from Follow the Money

Not guilty as charged. The banking crisis, not the budget deficit, is sucking funds out of the emerging world ...

February 4, 2009

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The US clearly failed to recognize the risks associated with highly leveraged households and an over-leverage and under-capitalized financial sector. The resulting implosion has reverberated globally.

But I don’t quite see the basis for arguing that the US fiscal deficit is siphoning funds from the rest of the world. It may in the future. But right now it isn’t.

The amount the US borrows from the world is a function of the trade deficit (really the current account deficit, but the trade deficit is a good proxy), not the budget deficit. And the trade deficit is coming down. Calculated Risk estimates that the January deficit could be as low as $30 billion, or only about 1/2 its peak level. Thank the fall in oil prices. Put simply, the US is borrowing a lot less from the rest of the world now than a year ago, two years ago or three years ago.

Moreover, the US doesn’t magically attract funds from the rest of the world. In order to pull in savings from the rest of the world, the US has to offer a higher (risk-adjusted) return than other borrowers do. The ten year Treasury has sold off (see Jansen). It no longer yields 2%, but it still yields less than 3%. And that isn’t exactly a high rate. The way the US pulls in funds from the rest of the world is by offering a higher interest rate than the rest of the world. That ends up driving up interest rates globally and forcing other countries to pay more to borrow. Today though US rates are well below there levels a year ago. If anything that should create incentives for US investors to send funds abroad -- not incentives to pull in funds from the rest of the world.

And well, I don’t think anyone can argue that high short-term rates in the US are sucking savings out of the world. If anything, low policy rates in the US should make it easier for other countries to raise funds. It isn’t hard to offer a yield pickup over the US right now. Last fall when the Fed was cutting rates and other countries weren’t, private money was flowing out of the US ...

This isn’t to say that the problems emerging economies now face trying to raise funds originated in the emerging world. They didn’t. Not really. They are suffering from the collapse of the US -- and European -- financial sector. Hedge funds are pulling back. And more importantly, capital constrained banks are pulling back. That -- not the fiscal deficit -- is what is pulling funds out of the emerging world. Emerging economies in that sense are no different than any other borrower facing difficulties getting a bank loan.

The fact that the financial sector now depends on a government backstop may have prompted the banks to pull back more from foreign markets than their home markets, though they are clearly doing both. Deglobalization -- particularly financial deglobalization -- isn’t going to be pretty.

But a few emerging economies are also suffering from self-inflicted wounds ...

Not the least Russia.

Russia exports a lot of oil. But for a long time it tried to keep the ruble pegged (more or less) to a euro-dollar basket even as oil soared -- and even as private capital poured into Russia. Russia though didn’t sterilize these inflows as effectively as China. The resulting rise in domestic inflation led Russia’s real exchange rate to appreciate quite significantly. Now, obviously, there is pressure for the ruble to depreciate in real terms. That could happen through deflation. Latvia has chosen this course. But investors -- and Russians -- believe that Russia will let the ruble depreciate in nominal terms to bring about the needed real depreciation. And until that process is complete, there isn’t much incentive to old rubles. See Slater and White in today’s Wall Street Journal. They quote Natalya Orlova, chief economist at Alfa Bank in Moscow:

"All the rubles that are out there have been turned into dollars. To get out of this spiral where everyone expects a devaluation will be very difficult."

Capital isn’t flowing out of Russia because the US fiscal deficit deficit has pushed up US Treasury interest rates to levels no other country can match-- or because Russia cannot match the high rates on offer on dollar bank deposits. It is flowing out of Russia because a lot of people believe the ruble is still overvalued.

It actually is fairly common for oil exporters to experience a real appreciation through inflation and a real depreciation through a sharp fall in the nominal exchange rate. The mechanism for real exchange rate adjustment isn’t always symmetric. I though would argue though that the oil-exporters generally would be better off letting their currencies rise along with oil -- and also fall along with oil. The right exchange rate for Russia is -- I suspect -- tied to the price of its key export. But at this stage, though, this is a rather academic point. The key issue is just how many more reserves Russia is willing to spend to prevent the ruble from falling further ...

p.s. On a more technical basis, the investors who buy US treasuries aren’t typically the same investors who buy emerging market debt. They rather are the kind of investors who might otherwise buy Agency paper or similar close substitutes for Treasuries. The money market funds now buying Treasuries were never buyers of emerging market debt. Russian debt -- particularly ruble debt -- is held by investors with a higher appetite for risk. That problems Russia faces right now consequently have a lot more to do with the broader deleveraging process than the scale of Treasury issuance. Yes, there are knock-on effects if the US sucks up a lot of funding with a large fiscal deficit. But those effects are indirect and generally operate through a rise in US interest rates. Conversely, Russia would certainly benefit if a fiscal stimulus pushed up US demand and that in turn pushed up oil prices ...

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