Follow the Money

The negative correlation between the dollar and the price of oil was much in evidence  last week – The dollar hit a record low against the euro, and is quite weak against most of the major currencies Oil hit a record high in nominal terms, and not all that far off its 1979 high ($109 a barrel) in real terms …Dean Baker – and OPEC – argue that the link between a weak dollar and a rise in the price of oil is almost mechanical.   When the dollar goes down, oil has to go up in dollar terms to stay constant in say euro terms.     There is something to that.   But this isn’t the entire story either.  Over the past few years oil has gone up v a basket of currencies while the dollar has gone down v a basket of currencies.   Oil isn’t up as much in euro terms as in dollar terms, but it is still way up. Plus there have been times – like 2000 – when oil rose in dollar terms even as the dollar was rising against the euro.  During that period oil rose very strongly in euro terms.  2005 is a more recent case.So why then is oil going up when the dollar is going down? My answer: global growth is strong, while US growth isn’t.Strong global growth – particularly in conjunction with a fairly limited supply growth – pushes up the price of oil.     If easy-to-produce oil is close to peaking (the FT reports that “global oil production is estimated to have shrunk by 650,000 b/d in the third quarter”), the price of oil should be rising in secular terms so long as global demand is going up.   Political constraints on more production  -- whether instability in key oil producing areas or a desire to limit production to keep prices up -- would have the same effect.  And if easy-to-produce oil outside of the Gulf and other less than stable areas has peaked (Both Cantarel and North Sea production are falling …), the geopolitical risk premium in the price of oil should also be trending up …  And strong global growth and weak US growth – indeed, a growing risk of a recession – are a recipe for a weak dollar.It should go without saying that the strong oil/ weak dollar mix creates real problems for all the Gulf countries that insist (still) on pegging to the dollar.   They are effectively importing a weak currency and low nominal interest rates when there economies are booming.   The result: massive inflation and very negative real rates that are adding to the boom now, but risk creating problems later. Pegging to the dollar has – at least in my view – been a recipe for macroeconomic instability in many oil exporting economies.There also could be another reason why strong oil adds to dollar weakness – the investment preferences of the oil-exporting states.   This is a bit more speculative, but here is the basic idea.A rise in the price of oil, all else kept constant, reduces the current account surplus of Asia (and pushes Europe into a bigger deficit) while increasing the current account surplus of Russia, the Gulf, Norway, North Africa and a host of African economies (Nigeria, Gabon, Angola).  If the US responds by cutting into its savings to pay for its higher oil bill, the US current account deficit also rises. Let’s assume, for a second, that the rise in Europe’s deficit from higher oil is offset by rising spending on European goods, so there is no net change in Europe’s aggregate balance.   This is a bit disingenuous, since there is good reason to think that the oil-exporting economies spending on European goods would be going up even if the oil price had stabilized.    But it simplifies things, as it implies that the oil surplus trades off with the Asian surplus.  Let’s also assume that Asia’s current account surplus shows up as Asian reserve growth, and the oil surplus shows up as reserve growth/ an increase in the assets of the world’s oil investment funds.Now suppose that the oil states currently hold – in aggregate – a smaller fraction of their external wealth in dollars than Asia and that they are currently trying to lower the dollar share of their assets.  This isn’t totally implausible.  Norway has long held only about 35% of its oil revenue in dollars, Russia now has less than 50% of its reserves in dollars and a few Gulf states have also rather clearly trying to reduce the dollar’s share of their (growing) portfolios.  In 2000, for example, as much as 85% of the Kuwaiti investment authority’s assets may have been in dollars.   That total is now probably under 50% (KIA’s equity portfolio is certainly under 50%).  ADIA reportedly shifted toward emerging economies a few years ago.   And a host of Gulf funds now want to invest in emerging Asia …  If all these conditions hold, a shift in the world’s current account surplus from Asia to the oil exporting economies might lead to less demand for dollars, and thus contribute to dollar weakness.    In his now classic paper on the oil-exporting economies, Ramin Toloui of PIMCO calculates that if oil exporting economies invest 60% or more of their rising revenues in dollar assets, an increase in the price of oil is dollar positive (see figure 14).   And if they invest less than 60% in dollar assets, a rise in the price of oil is dollar negative. However, the idea that a shift in global savings from Asia (and potentially Europe) toward the oil-exporting economies is dollar-negative isn’t totally bullet-proof.   There an obvious counter-example: both oil and the dollar rose in 2005, contrary to what the story above would suggest.   Of course, a redistribution of world savings toward the oil-exporting economies -- and specifically a redistribution of official asset growth toward the oil-exporting economies -- is just one of the factors that affects the dollar.  