from Follow the Money

Reserve accumulation and the financing of the February US trade deficit

March 9, 2005

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The dollar is under a bit of pressure today. The renminbi keeps falling too. The logic behind China’s tight peg to the dollar continues to elude me. The US dollar needs to depreciate as part of any scenario for "current account adjustment without a sharp slowdown of growth," including the scenario put out recently by the Federal Reserve Board’s staff. But China, which has a current account surplus, hardly needs for its currency to depreciate against the world. It may not be an intentional strategy to keep the renminbi weak, but that is the effect.

The argument that strong growth in the US is a dollar positive has always confused me a bit. Strong growth -- particularly if the growth is driven by growing consumption and investment geared toward meeting domestic demand -- tends to widen the trade deficit (so would investment in export industries, but it also lays the basis for future export growth). Less saving and more investment leads to more imports. A wider trade deficit implies a greater need for external financing.

Now, if foreign investors are starting to buy lots of US equities in the expectation that strong growth in the US will produce large gains in equity prices, then the inflows attracted by a growing US would be dollar positive. That, after all, is more or less what happened in the late 1990s.

However, that does not seem to be the current pattern. At least in 2004, the trade deficit was financed by sales of US debt, not US equities. And the latest State Street data (reported by Bloomberg) suggests that foreign interest in US equities remains rather muted.

State Street’s client figures for the past 20 days show the biggest flow of funds out of U.S. stocks since October. UBS customers sold a net $1.2 billion of U.S. stocks last week and Europe received a net $1.3 billion, Benedikt Germanier, a UBS strategist in Zurich, wrote in a report yesterday.

``The net equity outflow we’ve seen for the U.S. is a problem for the dollar,’’ said Michael Metcalfe, a senior strategist in London at State Street, the world’s largest provider of investment services to institutions. ``Strong U.S. growth expectations aren’t being reflected in investor flows.’’

So how did the US finance its February trade deficit?

We won’t know for a while, but here is an educated guess: By selling debt to foreign central banks.

We don’t yet know China’s February reserve accumulation, but we know the February reserve accumulation of 9 other large emerging economy central banks -- Korea, Taiwan, Hong Kong, Thailand, Malaysia, Singapore, India, Russia and Brazil collectively added about $30 billion to their reserves in February. That is a lot more than in January. Suppose China added $20 billion to its reserves. That would be consistent with the forecast Nouriel Roubini and I laid out in our recent paper. It also is consistent with Malaysia’s strong reserve accumulation and evidence suggesting that China’s trade surplus is widening. Then the major emerging economies added about $50 billion to their reserves.

That is more than in January. No wonder the Treasuries and Agencies the Fed holds on behalf of central banks surged in February.

Say $40 billion of this $50 billion reserve increase went into dollar reserves. Then 10 emerging market central banks effectively were able to finance about 2/3s of the roughly $60 billion (maybe a bit higher because of oil) expected February US trade deficit.

That is all the more remarkable because only one of the ten emerging economies now financing the US -- Russia -- is a major oil exporter. With oil around $50 in February, the Gulf states clearly had tons of spare cash as well -- though they are presumably less interested in vendor financing than East Asia.

February reserve growth was particularly strong in Taiwan ($3.9 billion), Malaysia ($2.65b), India ($5.9b), Russia ($9.2b) and Brazil ($4.8b). And remember, smaller countries like South Africa are also adding to their reserves. The $50 billion increase came from just ten emerging economies.

Credit should be given where credit is due: one of the predictions of Dooley, Garber and Folkerts-Landau was that Latin America would join Asia in de facto pegging to the dollar. No Latin country has followed the example of Malaysia and China. But many now are intervening heavily to resist pressure on their currencies to appreciate. Countries like Brazil and Argentina, though, still have quite substantial external debts; they are a long ways from joining emerging Asia and becoming true net creditors to the world. But they equally clearly now prefer keeping their currencies a bit undervalued and building up reserves -- rather the opposite of the strategy Brazil pursued in the mid-90s, and Argentina pursued until the end of 2001. Latin America on its own, though, cannot come close to generating the flows required to sustain the enormous expected US current account deficit.

One last thought: I wonder if the recent run up in Treasury yields has something to do with the fact that the central banks currently supporting the dollar/ financing the US trade deficit tend to be less interested in the Treasury market than the Bank of Japan/ Ministry of Finance? There clearly has been a fall off in interest in Treasuries from official buyers ever since the Japanese left the market. No doubt there are other reasons as well and the correlation is not perfect (Japan was out of the market when Treasury yields fell earlier this year). But it is at least something to consider. China clearly buys fewer Treasuries than Japan, and most Asian central banks have indicated that they intend to diversify the type of assets they are holding as reserves, even if they deny any intent to diversify the currency composition of their reserves. Even if the US gets as much financing in aggregate from foreign central banks this year as in 2003 and 2004, less may flow directly into the Treasury market.

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