Economics

Apparently, the US fiscal deficit is set to disappear and the US current account deficit has peaked.  At least it has in Stephen Jen-land.  In his latest email Jen writes: “US’s corporate revenues are growing rapidly and the US’ Federal budget could be in balance by 2010; the US’ C/A deficit is likely to be peaking this year”Color me unconvinced on both points.  I’ll take Douglas Holtz-Eakin’s forecast for the 2007 fiscal deficit over Stephen Jen’s forecast.   Holtz-Eakin in the Journal: The world doesn't end, but the deficit goes in the other direction next year," says Douglas Holtz-Eakin, a former CBO director. Interest rates are rising, adding to the government's annual interest tab. Iraq continues to be costly. The revenue surge already is beginning to fade. And a slowing economy is likely to restrain revenue growth even further. A one-percentage-point drop in economic growth for a full year increases the deficit by about $35 billion.Holtz-Eakin was talking about 2007, not 2010 -- but I doubt he would forecast the 2010 deficit at zero either. Corporate tax revenues won’t keep growing at their current rate unless profits continue to increase as a share of GDP from already high levels.  Receipts from corporate profit taxes are now 2.7% of GDP – their highest level since Jimmy Carter.  I rather suspect that those receipts are not likely to continue to increase at close to 30% y/y (they were up 27% in FY 2006).    And I really would like to see the details of Jen’s forecast for the 2007 US current account deficit.    From what I gather, Jen thinks:  The US won’t slip into a recession – as the slump in residential housing won’t spill over into a major slump in US consumer spending.  US growth will slow, but not stop – the classic soft landing.  So US non-oil import growth continues, one assumes.The dollar will rally v. the euro as structural dollar bears give up.  That cannot be all that good for US exports – even if Jen thinks Asia will appreciate modestly against the dollar.  A modest yen appreciation won't provide Toyota with a strong incentive to increase the US content of its (growing) US sales.US interest rates will remain roughly at their current levels.  So interest rates on US external debt should continue to rise, increasing the income deficit.The only way I can see the US current account deficit falling in those circumstances is if oil continues to fall from its current levels.   If oil stabilizes at $60, I would argue the current account deficit will continue to rise.  Remember, the harsh math of the US current account.The US imports about 55% more than it exports, so exports have to grow 55% faster than imports just to keep the trade balance constant.  5% import growth and 8% export growth more or less just keeps the deficit stable.   And US imports have not grown at 5% (in nominal terms) since the last recession.The average interest rate that the US pays on its external debt was only about 4.2% in the first half of the year.  As the interest rate on the United States’ roughly $8 trillion in (gross) external debt  renormalize at around 5%, the US income balance will take a $60b hit.   And the $900b or so deficits imply a $45b a year hit from new borrowing.  Yuck.    Some of the sting of rising interest rates on US external debt has been offset by rising interest receipts on US lending, but I think a close reading of the data suggests that US lending already has largely reset at higher interest rates, while US external borrowing is still in the process of being reset.  In the first half, the average interest rate on US lending was already 5% --it doesn’t have much further to rise -- unlike the average interest rate on US external borrowing.  Remember, the US lends at short-maturities and borrows at a longer maturity, so the average interest rate rises/ falls faster on US lending than on US borrowing. All that makes an outright fall in the US current account deficit rather difficult.   Real improvement in 2007 is particularly difficult if, as I expect, the income deficit is likely to go from say $25b this year to over $100b next year.  Absent a sharp recession, my sense is that the only thing that could realistically bring the trade deficit down enough to offset the rise in interest payments is a big fall in oil prices.  Going from $70 to $60 won’t cut it.  If oil stays at $60 through 2007, the US oil import bill in 2007 wont be much lower than the 2006 oil import bill -- and both will be larger than the 2005 US oil import bill.Jen’s forecast for soft landing in the US does suggest some moderation in US import growth.   But I would argue that Jen’s broader forecast also implies that the pace of US export growth is likely to slow.    Jen, after all, expects the dollar to rebound against the euro.  That won't help US exports.   And in case, Boeing’s exports are pretty much capped out until the 787 line starts up.  Production has maxed out, and pretty much every Boeing off the line is being exported.     Remember, from 2004 through 2006, the US has enjoyed the strongest three years of export growth since 1987-89 --  presumably a result of the dollar’s depreciation from 2002-04 and strong global growth.  Combine a maxed out Boeing, a stable dollar and slowing global growth … and it seems to me that export growth is likely to slow from its current pace.  And given the harsh math created by the big gap between US imports and US exports, it is really hard to bring the trade deficit down quickly if US export growth slows.   Absent a US recession that is.What would bring the 2007 current account balance down in nominal terms if US non-oil imports continue to increase in line with US GDP? Well, a $20 a barrel fall in the price of oil from its 2006 average would help a lot.  A $20 fall should reduce the US trade deficit by about $100b.   That would offset the expected deterioration in the income balance.I would be interested in seeing the internals – the export growth/ import growth/ oil price/ interest rate on US external debt/ interest rate on US external lending and so on – that support Jen’s overall forecast that the US current account deficit is close to its peak.   There is some evidence that the trade deficit – in real terms -- has stabilized as a share of US GDP.  But I haven't seen much evidence that the US current account deficit has stabilized.  Sure, it has fallen a bit from its peak in q4 2005.  But the deterioration in q4 2005 was quite sharp, so some bounce back in q1 wasn't a total surprise.   The latest monthly trade number wasn't encouraging.And some strange dynamics in the income balance -- US external lending has repriced faster than US borrowing -- have limited the recent deterioration in the income balance.  But that just stores up a bigger adjustment in the income balance. There is a scenario where the trade deficit falls faster than the income balance deterioratesin 2007.  In that scenario, the US slows significantly, oil prices fall, the Fed starts lowering rates and the dollar slides further.      But that is Roubini-land, not Jen-land. 