Other factors might have just overwhelmed the “oil exporters don’t like dollar assets as much as Asia” effect in 2005.    In 2005, Europe’s constitutional crisis, along with the perception of economic weakness left over from 2004, made the euro less attractive.   And the combination of the Homeland investment act and rising US rates (v Europe) made the dollar more attractive.     Plus, back then at least one oil exporter (Russia) was putting a lot more of its rapidly growing reserves into dollars (roughly 70%) than it is now (a bit under 50%).   It is not inconceivable – given the shift in the composition of Russia’s reserves and ongoing changes in the way that the Gulf manages its money -- that a rise in the price of oil was dollar positive (i.e. more than 60% of marginal oil savings flowed into dollars) in 2000 and even in 2005, but not now … That though leaves the question of why rising oil did help the dollar back in 2003 and 2004.     The obvious answer is that that interest rates also matter, and policy rates were low back then. I would add another component to the story.   While there is some debate over the impact of a rise in oil-savings on the dollar, there isn't really much doubt that a rise in oil spending results in a shift in demand away from US assets toward Asian and European goods, and that too has an impact on the market.   Work by the IMF indicates that the US current account deficit woudl rise even if the oil-exporting economies spent all of the increase in oil-revenue from higher oil prices, largely because the oil-exporting economies buy so few US goods.  And then there is a final twist.   If the oil exporting economies are “diversifying” by investing in Asia, they just end up fueling Asian reserve growth.   The oil funds get a claim on an Asian economy – whether India, Korea or China – and the Asian economy gets a claim on the US …Or some would.  India is probably less keen on the dollar than even Russia --  and Thailand and Malaysia aren’t much keener on the dollar than the big Gulf states.  A lot depends on where the money goes in Asia; not everyone is as wed to the dollar as China seems to be … Still, it would be rather ironic if the desire of some of the smaller Gulf states to diversify their external portfolios away from the dollar is adding to the dollar’s current weakness – and thus the activities of their investment funds are making it harder for their central banks to sustain their dollar pegs …Or perhaps the word “sustain” is wrong.   So long as the GCC countries are willing to accept high levels of inflation and keep their nominal rates low – probably below US rates to deter speculation – their pegs are sustainable.   It is just isn’t obvious why all this is actually desirable.

The q2 US current account data poses two puzzles. The first is the sharp drop off in official inflows in q2.   They fell from $150b in q1 to $70b in q2.   That fall was, incidentally, offset – mechanically – by a change in (net) FDI outflows.  The large net outflow of q1 disappeared.  Net private portfolio flows were more or less constant.The second is the continued absence of any evidence of deterioration in the income balance.   Or, if you prefer, the continued growth of dark matter.   I am fairly sure Ricardo Hausmann and Federico Sturzenegger would argue that this the real puzzle is the unwillingness of some others to accept the evidence that the US has a lot of dark matter on its balance sheet.  After all, the US seems to be able to continually conjure up additional dark matter whenever it is needed to keep the income balance positive.The first isn’t really a puzzle.   Not in my view.   The US data is wrong.Not wrong in the sense that the BEA made an error in their calculations.   But wrong in a deeper sense.  The BEA’s quarterly data is based on the TIC data, and the TIC data simply doesn’t capture all official inflows. Why I am I so confident –  First, the last survey data revised total official inflows up by $130b between q3 05 and q2 2006.  I expect a similar revision.   The pattern here is very consistent.  Look at the gap between the unrevised data and the revised data in the following graph. When the data for the last four quarters is revised, I expect that net official purchases will be revised up, and foreign private purchases will be revised down.  Indeed, I would be surprised if net private bond inflows (foreign private purchases of US bonds net of US purchases of foreign bonds) are currently about flat.    No doubt there has been some true private inflows form abroad, but I would bet the scale of those inflows is about equal to the scale of US purchases of foreign bonds.Second, different US data sources don’t tell a consistent story.  The BEA – using the TIC data – reports a $43.3b increase in foreign official holdings of Treasuries and Agencies in the second quarter.   The New York Fed’s custodial holdings of Treasuries and Agencies increased by $90.8b over the same time period – that is a rather significant difference, and the FRBNY data in theory captures a narrower set of holdings (only those at the Fed) than the BEA’s data. Third, $70b is just too small given the scale of official reserve growth in the second quarter, which I estimate to be close to $300b (The COFER data will offer a more definitive answer at the end of September).   You don’t need to take my word for it though.   Brazil, Russia, India and China combined to add $250b to their reserves.   