from Follow the Money

Too big to behave rashly

March 29, 2005

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According to Andrew Samwick, the world’s central banks are too big to behave rashly. As he puts it:

"We’re too big an economy, and our creditors’ portfolio holdings are simply too large for them to behave rashly."

That, according to Samwick, and I suspect Altig and Polley, is a key reason why the US will be able to reduce its large current account deficit gradually, without any major disruptions in financial markets or a sharp slowdown in US economic activity. Foreign central banks won’t sell their vast dollar holdings; hell, they might be willing to keep adding to them to keep the global financial system safe and sound.

I have one problem with the Samwick argument. It relies on a strange definition what constitutes prudent (assuming prudent is the opposite of rash) behavior by Asian central banks. Why exactly is it prudent for central banks to be issuing large quantities of local currency denominated debt (if they sterilize) to buy $500 billion of dollar denominated claims on a country that is running a current account deficit that looks set to approach 7% of GDP in 2005? Does the coupon on US dollar denominate debt -- currently a bit over 4.5% for long-term Treasuries, and somewhat less at the short-end of the curve -- really compensate them for the exchange rate risk that they are taking? You know, the currencies of countries with 7% of GDP current account deficits often do fall. See: Mexico, 1995; Thailand, 1997, Brazil, 1998. The dollar does not have to fall further against the euro to hurt the big reserve accumulaters either; what counts is what the dollar does against their own currencies.

And is China really behaving prudently and strengthening its financial system by forcing state-owned banks to absorb low-yielding sterilization paper to prevent huge reserve growth from leading to a huge increase in the money supply? Behaving prudentally by letting strong money growth continue even with all their efforts to find (cheap) ways to sterilize the reserve inflow?

Creditor countries usually do not extend credit in the currency of the debtor. Afterall, why should the creditor, rather than the debtor, take on the currency risk? So, at least to me, it is rather strange for the world’s major creditor countries (China is rapidly joining Japan as its current account surplus looks set to explodes) to be accumulating assets denominated in the currency of the world’s largest debtor country. China look sets to add at least $250 billion to its reserves in 2005, or around 15% of its GDP. That is a lot of money to spend propping up your biggest customer by lending on what amounts to quaisi-concessional terms.

The stability of the world economy hinges on the central banks of major emerging economies not doing anything that would shake up the status quo too much, anything "rash." But not shaking up the status quo requires that they rashly put their balance sheets at risk and keep on extending large amounts of credit at low rates to the world’s biggest net debtor ...

In a recent discussion at the Council of Foreign Relations that touched on a lot of the themes of this blog, and the Roubini-Altig debate, Ethan Harris of Lehman Brothers noted:

"You know, you could make the case that we’re sitting on a powder keg here."

Indeed you could.That 7% of GDP US current account deficit, by the way, largely reflects the trade and transfers balance, not large interest payments on the United States’ existing stock of debt. But the US will soon start having to make (net) payment of interest on its external debt, pushing the current account deficit up further unless the trade and transfers deficit starts to fall. That is one reason why the US will run large current account deficits for some time even if the long-awaited external adjustment starts. US net external debt is set to keep on rising for some time and the US is going to keep needing external financing for a long time, no matter what. Nouriel and I are not arguing the US is at risk of an emerging market-style sudden stop, where creditors withdraw all financing and the current account deficit goes from 7% of GDP to zero in a year. We just argue that there is a real risk that the US will be forced to cut back fast enough to put real strain on the US economy/ financial markets.

As Steve Kyle astutely pointed out in the comments section, foreign central banks have acted as the residual buyer of US dollars and US debt over the past few years, buying the dollar and dollar-debt when others would not, and thereby putting a floor under the price of the dollar and dollar-debt. But as the US current account deficits expand -- barring a sustained surge in private willingness to finance the US -- keeping the game going could require that foreign central banks step up their willingness to financing the US, even if the US is not taking steps to increase its low levels of national savings ...

That said, no matter how large the medium to long-term costs that Asia has to incur so long as it keeps financing the status quo, any change has real short-term costs, as Kash notes over at the Angry Bear. That makes it hard to predict what will happen. Is it rash -- or is it prudent -- to put a higher premium on the short-term costs of any change or the medium-term risks of letting the current system continue? A lot rides on how a relatively small number of actors assess that particular trade off (and their ability to coordinate their actions). No matter how you look at it, the risks of a bad outcome are, in my view, too large to generate any real comfort with the United States’ current economic trajectory.

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