North Korea’s nuclear test.     At least that is an argument for selling yen that has long made a certain amount of sense.  Some other arguments for selling yen are, well, a bit more creative. Apparently – as Bill Pesek notes – strong Japanese growth is also now a reason to sell yen.  And, for that matter, slowing US job growth is a good reason to buy dollars. Sure, Friday’s report was ambiguous.   The number of jobs created in the past was revised up.  But directionally, there certainly was a slow-down in job growth in September.  No wonder some now think a slowing global economy (due in part to a slowing US) is good for the dollar …I understand now why fx forecasting is a hard job.     Not so long ago, US growth was good for the dollar.  And Japan’s slump was bad for the yen.   Now, the opposite seems to be true.  A slowing US isn't bad for the dollar.  And Japan's renewed growth shouldn't stand in the way of the yen testing record lows ... At least not so long as interest differentials are where they are.

Paolo Scaroni (interviewed by Jad Mouawad in the New York Times) points out that if Americans continue to drive SUVs with oil at $60 a barrel, oil isn't all that high.  Scaroni heads an oil company (INI), so he is talking his book to a degree.  Oil executives are not known for thinking oil prices are too high.   But he also frankly recognizes that the countries with lots of oil don't currnently see much reason to give the world's international oil companies a large share of the current oil windfall, in part because some of them don't have much need the international oil companies.  Scaroni:It’s their oil not mine. As a consequence we will have access to their oil as long as we bring something they cannot have by themselves. What do we bring — technology, project management capability, investment — something that adds value to them. If we do not add value we are out. Try going into Saudi Arabia and help Aramco to extract the easy oil. They don’t need us. First of all they are a good company. Second the oil is easy. Why should they share something they can do by themselves. Scaroni also recognizes that countries will try to renegotiate contracts that were based on a much lower assumed oil price should oil prices rise unexpectedly, just as companies will try to rengotiate contracts when oil prices are lower than expected.The second concept that I learned is that when oil prices move from $50 to $60 you cannot expect that this $10 difference falls into your pocket. You’d be happy if half of it went to you. All over the globe, there has been a big push to change the terms of the agreements over the past three years .... The same thing happens when prices fall. This time we renegotiate. When oil prices went down in the 1990’s, we renegotiated. But if renegotiation goes too far, and international oil companies leave, and then production starts to drop. At that point governments understand that the terms and conditions are important and that we have our own interest. That seems about right to me.   The countries that have the oil will utlimately decide how much of their oil they want to produce right now, and who they want to produce the oil.  Sometimes, they may not necessarily want to produce as much as they can at the lowest possible cost -- ultimately, that is their choice.  It is their oil.And what of the countries that don't have the oil needed to meet their domestic demand?  They aren't likely to have a lot of influence over the policies of the oil producers.  But they certainly can adopt policies to reduce their own demand for oil -- and thus their exposure to the policy choices made by the world's oil exporters.One of Scaroni's factoids: If US cars were as efficient as European cars, that would save 4mbd.  That is as much as Iran produces, and more than it exports.  Worth pondering.

