from Follow the Money

Summers on reserves, exchange rates, the international financial architecture and other big topics close to my heart

March 26, 2006

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Larry Summers has always believed that capital should flow from the already rich and aging societies that constitute the current core of the world economy to the poor and young countries on the periphery.   So it is not entirely a surprise that Summers thinks "the most surprising development in the international financial system over the last half a dozen years" is "the large flow of capital from the world's most successful emerging markets to the traditional industrial countries, and the associated build-up of reserves in the developing world." 

Summers notes that this surge in reserves was neither predicted nor predictable.  I would add, though, that Dooley, Garber and Folkerts-Landau noticed it more quickly than most, and certainly predicted back in 2003 that large-scale reserve accumulation would be sustained.   So far, they have been right.

Robert Hodrick of Columbia argues (through Daniel Altman's Economic View Column ) that "The U.S. capital markets are where people want to invest their money right now and the performance of our economy has been really extraordinary, so there's no reason to think that's a bad idea." 

Actually, the US is where central banks want to invest their money right now.  

Summers, citing work that Sangeetha Ramaswamy and I have done, notes that foreign central banks added $670b to their reserves in 2005.   That probably understates the real growth in all official assets.  It includes the entire expansion of the foreign balance sheet of the Saudi Monetary Authority.  But not any increase in the al-Saud family's personal assets, or, more importantly, any new funds that have been contributed to the Kuwait, Abu Dhabi and similar investment authorities.   Pick the fraction of $670 b plus that you think flowed into the US.  I am pretty sure it is far more than the $220b or so in official inflows that showed up in the US data.

Summers also doesn't think emerging market central banks investment in the US is all that good an idea, at least financially.   Remember, foreigners who bought dollars in say 2001 have not done so well in the world's greatest place to invest.  Talk to a few Europeans ...  or read Philip Lane and Gian-Maria Milesi-Ferretti.   Summers thinks emerging markets central banks will get a negative real return on their current investments in the US - as low real US rates fail to compensate them for the risk of a real depreciation against the dollar.

"[the] flow of capital from emerging markets to industrial countries, huge accumulation of reserves and expected negative returns on reserves constitute what might be called the capital flows paradox in the current world financial system."

The headline from Summers speech was "central banks shouldn't be so keen on holding Treasuries."   

Perhaps more importantly though, Summers also suggested that the time has come to start to reconceptualize the role of the international financial institutions.   

In many ways, both the Fund and the Bank were designed for a world where emerging markets were short on reserves and short on savings, and thus occasionally needed to borrow reserves from the Fund (in principle for short-periods) and savings from the Bank (in principle for long-periods).     The profits on this lending, in turn, cross-subsidized the provision of global public goods and grants and concessional lending to the world's poorest countries.

Summers argues that there may be a need for a new international financial institution (or facility inside the existing institutions) to help emerging market central bankers get a slightly higher return on their excess reserves (reserves in excess of what they need for prudential reasons).  This new institution would charge a fee for its services - and help to finance the provision of global public goods and concessional financing for the world's poorest economies.   

There may be something to this idea. It is hard to imagine that financing the US government is the best use of the large sum of Chinese savings represented by China's reserves.  Yet it would be hard for say the Chinese government to invest heavily in say GM debt.   Or in a range of perhaps more attractive assets that carry with them both the potential for losses and the potential of obtaining control over US firms.

Summers also argues that the IMF needs to take its mandate to do exchange rate surveillance a bit more seriously - and pay as much attention to countries with current account surpluses as to countries with current account deficits.

"The IMF has always had as its raison d'etre addressing imbalances, but its surveillance and indeed its lending has always been focused on who borrowed excessively.  ... In a similar vein, the IMF has perhaps been too reluctant to criticize the exchange rate policies of its members.  ... It has always struck me as ironic than the IMF - which is charged with maintaining the global financial system and should be particularly focused on policy choices that affect multiple countries is prepared to address domestic monetary and fiscal policy choices, which may have international ramifications, but is so reticent about addressing exchange rate issues which by their very nature are multilateral."

I agree.   As Summers notes, the argument that the current account deficit is "made entirely in the U.S." is hard to square with current low global real rates.    The current US fiscal deficit, unlike the fiscal deficit in the 1980s, hasn't put upward pressure on real rates globally, and thus pulled capital into the US and away from the rest of the world.   Presumably this is because demand growth globally has been weak (relative to income growth), freeing up spare savings to finance the US.   Bernanke got this right - though I still think he downplays central banks' role (and oil's role) in the creation of a global savings glut.  

Summers puts in a way that I (no surprise) find compelling: "one cannot understand US borrowing without understanding foreign lending."

I also agree with another of Dr. Summers conclusions: "the primary source of global demand to offset increases in US savings should come from the Asian consumer." 

I would have put a bit more emphasis on the role oil exporters need to play in the adjustment process than Dr. Summers did.  I have to show at least a tiny bit of independence from my former boss.  

Full disclosure: I worked as a staff economist in the Summers' Treasury and, as is obvious from Summers' speech, I have shared my recent work on global reserve accumulation and the global flow of funds with him.

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