from Follow the Money

Alan Greenspan, financial globalization, home bias and central bank reserves

December 6, 2005

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The very last paragraph of Alan Greenspan's last speech on global imbalances seems to have generated the majority of the press that came out of his London speech on global imbalances.   I kind of liked the message of that paragraph as well.   Concerns about "the pernicious drift toward fiscal instability in the United States and elsewhere is not arrested" and warnings that "the adjustment process could be quite painful for the world economy" appeal to my inner bear.

Alas, I thought the warnings in the last paragraph were a bit at odds with the rather rosy tone of the rest of Greenspan's speech (No wonder Stephen Jen liked it).  Greenspan spent most of the speech arguing that deep fundamental forces in the global economy explained the widening of the US current account deficit, will allow relatively large deficits to be sustained, and will facilitate gradual adjustment so long as the US economy retains its vaunted "flexibility."

Among those fundamental forces: a fall in home bias - the propensity of folks to use their savings to finance investment at home, not in the world at large.  That means, best I can tell that the deficit of say US households should not be compared to US GDP, but rather to global GDP.  That makes the US household and US government deficit look far smaller. 


Greenspan is tempted to conclude that since the US household deficit is small relative to the pool of global savings, there is little to worry about.  But he is not quite willing to go that far.

.. anecdotal, circumstantial, and some statistical evidence is suggestive that the historically large current account deficit of the United States may be part of a broader set of rising unconsolidated deficits and accumulated debt that is arguably more secular than cyclical. The secular updrift in deficits and debt doubtless has been gradual. However, the component of those broad measures that captures the share of net foreign financing of the balances of individual unconsolidated U.S. economic entities--our current account deficit--has increased from negligible in the early 1990s to more than 6 percent of our GDP today. The acceleration of U.S. productivity, which dates from the mid-1990s, was an important factor in this process.

Accordingly, it is tempting to conclude that the U.S. current account deficit is essentially a byproduct of long-term secular forces, and thus is largely benign. After all, we do seem to have been able to finance our international current account deficit with relative ease in recent years.

But does the apparent continued rise in the deficits of U.S. individual households and nonfinancial businesses themselves reflect growing economic strain? (We do not think so.) And does it matter how those deficits of individual economic entities are being financed? Specifically, does the recent growing proportion of these deficits being financed, net, by foreigners matter?

But national borders apparently do matter. ...  

Regrettably, we do not as yet have a firm grasp of the implications of cross-border financial imbalances. If we did, our forecasting record on the international adjustment process would have been better in recent years. I presume that with time we will learn.

Lots of rumination, not a very clear conclusion.

Greenspan also argues that the state has gotten out of the business of managing the economy over the past few years:

Whether by intention or by happenstance, many, if not most, governments in recent decades have been relying more and more on the forces of the marketplace and reducing their intervention in market outcomes.

The last argument jumped out at me, because one of the defining features of the global economy over the past few years has been a surge in the reserve accumulation - that is to say foreign exchange intervention -- by the world's central banks.   And another is a shift in the world's spare savings to the oil exporters, countries that are not exactly known for a small state role in the economy.

Central banks certainly do not hold the majority of the world's cross-border financial claims.  But they have been adding to their foreign assets at a very fast clip, so their chare of total cross-border claims is rising.   Global reserve accumulation this year may not top 2004's $600 billion plus, but it also probably won't fall much below $500b.  And that total leaves out a lot of money being invested through state owned oil funds - whether in Norway, Russia, Kuwait or the Emirates.    $500 b can be compared to a global current account deficit/ surplus of around $1000 b - it ain't small.

And last I checked, central banks were part of the public sector.  As RP noted in a comment to a previous post: "I ... have noticed that a few Central Banks have lost their home bias."

I think Greenspan's core argument more or less goes like this:

Modern finance means that you do not have to save to spend.  If households want to run a deficit, and firms a surplus, the financial system will intermediate between firms excess savings and households borrowing needs.  Plus, a fall in home bias means that the borrowing needs of key US sectors can be financed globally, not locally.   Those in need of financing can tap global markets.   US household deficits can be financed by the surplus of Japanese, Chinese, or European firms.