I guess it is only natural that in world where capital flows – in unprecedented sums – from the poor to the rich, that the poor countries on the periphery also have lower inflation rates than the US. Not just China.   Brazil and Mexico too.   Valerie Rota and Adriana Brasileiro of Bloomberg:Annual inflation rates that reached 6,800 percent in Brazil in 1990 have fallen to 3.7 percent in the 12 months through mid-September. Inflation in Mexico, which surpassed 180 percent in 1988, was 3.5 percent last month. It is the first time both of the countries have recorded lower inflation rates than the United States, where consumer prices rose 3.8 percent in August.What a difference a decade and a half makes.   Today Brazil and Mexico are paragons of price stability.   And the US -- not any of the big Latin countries -- is the world’s biggest external debtor   Iceland and New Zealand have bigger current account deficits -- measured as a percent of their GDP -- than the US.  But both are tiny.  The US isn’t.    Spain, Greece and Portugal all also have large deficits, but they are part of the eurozone.   Whatever you want to say about Bretton Woods two/ the dollar zone, China, the oil exporters in the Gulf and the US are not tied together they way the countries of Europe are.The other striking thing about the (new) financial world order?   An unbalanced world has been a financially stable world.   At least to date. That has not escaped the notice of Ken Rogoff.  Or Rich Clarida.    More below.Some things, it should be noted, are still as they always have been.    The US may have higher inflation than Mexico or Brazil, but the US still has lower nominal interest rates than either big Latin economy.  That means the US has much lower real rates.  It also means that the “carry” on Mexican and Brazilian financing of the US is negative – something that has not escaped the notice of the governor of Mexico’s central bank.     Chinese rates, by contrast, are lower than US rates.  So China’s central bank gets “paid” to take on the exchange rate risk associated with financing the US.  I suspect that this has something to do with China’s willingness to continue to finance the US on a huge scale.  The cost of financing the US is immediate and visible in Mexico and Brazil, while China gets to push off all the costs into the future.  That is one reason why a country with a capital stock per capita of $4000 (according to Goldman) is happy to finances a country with a capital stock per capital of $150,000.     How else is our current world upside down? Well, at least to date, an unbalanced world –  – has been a financially stable world.    Or least a world with very little volatility.    Rich Clarida argues that the world will (most likely) remain unbalanced and (most likely) remain stable.   The financial markets seem to agree.    The logic seems to be as follows. Larger imbalances haven’t led to any increase in volatility.  So why should persistent (but perhaps no longer growing) imbalances lead to any more volatility?     Moreover, the very folks who have facilitated the increase in the world’s imbalances stand ready to insure against any precipitous change. China, the argument goes, cannot tolerate a more volatile world.    If private investors don’t want to hold dollars, China will.  It has to protect the value of its existing portfolio (even if that means doubling down on the dollar, and adding to the PBoC’s VAR … ).   If China needs to add $400 or $500b to its reserves to keep the current system going, the market believes it will … So far, that has been a good bet.   A far better bet than listening to me, or any of the others who have doubted the stability of the new (financial) world order. If the US has a hard landing in 2006/07, it won’t be because the US exhausted its foreign credit line.   Nouriel and I overestimated that risk. But the argument that since volatility fell as imbalances (large US deficits, large surpluses elsewhere) built up,  imbalances can also shrink without a rise in volatility remains entirely untested.  We don’t know if the world where imbalances unwind will be as benign as the world where imbalances built up. Because imbalances haven’t started to unwind.    One source of concern.  The yen/ euro today (hell, even the yen/ dollar – in real terms) looks a lot like the yen/ dollar in 98.    I don’t know to what extent hedge funds have joined real (Japanese) money in the (new) yen carry trade.   But it sure seems like real Japanese money is taking a very large – and increasingly unhedged bet that strong Japanese growth is consistent with a weak yen …. Hedging was cheap when US interest rates were low.  But now that it is expensive, lots of folks just stopped hedging.  See Joe Prendergast of Credit Suisse.  That makes me nervous.  If the yen started to move and the BoJ/ MOF stayed out of the market, lot of folks might suddenly want to reduce their exposure to further rises in the yen.    We know what that means.  At least those of us old enough to remember 1998. Another example:  Both LTCM and Amaranth were brought down by market moves that were as rare as “100 year” floods.   At least by what their (backward looking) risk models thought were events even rarer than 100 year floods.    Think meteors.“The Edhec study, based on public reports of the debacle, confirms that the price changes were extremely unlikely based on historical analysis. But it also notes that the size of Amaranth's positions made unusually sharp market moves almost inevitable as it tried to scale them down.Hilary Till, a research associate at Edhec and a principal of Premia Capital Management in Chicago, said her analysis suggested the market moves that hit Amaranth were statistically even more improbable than those that brought down Long Term Capital Management in 1998.The probability of those events has been likened to the chance of a meteor hitting the earth. But with positions as large relative to the market as Amaranth's, the attempt to get out of trades can itself dramatically move prices.”Which suggests to me that meteors strike a bit more often than folks think.  They seem to hit the financial markets once every ten years, if not more frequently.   That also worries me. Especially since many playing the credit markets seem to think spreads only go down, never up … A tanking housing market?  Hardly a reason not to sell insurance on a CDO composed of a pool of a junior tranches of a mortgage backed securities …  we know Americans never default on the loans that finance their homes. In the near future, I want to delve into a world where mortgages are pooled together and then divided into tranches (asset backed securities) and the tranches of different mortgage pools are themselves assembled together into a new security (a CDO) that itself is divided up into risky and not-so-risky tranches.  And then, to top it off, lots of folks feel sufficiently confident in the pricing of the credit risk in the tranches of these CDO that they sell insurance (a credit default swap) against a default on one tranche of a pool of tranches of a pool of mortgages.  Makes lots of sense, right?   Remember, Paul Krugman once summed up the US economy as a place where Americans are busy selling homes to each other, with the Chinese financing it all.   Helped along by a lot of financial engineering.  Which, if nothing else, does create jobs for well-educated Americans ...  Update: this week's Buttonwood (on the popularity of carry trades in a low volatility world) is quite relevant.

