Note: This is Brad Setser, not Michael Pettis. Mr. Pettis will be doing most of the heavy lifting for the remainder of this week as well.
Last week was rather interesting.
Gisele Bundchen was all over the financial pages and not entirely -- as the FT's Chrystia Freeland notes -- because of her currency trading powers. Gisele doesn't just work for euros either; her manager notes that she is also happy to be paid in Brazilian reais.
"It's false that she only takes euros,'' Patricia Bundchen said in a phone interview on Nov. 7 from Porto Alegre, Brazil. ``It's a Brazilian contract, in reais,'' she said ... That's turned out to be the better choice. The real has risen 21 percent against the dollar this year, while the euro gained 10.4 percent."
Maybe she accepts RMB too.
The People's Bank of China has no choice but to take dollars in the market. The RMB/ dollar only clears because of the PBoC buys a lot of a dollars every single trading day. But it doesn't necessarily have to hold on to the dollars it buys.
The Vice-Chair of the Standing Committee of the People's Congress, Cheng Siwei, clearly doesn’t manage China’s reserves. It still isn’t entirely clear whether he was just speaking out (as a number of analysts note he has done the past), or whether he was speaking out with the tacit approval of China’s leadership. However, wasn't the only official (or former official) in China calling for China to buy strengthening not weakening currencies. Tang Shuangning seems to be thinking along similar lines.
The French President seems to want the US to take steps (keep interest rates on hold?) to support the dollar. Or perhaps he really wants the ECB to avoid taking steps (keep interest rates on hold?) that might produce an-even-stronger Euro.
Presumably the last thing Sarkozy wants is for China to take Cheng Shiwei’s advice and start buying more “strong” currencies. There aren’t that many places big enough to absorb a decent share of China’s $100b plus in quarterly foreign asset growth. And Sarkozy made it clear that the Euro is already strong enough.
The Euro is already more of a reserve currency than some in Europe would like.
From a tactical point of view, the last thing that China’s leadership likely would want to do is to announce its plans to diversify away from the dollar before it actually has diversified away from the dollar. Talk about moving the market against you. That is why I would bet that Cheng Siwei’s comments were unplanned -- or, if they were planned, they were intended to remind the US that it cannot count on China’s government and a few other central banks to continue to absorb ever-more sinking dollars rather than to signal a change in China's reserve composition. In that sense, they served much the same function as Sarkozy's more direct statement.
However, it is also possible that the various comments in the press indicate that there is a vigorous internal debate about the logic of the RMB's tight tie to the dollar, and the resulting need to accumulate an ever-increasing stock of dollar reserves. I certainly don’t know. A few days in Beijing only makes me a slightly more informed observer of Chinese policy and Chinese policy debates.
But there is no doubt that the dollar’s new bout of weakness isn’t helping policy makers in the dollar block – whether China or the Gulf -- manage their own economies. Indeed, it is hard to think of a time when economic conditions in the US and in the other main components of the dollar block were ever so different.
China and the Gulf are booming. The US not so much. Private funds are flowing in to both China and the Gulf. The US not so much. Inflation in both China and the Gulf is clearly far higher than inflation in the US
There is little doubt that China’s policy of controlled appreciation against the dollar has produced a close to uncontrolled pace of increase in China’s dollar holdings.
To my mind, the most important dollar story of the past week didn’t come from Gisele, Cheng or Sarkozy. Rather it came from Richard McGregor of the Financial Times. He reported last Wednesday that China added $180b to its dollar assets in the third quarter.
The combination of an expectation of higher Chinese interest rates, to combat the effects of an inflationary spurt in recent months, and a slightly faster pace of renminbi appreciation, already appears to have reignited capital inflows. In the three months to the end of September, foreign exchange inflows increased by $180bn.
Of this, only about $73bn was accounted for by the trade surplus and $30bn from foreign direct investment and interest payments from China’s reserve holdings invested offshore.
Assuming McGregor is right – and I have no reason to think otherwise – Chinese foreign assets are now growing far faster than China’s reported reserves. Once you adjust for valuation effects, China only added a bit over $80b to its reserves in q3. Even if you add in the valuation effects, total reserve growth was around $100b. And once you net out the purchase of Huijin, the fx purchased by the CIC won’t add all that much to China’s total foreign asset accumulation either – maybe another $10-15b. To get up to $180b, Chinese banks and companies also would need to have added to their holdings of foreign exchange in the third quarter.
$180b is a stunningly large number for the quarterly increase in the foreign assets of any country, let alone an oil-importing economy.
The combined current account surplus of the oil exporting economies in q3 will certainly be far smaller than $180b – they will be lucky to get to $100b in q3 (though not in q4).
$180b is actually bigger than the $172b q3 US trade deficit – and will be close to the q3 US current account deficit.
China’s data – plus a reasonably inference about the scale of official asset accumulation in the oil exporting economies – suggests that China’s government, a few Chinese state banks and firms and the governments of a handful of oil-exporting economies provided the bulk of financing for the US deficit in q3.
That is the underlying reason why the market is sensitive to any suggestion that China might adjust the composition of its reserves. It is pretty hard to see how the dollar’s decline can be orderly if China joins some of the smaller oil-exporting economies in trying to diversify away from the dollar, even at the margin.
The key question then is whether the current global equilibrium – one based on a falling dollar that is cutting into the financial wealth of a host of emerging governments – is sustainable. Those countries have to be willing to add not just to their reserves but to the dollar reserves even as US rates fall and the dollar slides in order to keep the current international financial system going.
The costs – and by that I mean to the costs to those now buying dollars – of this system are increasingly visible.
The US current account deficit is falling a bit, but it is still large. Moreover, the improvement in the US current account balance might not last. $90 plus oil will have an impact. There dollar is under a lot of pressure. But the stability of the US financial system – such as it is – rests on the United States ability to direct its monetary policy at domestic conditions and still finance its external deficit in dollars at low rates.
Should that change – as Krishna Guha explains in his excellent analysis in the Saturday FT – the weak dollar might not just be Europe, China and the Gulf’s problem. The Wall Street Journal's dollar story today is also worth checking out, not the least for the quotes from Ted Truman of the Peterson institute.
Krishna Guha writes:
The latest decline in the dollar has been accompanied by a falling stock market and rising credit spreads. This could be a coincidence – US long-term bond yields remain low. But it could be a sign that foreigners are starting to demand higher returns on dollar assets. In a worst-case scenario, fears about the dollar could lead to a scramble for the exit. The Fed would come under pressure to raise interest rates to prop up a collapsing dollar and offset its inflationary impulse – at a moment when the economy might desperately need rate cuts. Such an extreme outcome is still unlikely. But even if this episode ends happily for the US, there are lessons to be learnt.
First, as monetary policy works increasingly through exchange rates, central banks will be exposed to international political controversy.
Second, the large US current account deficit complicates the Fed’s efforts to deal aggressively with risks to growth, because a deficit economy is always potentially vulnerable to a loss of global investor confidence.
Third, there are circumstances in which the Fed might not be able to rescue the economy and US financial markets. For investors accustomed to believing the Fed is all-powerful, this is a sobering thought.
Guha’s second point is the one that has long worried me. The US has put itself in a position of needing large capital inflows when US growth is slower than global growth, US interest rates are lower than interest rates in many other parts of the world and US assets are under-performing other financial assets …
That's all from me. Back to Mr. Pettis.