And a surge in US productivity (all those platform companies?) made the US an attractive place to invest.  That is why a fall in "home bias" is leading to large net flows to the US.    After all, if US investors lost their home bias and say European investors lost their home bias, US investment in Europe would be offset by European investment in the States, and there would be no net flow of capital.    Everyone would just hold a more diverse portfolio.

Let's also set aside the fact that - at least judging from observed data - the US is not such a great place to invest.  US firms earn far more investing abroad (mostly in Europe and Canada) than foreign firms earn investing in the US.  See the CBO , the IMF and Lane and Milesi-Ferretti ...

Past returns are no guarantee of future performance, and the low observed returns may have something to do with taxes and transfer pricing.  What of the future?  How well does Greenspan's story explain the current pattern of capital flows?

Not very well, I would argue.

Yes, productivity growth in the US is up.  But the current world is not marked by large net flows from sclerotic Europe to the dynamic US, but rather by large net flows from the dynamic emerging world to the dynamic US.   I am not sure productivity differentials explain why capital is flowing from China to the US, rather than from the US to China.

Private capital certainly is not fleeing China.  Far from it.  It is banging on the door trying to get in.  Net private capital flows into China are quite large.  Think close to $60 b plus of FDI, and $50 b, if not more, of "other" inflows. 

That story can be extended.  If you look at the chart below, it is clear that private investors have regained their appetite for financing high growth, high-risk emerging economies over the past few years - even Russia, even after 1998.  Net private capital flows to the emerging world were back at their 1997 peak in 2004.  They are expected to fall a bit in 2005 - but that partially reflects "private" outflows from the Gulf.   I put "private" in quotes for a reason: the build up of the private accounts of Gulf sheiks and the al-Saud family is probably not quite what Greenspan had in mind when he was talking about the growing role of private capital ...

The blue bar in the chart represents net private capital inflows, the white bar reserve outflows.  the magenta bar represents government and official flows.  Data is from the IMF.   Note that the reserve data is not valuation adjusted, and it just for emerging and developing economies.
home bias and central banks

What explains the large (net) flow of funds from emerging economies to the US then?  Not the decisions of private investors, but rather the decisions of foreign governments.  

There actually hasn't been a fall in home bias among private savers in China, one of the world's big net lenders right now.  

Ok, onshore RMB deposits are trapped by China's capital controls.  For a fair test, let's consider what Chinese investors with money offshore - money that has escaped from China's capital controls -- have sought to do with that money over the past few years.

Have they decided to shift it from the US to Europe or from Europe to the US?  Not really.

Have they decided to try to bring it back to China?  Absolutely.   See the chart I posted here; the white bar represents "hot money flows" to and from China.   Hot money stopped flowing out of China around 2001 and started flowing back into China in a big way in 2003.

Bottom line: Right now, private Chinese savers are running down their offshore accounts to increase their RMB holdings.  They want RMB assets, not dollar assets.  Hardly a reduction in home bias.

What explains the net flow of funds from China to the US then? 

Simple: the People's Bank of China is willing to transform Chinese demand for RMB assets (and foreign demand for RMB assets) into Chinese demand for dollar assets.  It no longer holds domestic bonds (at least not many) against the money it issues; rather, backs the renminbi in circulation with dollars and euros - and since it holds more reserves than it needs to back the RMB in circulation, is also issues more and more sterilization bills.

Household savings in China are deposited in RMB in the Chinese banking system, the banks buy central bank bills, and the central bank uses the proceeds to buy US debt.  The result: more Chinese savings is invested abroad, but the investment is not exactly done through the market.  Same in Saudi Arabia: the Saudi government deposits its budget surplus with the central bank, and the central bank invests the government's surplus petrodollars abroad.

OK, call me reserve obsessed.  But I don't think you can explain the current global flow of capital - or the recent fall in home bias among savers in emerging economies - without talking about the actions of the world's central banks, or the actions of the governments of the world's oil exporters. 

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