Like Dean Baker, I am growing tired of reading editorials complaining about a failure to take “Social Security’s long-term problem” seriously.True, projections show a deficit of something like 1.5% of US GDP in Social Security starting around 2045.    See Figure 1-3 in the CBO’s outlook.    That of course assumes the US treasury doesn’t default on its obligations to the Social Security trust fund. However, I don’t get why a 1.5% of GDP deficit after 2045 is a bigger problem than the  current 3.5% of GDP gap (per the CBO – see the on-budget deficit in 2006 on p. 22) between the revenues of the government (excluding social security) and its current spending (excluding social security).    The current on-budget deficit came even with more revenues from the tax on corporate profits than at any time since the 1970s.  That may not last (even if the stock markets seems to think it will).Deficits in the non-Social Security part of the government now, usually financed by borrowing from the central banks of non-democratic countries v. smaller deficits in Social Security after 2045.  Which is the bigger problem?     True, current levels of spending are not written into law, but it doesn’t take a rocket scientist (or an ex rocket scientists now working on the street) to figure out that they are unlikely to come down significantly.   The Bush Administration cut into the government’s (non-social security) revenues without cutting its (non-social security) expenditures.And I haven’t even mentioned that Social Security strikes me as the best – indeed virtually the only – insurance most Americans have against the risk that unexpected volatility in their pre-retirement wages will lead to large falls in their retirement income.   Political realists who favor free trade really should support more – not less -- Social Security ….

Stephen Roach thinks that China’s exchange rate policy plays (almost) no role in an unbalanced world; it all stems from the Bush Administration’s loose fiscal and the Fed’s loose monetary policy.  Stiglitz, among others, tends to agree.  Martin Wolf – in his Economists’ Forum – makes the opposite argument.  The world could not have grown as fast as it did if, in the face of Asian exchange rate targets and the resulting surpluses, the US has tried to slow its demand growth.    “If a country cannot influence the relevant policies of others, it has to respond to them. I believe the US has responded reasonably sensibly to the impossible position in which it has been put by the surplus savings and associated exchange-rate policies of much of the rest of the world.”   "More restrictive monetary and fiscal policies" in the US would only be desirable if they "would have led others to alter their exchange rate and macroeconomic policies.”  I increasingly think Wolf has a point.  US policy choices have been constrained by the policy choices elsewhere.  However, I still would rather have had a less expansionary set of policies in the US, smaller imbalances and more pressure to change policies abroad - even at the price of a bit less growth. I do fully agree with another of Martin Wolf’s points. In Wolf's forum, Buiter and McKinnon argue that if US domestic demand growth slows, the US will export more, even if the exchange rate doesn’t adjust.  Why?  Because slowing demand implies more production is available to sell to the world.  US firms will lower prices, and, at some point, the world will buy ...   That isn’t entirely wishful thinking.  We have one good example.   Boeing.  Domestic demand for civilian aircraft has collapsed.   US airlines are all more or less bust.   Of Boeing’s 260 or so deliveries so far this year, less than 40 -- by my loose count -- were to Americans.   And most of those were (cheap) 737s, not (expensive) 777s.  Americans only took 2 of the 43 777s that  have rolled off the line this year.  Of course, exchange rates also played a role here.    Europe didn’t buy most of Boeing’s output (though Air France has delivery of more 777s this year than US carriers).  But I suspect that at least some of EADS troubles are due not just to the A380, but also to the euro/ dollar. Boeing has trouble with the euro/ $ at 0.85.   EADS is having trouble with the euro/ $ at 1.25 – especially when it prices in dollars and buys parts in euros.  But I agree with Martin Wolf’s broader point.  There just aren’t that many Boeing’s out there. A 737, 747, 777 or 787 can be sold to a customer any place in the world.  That isn’t the case with much of the US tradable goods output.   Autos produced in the US -- whether by US or foreign firms -- tend to be very, very big.  Often too big for other markets.    The same is often true of appliances.   Changing the composition of US output so that it better suits foreign demand, not US demand (at least US demand when energy prices are low) won’t be easy. Wolf:  I also wonder how exportable many US tradeables really are and, for that matter, how easy it would be to expand US supply of import substitutes. The world market for cars, washing machines, refrigerators and other goods made specifically for the US market is likely to be modest, even with very large price changes. Equally, the US has next to no supply capacity in the production of many imported manufactures. Think of all the many components of a PC: screens; memory chips; and so forth. And I cannot see how the US can convert its recent investment in housing and other non-tradeable services into the balance of payments with ease. Not only will labour need to be reallocated, but a different capital stock will also need to be created. I suspect that this will need quite large relative price changes.  Buiter says that Wolf underestimates the United States capacity to export services.  I hope he is right:  I work for a company that does export services (RGE certainly doesn’t provide a tangible product).  But generally speaking, most US services business seem very domestically oriented.  The US financial services industry, for example, seems a lot better at using US labor to repackage mortgages into a product that can be sold to China's central bank (exporting debt) than at using US labor to repackage domestic Chinese mortgages for sale to Chinese pension funds (exporting financial services).   

