from Follow the Money

How private investment in China (and other emerging economies) ends up financing the USA

April 5, 2005

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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The best thing the Institute of International Finance does is put together data on private capital flows to emerging economies.

They just released their estimates for net private flows to the set of emerging economies that they track for 2004: their data covers most of the key players, at least outside the Middle East.

Was private capital -- that global savings glut -- flowing to the US to help finance the US current account deficit? Yes and no. Net private flows to the US were somewhere between $250 billion and $300 billion. We won’t know for sure until the BIS publishes its data on dollar reserve accumulation for 2004. That is not enough to finance a current account deficit of more than $665 billion.

Net private flows to emerging economies were comparable to net private capital flows to the US. They totaled $303 billion in 2004. But, unlike the US, emerging economies did need this capital inflow to finance a current account deficit. They collectively ran a current account surplus of $170 billion. That means that they had $473 billion to play with.

What does the IIF think they did with this money --

a) paid $28 billion back to the IMF, the World bank and other official lendors.

b) bought gold, and otherwise sent $54 billion back out of their economies (this includes lots of private capital flight from Russsia) c) increased their foreign exchange reserves by a whooping $392 billion.

The rise in private capital inflows to emerging economies -- they rose from $120 billion in 2002 to $303 billion in 2004 -- fueled the rise in emerging economies’ reserve accumulation from $151 billion in 2002 to $392 billion in 2004. Over the same time, emerging economies aggregate current account surplus only increased by $91 billion.

Put differently, emerging economies could not grow your reserves by $392 billion on the back of a $170 billion current account surplus alone; they also needed to be attracting large net inflows of private capital.

Private investors want to invest (almost) as much in China as in the US. But China does not need their money; it already save more than it invests at home. So it stockpiles the foreign capital inflow in its reserves, and uses its growing reserves to finance the US.

What does this all mean:

More private capital flows to emerging economies = more reserve growth, and more financing for the US.

Less private capital flows to emerging economies = less financing for the US.

Emerging economies opt to spend rather than save this capital inflow = less financing for the US.

What happens if private capital inflows to emerging economies start to finance private capital outflows rather than central bank reserve accumulation? My best guess: less financing for the US. Private investors probably will want a more diverse -- meaning less dollar-heavy -- portfolio.

Both emerging Europe and emerging Asia attracted large net flows of private capital last year. But the IIF data slo illustrates that there were big differences in how they used those inflows.

Emerging Europe ran (in aggregate) a small current account surplus: Russia’s oil-driven surplus offset deficits elsewhere. Sum everything up and private capital flows to this region financed private outflows and reserve accumulation in roughly equal measure, along with some payments to the IMF (by both Turkey and Russia).

However, the aggregate picture is clearly misleading: Russia ran a large current account surplus that financed both reserve accumulation and private capital outflows. Other countries in emerging Europe used private inflows -- mostly from the rest of Europe -- to finance current account deficits. Call it a success for European integration: the flow of capital inside Europe went from rich to poor, and probably also from old to (relatively) young.

Emerging Asia looks a bit different. It also attracted large capital inflows. But unlike emerging Europe, it also ran a large current account surplus. In made some small payments back to the IMF and World Bank, but there were not large private capital outflows. Instead, everything got socked away in reserves. The $290 billion in reserve accumulation the IIF reports for seven emerging Asian economies is about 1/2 of global reserve accumulation. That total, incidentally, excludes the reserve accumulation of Taiwan, Singapore and Hong Kong as well as a host of smaller Asian economies. Total Asian reserve accumulation was higher, even leaving out Japan.

The real question, of course, is whether this game continues.

The most recent data release from the Fed suggests it has. The Fed’s custodial holdings -- which only capture a portion of all central bank reserves invested in the US -- rose by $27 billion in March (end February data v. end March data), and are up $56 billion in q1. Annualized, that is a $224 billion annual pace - a bit slower than the $269 billion increase in the Fed’s custodial holdings in 2004. But Japan has been out of the market -- so all the reserve increase is coming from emerging economies. And some emerging economies -- like China -- are quite keen to disguise their purchases, and thus don’t always go through the Fed.

Mon cher General: the world does not just consist of Japan and Europe. To finance a $850 billion plus current account deficit, the US needs help from all over the world ... too bad the IIF data does not help us understand better what the petrosheiks in the Gulf are doing.

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