from Follow the Money

A savings glut, not an investment drought -

September 12, 2007

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So argues Ben Bernanke.  

His basic argument is very simple. 

The emerging world now has a large and growing current account surplus that finances a large and growing current account deficit in the world’s industrialized (or perhaps formerly industrialized – no advanced economy, with the possible exception of Germany, is as industrialized as China is now) economies.

From 1996 to 2004, some of the rise in the emerging economies aggregate current account surplus came from a collapse in investment in southeast Asia. 

But some also came from a rise in Chinese savings – which even then was beginning to push China’s current account surplus up.   Chinese savings was even then rising faster than Chinese investment, for reasons what remain poorly understood.    Some think the rise is tied to the policies China adopted to support its dollar peg, particularly after the dollar started to depreciate.  Others emphasize weakness in China’s financial system (which limits access to consumer credit) and the lack of a modern social safety net.

And some came from a rise in the savings of the world’s commodity exporters, fueled (literally) by the rise in the price of oil. 

In 2005 and 2006, though, Dr. Bernanke argues that there really can be no argument.

Much of the rise in the emerging world’s overall surplus came from a roughly $200b rise in China’s current account surplus.   China clearly doesn’t suffer from a shortage of investment.   The surge in its surplus comes entirely from a surge in its savings, one that exceeded a large increase in Chinese investment. 

And the rest comes from a rise in the surplus of the oil-exporting economies.   And there too investment has picked up (just look at the skyline of Dubai, or Moscow).    But with oil rising steadily, the oil-exporting economies were able to spend more, invest more and still save more.   Oil may be a curse if oil sells for $20 a barrel (or less), but it sure doesn’t seem to be a curse at $70 a barrel.

Dr. Bernanke makes two additional points – 

First, over the past two years, the US hasn’t been the sole counterpart to the emerging world’s rising surplus.    Europe has also played a growing role in absorbing the emerging world’s surplus.   The eurozone’s small ($100b) surplus in 2004 turned into a small deficit in 2006, and non-eurozone European economies chipped as well.    The swing in the current account balance of industrialized economies outside the US was around $140b.    The US still did the heavy lifting though – its deficit increased by around $170b.

Here it is worth noting that Europe also increasingly enjoys the largess of the emerging world’s central banks.   Talk about how the euro will never be a global reserve currency misses the point.   The euro already is a major global reserve currency.    Central bank inflows into the eurozone are now far bigger than central bank flows to the dollar in the 1990s – or for that matter in 2000 and 2001.   

Second, the rise in the emerging world’s savings surplus over the last two years wasn’t associated with a fall in equilibrium rates in the US and Europe.    This, Dr. Bernanke argues, is evidence that investment demand picked up in the US and Europe.

That is right – though an awful lot of that investment was investment in residential real estate, in Europe as much as the US.   Spain’s real estate boom puts the US boom to shame (check out these old posts by Charles Gottlieb).    The fall in the US deficit over the past two years also helped.    And it is of course possible that the policies of the Fed and the ECB also played some role in pushing up US and European rates over the past few years – though with long-rates below the short-rates set by central banks, there is a strong case that global forces mattered more.    Think of it this way: the Fed sets US short-term rates, the PBoC sets US long-term rates and the Bank of Russia increasingly sets long-term European rates. 

I would endorse Dr. Bernanke’s analysis but for one point.

He – along with other US policy makers – continues to minimize the role the official sector has played in the intermediation of the global savings glut.  The US current account deficit is, he argues, mostly a market phenomenon:

These external imbalances are to a significant extent a market phenomenon and, in the case of the U.S. deficit, reflect the attractiveness of both the U.S. economy overall and the depth, liquidity, and legal safeguards associated with its capital markets. Of course, some foreign governments have intervened in foreign exchange markets and invested the proceeds in U.S. and other capital markets, which most likely has led to greater imbalances than would otherwise exist.  But the supply of capital from foreign governments is not as large as that from foreign private investors.  From 1998 through 2001, even as the U.S. current account deficit widened substantially, official capital flows into the United States were quite small.  During the years 2002 through 2006, net official capital inflows picked up substantially but still corresponded to less than half (47 percent) of the U.S. current account deficit over the period.  On a gross basis, during the same period, private foreign inflows were three times official capital flows.Moreover, even public investors are motivated to some extent by the attractions of the U.S. economy and U.S. capital markets." 