The IMF released its data on global reserve growth on Friday.   And – to no one’s real surprise – the IMF data indicated that there is one key reason why capital flows uphill in today’s global economy.   Central bank policies. The world’s central banks added $225b to their reserves in the second quarter – a bit more than the $181b they added in the first quarter.   That is a lot.    Back in the pre-Bretton Woods 2 era, $225b in reserve growth would be a lot for an entire year.  Now is, more or less, only a slightly above average quarter.  I like to look at a slightly broader measure of reserves that picks up funds shifted (nominally) to China’s state banks and the Saudi Monetary Agency’s non-reserve foreign assets.   China didn’t shift any funds to the state banks in first half of the year, to my knowledge, but the Saudi’s non-reserve foreign assets increased significantly in the first quarter. Consequently, my measure shows an increase in central bank reserves of $234b in the second quarter – a bit more than the $206b increase in q2.     Changes in the dollar/ euro and dollar/ pound, though, contributed to the strong increase in the world’s reported reserves in q2.   I estimate that valuation gains explain $63b of the q2 increase, and $28b of the q1 increase.   If the effect of valuation changes is removed from the global data, q2 reserve growth – by my estimates -- was actually a bit lower than in q1: $171b v. $178b ...  The fall-off in reserve growth largely stems from the fact that Saudis didn’t add as much to their foreign assets in the second quarter as they did in the first quarter.  It seems to be a seasonal thing (Warning: the link is to RGE prop content).   It certainly didn’t reflect a fall in oil prices. If the $348.3b in (valuation adjusted) reserve growth from the first half of 2006 is repeated in the second half of the year, the world is on track to add about $700b to its reserves in 2006.  That would be a bit more than in 2004 or 2005.    The available data suggests that the pace of reserve growth slowed a bit in the third quarter.   That though is entirely because Russia and Mexico used their reserves to make large payments on their external debt in the third quarter.  There doesn’t seem to be any real drop-off in the underlying pace of reserve growth.  More importantly, we don’t (yet) know how much China added to its reserves in August or have any hints about September.  Personally, I suspect both numbers will be big  -- China’s trade surplus is large and I suspect hot money inflows picked up as well.   The RMB sure looks like a one way bet to me. I would consequently be surprised if there was a major slowdown in global reserve growth in the second half of the year.   Generally speaking, I expect Chinese reserve growth to pick up and oil exporters reserve growth to slow a bit.  Oil isn’t quite as high as it was, while China’s trade surplus is likely to be very large in the second half of the year.  Sustained global reserve growth is consistent with what Michael Dooley, Peter Garber and David Folkerts-Landau predicted back in 2003.  They argued that not only was global reserve growth high, but that there was no reason to think that global reserve accumulation would fall back.  So far, they have been right.    Data on the overall increase in global reserve growth doesn’t tell us how much financing central banks provided to the US.      That requires estimating what fraction of the central bank’s reserve growth was invested in dollars – and what fraction of those dollars were lent, directly or indirectly, to the US. I rarely agree with Stephen Jen.   I certainly don’t think current imbalances are a natural byproduct of global integration, rather than a natural consequence of unprecedented reserve growth in emerging economies.  Global integration didn’t start with the Asian financial crisis – or with the post-2002 surge in reserve growth and the US current account deficit.  But Stephen Jen is right on one point.  Best we can tell – central banks have not been diversifying their reserves.  Rather than selling dollars when the dollar is under pressure, central banks have tended to buy more dollars when the dollar is falling – helping to stabilize the market.   That trend seems to have continued in the first half of 2006.   In 2005, central banks reduced the share of their reserves going into dollars, and picked up their euro/ pound purchases.  Think of it as taking advantage of the dollar’s 2005 strength to pull back a bit on central banks’ massive “overweight” dollar position.   In 2006, by contrast, central banks have resumed their 2003/2004 practice of investing most of their new reserves in dollars.   Estimated dollar share of (valuation-adjusted) reserve growth   2003 2004 2005 Q1 2006 Q2 2006 Global (estimate) 84% 79% 60% 80% 77% Countries that report data to the IMF 79% 82% 57% 75% 68% Industrial countries 105% 92% 28% n/a 50% Emerging economies 61% 63% 49% 63% 71% Emerging economies that do not report data to the IMF (estimate) 86% 79% 69% 82% 89% The data shows that the overall share of new reserve growth invested in dollars fell a bit in q2 – relative to q1 – even though the dollar slumped more in q2.   