monetary authorities try to sterilise this liquidity by placing it on assets outside China. They grab all kinds of assets ranging from oil fields to treasury bills of practically every single country with a non-junk presence in bond markets. This simple story seems to explain "the conundrum" of ever-falling long-term interest rates. Two factors make that extraordinary outlook for interest rates look sustainable. First, there are many more Chinese people waiting to join the super-earners and super-savers. Second, thanks to China's population (non-)growth policies, the (hopefully) more profligate successors to today's thrifty Chinese parents will be fewer in number than their parents, thus slowing the inevitable drawdown on savings, expected somewhere around 2035.

[Scott Martens]

A propensity towards savings does seem to be a social characteristic of China, although I think that its motivated less by cultural factors - some sort of Confucian economics is often proposed - than by a realistic assessment of the risk born by Chinese households. It's not unrealistic for people to wonder how long cushy jobs with good pay will hold out. These things tend to be temporary everywhere, and most of China's population retains in living memory some very harsh times, and free market China doesn't seem to interested in generous social security programs. Furthermore, the traditional Chinese savings plan was to have a large family and make your children take care of you. With one child per couple, and perforce one grandchild per four grandparents, that doesn't look very likely to continue. In the end, you can only rely on cold hard cash.

If that's the real reason though, it seems to me that it's even worse news in terms of sustainability. The rapid declines in the Chinese birth rate took place in the mid-70s, so the first generation that can't rely on their children in their old age starts retiring circa 2015, assuming poor health doesn't remove them from the labour pool before age 65. And, that generation is huge - a couple hundred million or more. If Chinese workers have to start drawing down their savings to support their parents or themselves in 10 years time or sooner, it will certainly make it hard to keep financing American debt.

[anne]

Suddenly we have all discovered demographics. The only question left now is who will age fast enough to become extinct first America or China? Imagine, 1.4 billion Chinese and not a sould to spare. I know the problem must be an absence of sex. Can it be corrected before the end comes :)

[brad setser]

Dr. Delong -- I did some ballpark math on my blog, but on a stock rather than a flow basis. $800 b in reserves, $250 b in sterilization bills (overwhelmingly held by the banks), $100b in other forms of sterilization (bank reserves, other stuff) per Anderson of UBS, and $450b in base money backed by reserves. I think overall base money is substantially higher, but am still working on getting an end year number that makes sense (or waiting for an i-bank to do it). If you are interested in the numbers on a flow basis, email me --

[anne]

"Soul" as in "Dead Souls" by Gogol which is certainly apt for case of the disappearing Chinese. And here we are told to worry about Social Security and Medicare, hmmm. I fancy myself becoming in many many years the oldest and only American worker supporting 250 million rapidly dying off retirees.

[John]

Has anyone read the following books ...Superimperialism (Michael Hudson)- also Global Fracture, Weight of the Yen (R Taggart Murphy) - also Japan's Policy Trap, and Gold Warriors (Seagraeves)? In your opinion, do these books/authors shed any light on these questions? Thanks

[Barkley Rosser]

I am not in a position to make any estimates about the breakdown of the source of the financing as Brad S. is doing. It is not obvious to me that it is all that important given the very high savings rate in China, well over 30% last time I looked. That could be channeled by any of several routes. Furthermore, the financial markets in China continue to have many controls, despite some recent loosening.

No one needs to get all mushy about cultural arguments. Inertia of consumption that is well known is quite sufficient. Thus, a high savings rate is endogenous to a high growth rate as increases in consumption lag behind increases in real income. It happened in Japan and it is happening now in China.

BTW, as of yesterday the Chinese have announced that they are going to broaden their portfolio of currencies. The rumors I have heard are that this has been going on for some time in some of the East Asian countries and that these announcements may be more a matter of after the fact letting people know. Of course, if the Chinese do this readjustment too quickly, all kinds of chickens will come home to roost, making the mumblings and worries of Feldstein look like a dinner party (which is not a revolution, as Mao informed us).

[DOR]

Chinese families have been through one hell of a roller coaster ride in the past 40-50 years, from post-war shock to optimistic upswing, famine, optimistic upswing, terrifying chaos, cautious uncertainty, optimistic upswing deep fear of the unknown and finally a wildly fantastic explosion of growth, prosperity opportunity and stability with occasional concerns about rising prices.

During that time, the iron rice bowl and its counterparts in health care, education, housing and pensions all vanished. And, new things to buy suddenly exploded across the store shelves, auto dealerships (what are those, Ma?) and real estate agencies (We’re supposed to pay for housing, Pa?).

Anyone who wouldn’t save 40% of income under such conditions has to be considered mentally unstable. Anyone who stops saving that much now should have their financial affairs reviewed by competent judicial authorities.

* * *

Forex reserves rose by about US$205 billion last year, to around $815 billion. We can account for $100 billion from trade, and about $60 billion from inward investment.

That leaves $45 billion to be allocated to outward investment, tourism spending abroad, statistical flaws and net illegal capital flows. Doesn’t seem like all that much, only about 2% of GDP.
.

[Andy B]

Few thought:

1. The role of central government is very large in China. (ie. industrial invesment, flow of large money) are all controled. This is usually not taken into account by modern economist as mean to control 'supply', be it money to the public or raw material.

2. China is essentially a third world country manufacturing consumer product for the west. Ask yourself. Does average farmer need 8MP digital camera, strange western toys, or huge LDP TV? For what...? The Chinese consumption behavior hasn't cought up with their new earning power yet. Hence the high saving. Most people still spend as if when they grew up. (better cloth, bettr food, etc... but definitely not latest iPod, exotic travel or versace.)

Imagine your grandma, having won a $5000 lottery tickets, would she buy Xbox/digital camera, or spend it on 'her past time favorite'? better clothing, little home improvement, maybe jewelry, and few gifts..etc.

All these may sound trivial here, but if you have 1 Billion people. Small behavior adds up.

[Gandharv Vasudev]

About how the Chinese are being able to keep inflation tamed, well we still arent really sure about how de-regulated the infaltion parameter are in that country. do we?
further there is no doubt that the soiciological built up of the economies in these part of the world including India, enourages savings. further, the old economics skool still sits in the instituttions of power here, and i see no threat of savings rate declining to affecting levels ever.
what turns out is that there shall be continued economic strength in this part of the world. whether the trade policies of the US government is able to reap benifits of the economic expanastion here (ex- outsourcing, with dubai and austrailia set to take over wall street), is the question.
also my intutive calculation tells me that the east asian countries, china, the indian sub continent are self sufficient intra-area to sustain their economic growth. (this should be worry the US govt), unless the polity spoils it all. what do you think??