That total hasn’t been adjusted for valuation changes, but it is indicative.   I don’t think anyone really thinks the world’s central banks put less than a quarter of their reserve growth into dollar assets. To be honest, China alone almost certainly bought more than $70b of US debt in q2, given it $125b or so in reserve growth. Sum it all up and I expect that, once the revised data comes in, the overall increase in central bank’s dollar assets over the past four quarters will be close to $700b – only a bit less than the US current account deficit.   Last year the revised survey data actually brought the total up to above the total implied by my estimate of dollar reserve growth (which comes from the COFER data, not the BEA data).  The absence of any deterioration in the income balance is, by contrast, a real puzzle.   Simple math would suggest that $800b a year more in net debt would tend to – at a 5% average interest rate – lead to a $40b deterioration in the income balance.   That though hasn’t happened.    And I don’t really feel like I understand why – in part because I don’t yet have a good feel for the revised data on income payments.    It does seem to suggest that the US has bigger gains from financial intermediation, that is borrowing cheaply to buy higher yielding assets abroad, than the previous data set.   That supports the “dark matter” hypothesis. Mechanically, the improvement in the US income balance in the second quarter came from a roughly $2b ($1.9b) improvement in the balance on FDI.  The US received $49.6b more on its investment abroad than it paid on direct investment in the US. Two points are important here –First, the gain doesn’t come from spectacular reported returns abroad so much as from low returns on direct investment in the US – the reported return on FDI in the US is only 4%.   That is less than the return on Treasuries. Second, almost all of the difference comes from a $37b gap in “reinvested earnings” – that is income that US firms earn abroad and then keep abroad.  The US tax code provides US firms with a strong incentive to do this; they don’t have to pay taxes on their overseas earnings until the earnings are repatriated.   Foreign firms also have a strong incentive to show profits in a low tax jurisdiction abroad – whether Ireland, Switzerland, the Netherlands or another locale.   Consequently, there is a good reason to think that tax arbitrage is by far the biggest source of “dark matter.”   The very low reported earnings of foreign firms operating in the US just don’t make economic sense; why run a business to earn less than you can make investing in US treasuries? The details of income data also suggest a bit of tax arbitrage.  Most reinvested earnings comes not from US manufacturing firms operating abroad but rather from financial firms, holding companies and the mysterious other … But the real mystery, at least to me, is the fact that net US interest payments didn’t increase (one small caveat – the US quarterly data doesn’t separate out dividends, so technically I should say the balance of interest and dividends on portfolio equities.  However, dividends historically have been small relative to interest payments). The amount of interest the US paid on its external debt is going up – it rose from $134.7b in q1 to $143.1b in q2.   But the interest the US received on its lending rose just as fast – going from $96b to $104.5b.    Net interest payments actually fell by a tiny bit ($0.1b).    Since the US has a borrowed a lot more – about $ 5 trillion more -- than it has lent out, mathematically, a constant deficit on the interest balance implies that either that the interest rate on US lending has to be rising faster than the interest rate on US borrowing or that the interest rate on US borrowing has to be falling faster than the interest rate on US lending.If I did all the calculations correctly, it turns out that the implied interest rate on US lending has been constant (at around 4.7%) while the implied interest rate on US borrowing is actually falling, from a bit under 4.4% in 2006 to 4.25% in the first half 2007.  These numbers all reflect the revised US data on income payments, and thus differ from some numbers I have calculated in the past.  They also are calculated by dividing payments by the estimated stock.I thought I understand the mechanics of this before:  the US lends short and borrows long, so a rise in short-term rates feeds into US interest income before it feeds into US payments.   But I am no longer quite as confident this is the entire story.  I certainly wouldn’t have expected a fall in the average interest rate on US external debt in the first half of 2007.  That to me is a real puzzle. On one point, though, there shouldn’t be much debate.   Exchange rate adjustment works.  The non-oil US trade balance is heading down.That reflects the fact that the US economy has slowed relative to other economies. But it also reflects changes in the exchange rate.  Growth in both Europe and China (and thus Asia, given China’s size) have accelerated relative to the US.  The US bilateral deficit with Europe is now shrinking rapidly – as the bilateral deficit with Canada.   The bilateral deficit with Asia (including China) isn’t.     It does not take a lot of sophisticated economics, at least in my view, to figure out why.   Europe has let its exchange rate adjust.     Emerging Asia, by contrast, has let the size of its central bank balance sheet adjust.  It has, generally speaking, opted to add to its reserves and in the process finance the US deficit rather than allow exchange rate appreciation.