That data point, however, is a bit misleading.  In q1, the world’s industrial countries, in aggregate, both: reduced their overall reserve holdings; and sold euros and other reserve currencies to buy dollars.   That pushed up the overall share going into dollars.  But in some sense, we don’t care so much about the world’s industrial countries.   At least not right now.   Almost all global reserve growth is in the emerging world. Many emerging economies – notably China – do not report data on the currency composition of their reserves to the IMF.   Right now, these countries account for about ½ of the overall increase in reserves. That limits the value of the COFER data.    And requires that I make some rather Herculean assumptions to fill in the gaps in the data.  But  the emerging economies do report data on the currency composition of their reserves added $92b to their reserves in q1, and $111b in q2.   Once valuation changes are stripped out, though, the basically intervened at the same pace in q1 and in q2 – with around $80b in valuation adjusted reserve growth in both quarters. What did they do with those funds?  In q1, They bought about $50b of dollars and $30b of other currencies.  And in q2, when the dollar came under increased pressure, the share going into dollars increased.  About $57.5b of their $81b in valuation-adjusted reserve growth went into dollars, and about $23.5b went into euros, pounds and yen.   The dollar’s share of their (valuation adjusted) reserve growth rose from 63% to 71%. The 71% share is significant -- it above the 60% overall dollar share of their portfolios.  Once again, key central banks upped their dollar purchases when the dollar came under pressure. Obviously, I don’t know what the countries that don’t report data to the IMF did.   They account for $106b of the valuation adjusted increase in reserves in q1, and $75b of the q2 increase.  The data in the table is a guess.  It could be way off.  It is based on the assumption that the central banks that do not report data are targeting a dollar portfolio share of around 75% -- a somewhat higher share the dollar portfolio share of those emerging economies that do report to the IMF.  Why the higher dollar share?   Simple: most of the countries that I suspect do not report their reserves to the IMF seem to peg to the dollar.  It also assumes that the central banks who do not report acted like their colleagues who did report, i.e. they buy more dollars when the dollar is under pressure.   What then is my bottom line?  I estimate that the world’s central banks added $141.5b to their dollar reserves in q1, and $131.6b in q2.    $273b of dollar reserve growth in the first half of 06 isn’t shabby.  It implies a $546b pace for the year – well above the 05 total (now estimated at $400b).   Estimated dollar reserves growth   Q1 Q2 H1 Estimated $ reserves increase 141.5 131.6 273.1         Recorded US inflows 75.7 74.9 150.6 o/w Treasuries 42.1 -8.9 33.4 o/w Agencies 24.1 30.5 54.6 o/w bank deposits -0.8 41.7 40.9 o/w other 10.3 11.6 21.9 International bank deposits (BIS 5c) 51.1 25? 76.1 Total 126.8 99.9 226.7         Gap 14.7 31.7 46   And, for what it is worth, the gap between my estimate of dollar reserve growth and the increase in dollar reserves that emerges from combining the US data and the BIS data seems to have shrunk a bit.    That likely implies one of two things:  I either over-estimated dollar reserve growth in 2005 or central banks scaled back their purchases of US securities through London based custodians. I am biased, but I vote for the later.    My sense is that a lot of central banks parked a lot of dollars in bank accounts.  The increase in the BIS data in q1 was quite high, and in q2, the US data shows a large increase in central bank dollar deposits in the US banking system.   They were waiting for US interest rates to peak.   Their purchases of Treasuries were way, way down.  And my sense is that a lot of central banks resumed their Treasury purchases in a big way in August and September.   They wanted to lock in higher rates …. And perhaps they also sensed that the tide was turning, and wanted to make some trading gains.    I may though be overanalyzing the data.  Best I can tell, the ratio between Chinese reserve growth and recorded inflows to the US rose a bit in 2006.  And, after dipping in 2005, the ratio between the Middle East’s current account surplus and recorded Middle East purchases also rose.   It still though, is quite low – far too low to account for all the dollars most folks think the Gulf states are parking away.  Remember, the global reserves data doesn’t account for the growth in the assets of the world’s oil investment funds, with the exception of Russia’s oil stabilization funds (it is managed by the central bank).   And they world’s oil exporters had lots of money to play with.    The US data still almost certainly understates US dependence on official inflows.

