from Follow the Money

The central bank (and oil fund) bid

February 8, 2006

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I am constantly amazed by the concern well paid Wall Street economists display for poor Chinese peasants.    China, you see, cannot revalue the RMB without devastating rural China.  A revalued RMB would make rice imports cheaper, lowering domestic rice prices and cutting rural incomes.

This is probably the only point of convergence between Wall Street Journal oped page stalwart David "don't tax capital" Malpass and Joseph "globalization and its discontents" Stiglitz.   

Those same Wall Street economists typically don't display similar concerns about the plight of US autoworkers and others facing competitive pressure from China's very competitive coastal manufacturing zones.    Or stalled real wage (and compensation) growth in the US.

Many may even think the CEOs of public US companies are somewhat under-paid. Principals in private equity firms do so much better ...

But right now, they really, really care about rural poverty China.  Funny that.

TECHNICAL UPDATE:  Comments went down over night-- an unexpected complication of some technical surgery on the site.   But they are now working, and comments posted overnight should now appear as well.

There is a real issue here.  The exchange rate that is right for coastal China may not be right for China's interior.

But I suspect that Wall Street's new concern for the welfare of Chinese peasants working small rice plots in la Chine profonde is not so altruistic.   Their concern probably has a lot more to do with the fact that a lot of market valuations are supported by relatively low long-term interest rates.   And so long as rural peasants in China cannot produce rice competitively (or China needs to shift its vast rural labor force into the export sector) China's government has no choice but to continue to finance the US at quite low rates.

I have been wrong about a fair number of things this I started writing this blog.   The Bretton Woods 2 system of Chinese financing of the US looks a bit more robust than I expected.  China continues to pile up reserves.  And oil exporters have emerged as a bigger source of financing for the US than even China, helping to sustain a large and growing US current account deficit. 

But I think I can claim one small success: the evidence that central bank intervention to defend undervalued exchange rates and the associated demand for US bonds from central banks looking to invest their (rapidly growing) reserves has helped keep long-term US rates low is by now fairly strong.   A lot of models that worked relatively well up til say 2000 predict interest rates of around 6% -- not 4.5%.   And the obvious change in the world economy over the past few years has been the huge surge in reserve accumulation by emerging economies.

Part of the impact of central bank intervention is indirect.  China's intervention keeps the China price low, and puts downward pressure on the price of many goods (as does massive Chinese investment in plant and equipment).  That has helped to keep rising energy prices from spilling over into broader price increases.  China's overall impact on inflation in the US is ambiguous - China is certainly pushing up the price of lots of commodities.  But it pretty clear has been helping to keep core inflation down.

But part of the impact is very direct.  The evidence is now pretty clear that central banks have not just been buying short-term Treasuries.   My source here is rather credible: the bond king himself, PIMCO's Bill Gross.  I cannot easily reproduce the charts in his latest note, so follow the link.  But his bottom line is clear.

... the following two charts/tables that point to an increasing presence, nay domination, of foreign buying - especially central bank buying - on the intermediate and long ends of the U.S. yield curve. Both charts point out that "Foreigners" and indeed "Official Foreign" central banks own greater percentages of notes and bonds up to 10-years in maturity, than they do bills

The first chart in Gross's note - originally from Merrill Lynch - is the clincher. 

And what's more, I suspect Merrill Lynch's note significantly understates total "non-economic" holdings of US treasuries.   Why?   The US data that these kinds of calculations are based on only captures 35% or so of this year's increase in China's reserves.  The remaining 65% are going somewhere.  Maybe not into Treasuries, but somewhere.   And the US data doesn't pick up any increase in the holdings of dollar securities by of oil exporters.

As the New York Times reported last week, most oil exporters are spending as if oil was about $30 - rather than $65 plus.  And since most oil revenues go to the state, the fact that budgets are based on oil prices far below the current level means that the oil states are saving a ton.   No doubt, oil states are spending more than they were in 2001.   spending at a $30 a barrel pace is more than spending at a $20, or $15, a barrel pace.   But oil prices keep rising faster than oil state spending.   The savings glut in the oil states is now even more pronounced than the savings glut in China.   In 2005, the combined current account surplus of the major oil exporters probably approached $400 billion.   Oil averaged about $55 last year.  If it averages $65, I wouldn't be surprised to see a $500 billion plus current account surplus in the oil states ...

That money is going somewhere, even if it does show up in the US data.   I suspect that a lot of private flows to the US are, in reality, not so private.   Martin Feldstein agrees.   Or at least, private investors are not taking the currency risk.   Saudi Arabia deposits dollars in Lebanon, which are lent to a bank in London, which finances a hedge fund ...

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