China indicated back in the 2004 that it wanted to rebalance its economy, and shift away from export and investment-led growth. Despite a common perception in the US business community that China’s leadership can do pretty anything (economically speaking) that it wants to do, it is increasingly clear that the policies China has adopted to try to rebalance its economy have not worked. The World Bank’s most recent quarterly update on China’s economy report notes that net exports will contribute as much to China’s growth in the first half of 2007 as in the last half of 2006:  “The external contribution to growth remained high …  Our estimates … suggest that the contribution of net external trade to growth remained at the high level of the second half of 2006, contributing over one-fourth of overall growth”  (Figure 1 of the quarterly has the details). China’s current account surplus is projected to rise to $380b (12% of China’s GDP) – even with very high oil prices.   That is an increase of $300b (and 8-9% of China’s GDP) since 2004.   If the US had experienced a comparable swing -- relative to its GDP -- in its current account balance, it would be running a substantial surplus now.  Incredibly, the rise in the current account surplus (an excess of savings relative to investment) has come even in the face of strong investment growth.   Sure consumption growth is strong, but consumption is such a small share of GDP that even strong consumption growth contributes less to overall GDP growth than might be expected – especially when consumption is growing more slowly than investment and exports.    The World Bank notes that “almost all of the variation in domestic demand growth recently has been driven by investment, including the upturn in the first half.”The World Bank notes that China’s surplus the “external imbalance remains the main macroeconomic issue” that China faces.    China’s steadfast defense of a very modest pace of appreciation against the depreciating dollar influences almost every other aspect of China’s economic policy.   But China’s huge external surplus isn’t just an issue for China.  China’s policy choices are shaping how the global economy adjusts to the US slump.    That slump – and the associated weakness in the dollar -- has already pulled down the US non-oil trade deficit a bit.   But the main impact of dollar (and RMB) weakness has been an increase in China’s trade surplus.  And while the US economy needs the boost from the external side right now, China’s economy doesn’t.  Basically, China’s continued de facto quasi dollar peg -- China broad exchange rate has actually depreciated recently, as the RMB’s rise v the dollar hasn’t offset the dollar’s broad fall – has redistributed some of the external boost from dollar weakness from the US to China. The Chimerican aggregate external deficit is falling.   But it is falling because China’s surplus is rising and the US deficit is constant, not because the US deficit is falling.   Recent improvements in the United States non-oil trade balance have been largely offset by a rise in the United States oil import bill. The result: China increasingly is using lending the surplus it earns selling goods to Europe to the US, not just lending the money it earns selling to the US back to the US.  On current trends, China will run a $260b or so bilateral trade surplus with the US, and a $380b global surplus.   It also will likely lend the US $350b or more of its $500b in reserve growth.  China will be lending the US significantly more than it makes selling to the US for the first time.  That, I suspect, is something that is likely to continue in the future.  It has a corollary as well: The gains to China from financing the US are falling, while the costs China has to bear to support the US are rising. The standard argument that China would shoot itself in the foot, financially speaking, if it stopped lending to the US is wrong.   China would certainly shoot its export sector in the foot if it stopped lending to the US.   And it is true that if China stopped lending to the US, the value of the RMB would rise relative to the dollar and the value of China’s existing US assets would fall.  But China would still be better off, in the purely financial sense, if it took its lumps now.  Remember, China has to buy an awful lot of dollars to keep from taking losses now.  It is has to do more than hold its existing position.  It has to add to its position.  And the more dollars China holds, the larger its ultimate losses.  Every time China’s government borrows in RMB to buys another dollar – a dollar that is almost sure not to hold its value relative to the RMB – it shoots another hole in its balance sheet … No doubt, those betting that been that China would be willing to pay an ever-growing price to maintain stability in the US bond market have made the right call over the past few years.   But those making the bet are betting that China will continue to prioritize the interests of its export sector over its own long-term financial health, and perhaps domestic macroeconomic stability as well.   It is a reasonable bet.  But in my view, it isn’t quite a slam dunk.