The increase in the interest bill of the US government is an underreported story.   The CBO reports that FY 2006 interest payments will be about $40b more than FY 2005 payments.  And that trend is set to continue.  From 2001 through 2004, falling interest rates – and a strategic shortening of the maturity structure of the US debt stock (see p. 11 of this document) by then US Treasury Under Secretary Peter Fisher – reduced US interest payments even as the US debt stock rose.The chart (link) in the Gross story tells the story.  We in the US are now starting to pay the price for the run-up in our debts. In two senses.  Rising rates and a rising debt stock are combining to increase the US government’s interest bill. And, as Dan Gross notes in his article, a lot of those interest payments are going to the United States external creditors.  That is only fair. Massive purchases of US treasuries by foreign central banks from 2002-2004 helped keep long-term rates, not just shor-term rates, low.  As a result, foreign creditors now own a majority of marketable US treasuries.  It is often argued that higher interest rates won’t have much of an impact on US households, at least in aggregate.   Sure, some folks will have to pay more on their ARM (especially once the low teaser rates expire), but others will get more interest on their bank deposits.   In aggregate, it is a wash – some are hurt, others gain. It is kind of like the interest the US Treasury pays the Fed on the Fed’s holdings.  Most of it comes back to the Treasury, as the Fed gives its operating profits back.  Not so with the rise in the interest rate on US debt held abroad.  That is just a net drain on the economy.OK, that is a bit too simple.   China and Japan get more interest on their exceptionally large (roughly $700b for China, over $900b for Japan) holdings of US debt.     They could use their higher interest income to buy more US goods and services.  But both China and Japan are already running trade surpluses.  And China’s surplus is growing.  So higher interest income on US debt just means more money to buy …. drum roll please … more US debt. The deterioration of the income balance in the US external accounts has occurred a bit more slowly than I expected, for complicated reasons related to the different maturity structure of US external lending and US external borrowing.  But I would be surprised if the 2007 income deficit isn’t closer to $100b than to zero.  The rise in US external interest payments will be bit faster than the rise in the US government’s interest payments because, well, the US has more (net) external debt outstanding that the US government has marketable treasuries outstanding, and US (net) external debt is increasing faster.   The current account deficit is far bigger than the fiscal deficit.    US net external debt should top $5 trillion by the end of this year.  I am using debt here to mean real debt – I am leaving out the positive net equity position of the US.   Increasingly, the world’s central banks will be buying new US debt to, in some sense, finance interest payments back to themselves. That will make it harder for the world’s central banks to finance an expansion of their own countries exports by lending to the US.  They can still do this, of course.  But if the US trade deficit continues to grow even as the US starts making big interest payments on its external debt, the current account deficit will get big fast.  I think this impending shift is another under-reported story.  Probably because it is a hard story to understand.   But basic balance of payments math says that the Bretton Woods 2 system is going to have to change in a subtle but significant way.  Unless you think the US trade deficit can get bigger, it will be hard for say China to finance the continued growth of its export sector.      Barring a big change in policy, China will still lend to the US, of course.   The US will still depend on a financial subsidy from China’s taxpayers.   But at some point, that lending will finance China’s current level of exports and growing interest payments on China’s rising holdings of US debt – not further growth in China’s exports.   China will still be financing a large US trade deficit – it just won’t be financing a growing deficit. That is a necessary implication of any forecast that has the US current account deficit stabilizing.   To keep the current account deficit constant in the face of rising US interest payments, the trade deficit has to fall …

The Doha trade round is deadlocked, essentially over U.S. and EU farm sector protections. Chief U.S. agriculture negotiator Richard T. Crowder says intense discussions continue, but he stressed EU market access must improve for a deal to be reached.