The argument that emerging market outflows and the associated inflows are a market phenomenon, though, is increasingly hard to support.   The recent increase in the current account surplus of the emerging world is almost entirely coming from China and the oil exporters -- places where the "official sector" accounts for all the country's outflows.  Contrary to the expectations of the Caballero, Gourinchas and Farhi model (which postulates that emerging economies would have trouble creating financial assets private investors would want to hold), the net private flow of capital is strongly toward the emerging world.  China has had no trouble keeping its savings at home recently.   Chinese investors prefer Chinese stocks to US stocks, and Chinese RMB to US dollars.

Indeed, official outflows from the emerging world (according to the IMF, and my own reserve tracking) top the emerging world’s current account surplus by a significant margin.    China’s savings surplus is brought to the world’s financial markets courtesy of China’s central bank (and soon the CIC).  Indeed, in aggregate, China's central bank uses capital inflows into China to finance its purchase of US and European bonds.   The Bank of Russia, SAMA and the big investment funds of the Gulf – not private investors -- carry the oil surplus to the US and Europe. 

Moreover, the share of the deficit financed by the official sector has increased significantly recently.  In q1, the BEA data indicates that the official sector provided 75% ($600b) of the roughly $800b in net inflows needed to sustain the US deficit.

And I deeply believe that the BEA's data actually understates official inflows.   The US TIC data -- which the BEA uses for its estimates -- systematically undercounts foreign purchases of US bonds (and in particular Chinese purchases) relative to the Treasury survey.  The BEA data on official inflows consequently tends to be revised up with a lag.  The world’s central banks also have built up their dollar bank deposits offshore, indirectly helping to finance the US deficit.  Finally, the US data – both the TIC and survey – do not capture all the activities of the Gulf investment funds or those central banks that use outside fund managers.  (For more details, click here—RGE subscription required) 

Dr. Bernanke also notes that official inflows are not all that large relative to gross capital inflows.   But the overall total includes a lot of short-term cross border bank flows – think lending between Citi New York, Citi London and Citi Caymans.   Those inflows are almost always offset by short-term outflows through the banking system.   They don’t generate any net financing.   The rise in gross flows is tied to the growing use of offshore centers and to be totally honest, tax arbitrage.   To paraphrase Bill Walton, it is important not to confuse activity with results.

There is little doubt at this stage that central banks and investment funds have provided the overwhelming share of the financing the US has needed to sustain its $800b deficit over the last four quarters.   This shouldn’t be a surprise.  The IMF’s forthcoming data (the COFER data) will show – once the Saudis are added in – an over $1 trillion increase in central bank reserves over this period, and an awful lot of that increase is still flowing into dollars.   China alone accounts for $400b of the total – and China’s share is still rising over time. 

Dr. Bernanke certainly understands China's role in this process.  Last fall, he correctly called Chinese reserve accumulation a de facto subsidy for Chinese exports.   He also recognizes that the world’s large deficits (and surplus) are ultimately unsustainable, and that a rather large change in the global pattern of economic activity is required to bring the world back into balance.

“Adjustment must eventually take place, and the process of adjustment will have both real and financial consequences.  For example, in the United States, the growth of export-oriented sectors such as manufacturing has been restrained by the shifts in relative prices and foreign demand associated with the U.S. trade deficit.  Ultimately, the necessary reduction in the trade and current account deficits will entail shifting resources out of sectors producing nontraded goods and services to those producing tradables.  The greater the needed adjustment, the more potentially disruptive and costly these shifts may be.  Similarly, external adjustment for China and other surplus countries will involve shifting resources out of the export sector and into industries geared toward meeting domestic consumption needs; that necessary shift, too, will likely be less disruptive if it occurs earlier and thus less rapidly and on a smaller scale. ”

Dr. Bernanke sees signs the necessary adjustment could begin.   He notes China’s rhetorical commitment to rebalancing the basis of its growth.   Alas, so far, all signs suggest that China’s surplus is still trending up.    Even if it stabilizes, it will stabilize at a very high level.

UPDATE: a slightly different take from Menzie Chinn

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