The IMF received its share of criticism over the past two weeks. The IMF governance structure is dated.  Europe is over-represented on the IMF board (and isn’t inclined to allow much change).  Asia is under-represented.    Countries guard their position on the board jealously.   The difficulty getting agreement on a modest ad hoc quota increase (Brazil and India objected because they were not among the winners) doesn’t necessarily bode well for the next set of more ambitious changes.The IMF remains strangely (given its original mandate) unwilling to criticize countries with inappropriate exchange rate pegs (its silence on Saudi Arabia’s peg is a case in point; the IMF only delivers criticism in its regional outlook); hopefully the G-7’s call for the IMF to update its guidelines for exchange rate surveillance will spur a bit of change.The IMF’s advice on how to reduce the surpluses of the world’s big surplus countries and the deficit of the big deficit countries is generally unheeded.    The US hasn’t shown any real commitment to balancing its budget over the economic cycle.  China has let its real exchange rate depreciate this year, even as its trade surplus exploded -- not that you would know about China’s growing surplus if you just read the IMF’s public reports.   For that matter, the markets -- at least after June -- don’t seem to share the IMF’s concern about imbalances.  Market players are bidding up the currencies of countries with large current account deficits (New Zealand, Iceland, the US – v. at least against the yen), and pushing the currencies of countries with surpluses down (Japan).The IMF isn’t – despite what some argue – outgunned by the private markets.  At least not in the emerging world.  The $25b the IMF provided to Turkey is far more than the international sovereign bond market ever supplied Turkey (once you net out the bonds held by turkey’s own banks, which are effectively a foreign-currency denominated domestic loan).   But it is outgunned by the huge stockpiles of reserves held by many emerging markets.  $200b and change in loanable funds isn’t what it used to be. The IMF’s model for generating the income needed to pay its staff is in a bit of trouble.  The IMF used to pay its staff out of interest in got from lending to the big emerging economies ….   That in some ways is a shame.   The IMF staff still do more comprehensive analysis than just about anyone- I challenge my friends in the markets to match the IMF’s analysis of petrodollars or its assessment of Lebanon’s balance sheet risks.  Ironically, though, the IMF’s current absence of income is evidence of some real successes.    The IMF isn’t in the business of providing long-term financing.  It is in the business of providing short-term financing to supplement the reserves of cash-strapped emerging economies.   That is an important role – there is a reason why emerging economies concluded that they need to hold more reserves … And lo and behold, if you look at the IMF’s balance sheet over the past ten years, it basically has performed its mission.   If you want to look at the supporting evidence (including some fancy charts), read on.  Over the past ten years, the IMF has lent counter-cyclically, supplying emerging markets with reserves when private market financing dried up. And – as one would expect – those emerging economies have paid the IMF back as private flows resumed and as higher commodity prices provided many emerging economies with a windfall.    That means IMF lending increased during periods of turbulence – Mexico in 95, Asia, Russia and Brazil in 97-98 and Argentina, Turkey, Uruguay and Brazil again in 2001-02.     Those surges of lending show up clearly in a chart of the IMF’s non-concessional loans outstanding.Incidentally, if US bilateral lending was added to IMF lending in 1995, the peak would be a lot sharper – the US lent its funds out fast, and got repaid far faster than the IMF. The following chart presents the same data in a slightly different way.  It shows the one year change in total IMF loans outstanding.  It is in dollars billion – not SDR – so it tends to slightly understate IMF lending when the dollar is strong and slightly overstate IMF lending when the dollar is weak.  But that source of error is small (and few folks think in terms of SDR).>In Bailouts and Bail-ins, Nouriel and I argued that the IMF’s lending subtly changed between 97-98 and 01-02, as the countries that the IMF lent to in 01-02 were more indebted than the countries the IMF lend to in 01 and 02.    This experiment lending to more indebted countries – countries that needed a sustained period of adjustment to bring their debt ratios down – looks to have worked out better than Nouriel and I expected.   Argentina is obviosly the case that didn't work.  IMF financing was -- mistakenly in my view -- used to put off a necessary depreciation in the peso and a necessary debt restructuring.  But even Argentina ended up in a position where it could repay the Fund.   And Brazil, Turkey and Uruguay all avoided default. Global conditions took a turn in emerging markets favor.  The dollar’s decline helped those emerging economies with lots of dollar debt (particularly if they exported a lot to Europe).  Turkey is a case in point.   Commodity prices rallied, big time.  Low rates in the “center” fueled a new wave of capital flows to the periphery.   Global growth was exceptionally strong. I think though the evidence does still suggest that lending to more indebted countries is more risky.  Even with very favorable conditions, the countries that took out big IMF loans in 01-02 have repaid the IMF a bit more slowly than the countries that received large amounts of IMF money in 97-98 (Russia actually didn’t get that much new money in 98, which no doubt helped … ).    Consider the following graph, which plots the IMF lending surge in 01-02 against the 97-98 surge for comparison’s purpose.   >The big loans stayed outstanding for longer in 01/02.  That may reflect the slower buildup of the crisis.  Brazil took out a loan in 2001 to guard against contagion from Argentina, got into real trouble in 2002 and ended up borrowing a lot of money in 2003 to rebuild it reserves.  Brazil consequently explains most of the surge in IMF lending in the q8-q12 period of the most recent wave of crises.   But I suspect it also reflects the fact that the IMF is lending to more indebted countries. Consider a graph showing both IMF and US loans outstanding to Mexico and to Turkey when both are plotted side to side.  Turkey had a lot more debt.  And it has taken a lot longer to repay.>However, even Turkey now looks to be in a position where it will be able to repay the IMF when the time comes.  That is how it should be.  The IMF shouldn’t have large loans outstanding when times are good.  Its job is to be ready to lend when times aren’t so good. Alas, that isn’t the only role the IMF should perform either.   Indeed, looking ahead -- given all the changes in the world economy --  providing crisis financing to cash-strapped emerging economies may be the IMF's least important future role.