World Economic Update

Tuesday, October 24, 2023
Timothy A. Clary/Getty Images

Co-Chief Investment Officer, Bridgewater Associates, LP; CFR Term Member

Managing Partner, International Capital Strategies; Non-Resident Senior Fellow, The Brookings Institution

Whitney Shepardson Senior Fellow, Council on Foreign Relations; @Brad_Setser


Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; @scmallaby

The World Economic Update highlights the quarter’s most important and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy.

This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies and is dedicated to the life and work of the distinguished economist Martin Feldstein.

MALLABY: Good morning, everyone. Welcome to today’s Council on Foreign Relations World Economic Update. I’m Sebastian Mallaby. I work here at the Council. 

This series is dedicated to the life and the work of the distinguished economist Marty Feldstein, who himself participated in the World Economic Update sometimes and was a friend and mentor to many of us. 

We meet at a time when a discussion of international economics at CFR is maybe especially apposite because I think politics is impinging on economics, and geopolitics is impinging even more than usually. The IMF’s latest forecast for growth five years out, so in 2028, is actually the lowest it’s been in three decades. And a lot of that depressed forecast seems to reflect the fear that both war and the ripple effects of war are causing globalization to stall, fragmenting markets, fragmenting kind of global leadership, and making investment choices for business extremely difficult. 

So with me to discuss this stuff we’ve got, as usual, a fantastic panel. Karen Karniol-Tambour, at the end there, is the co-chief investment officer at Bridgewater. Doug Rediker, in the middle, is the managing partner at International Capital Strategies in Washington. Brad Setser here is my colleague at the Council on Foreign Relations. 

And I want to start this morning with the obvious subject by asking Karen about the newest geopolitical shock, the Israel-Hamas confrontation. Karen, where do you see consequences for markets and economies from this awful war? 

KARNIOL-TAMBOUR: Thanks, Sebastian. 

I think that when you look at a war like this, you see that something that’s very consequential for humanity—and of course, it’s been, you know, devastating from a human-toll perspective—is not necessarily that impactful on markets and global economies. You had an oil price move that is moderate, you know, under 10 percent; a gold price move that is similar. 

And I think that, you know, oil is kind of the most natural first place to look. And what’s really important to remember about the oil market, especially if you compare to, say, fifty years ago in 1973, is you’re talking about an oil market that is significantly more fragmented—so there’s not as much, you know, singular power in any place—and where the U.S. isn’t an importer anymore. So, actually, not a very good lever to go put pressure on the U.S. And I think what you’re seeing in the oil market is the sense that a lot of different scenarios how this war could expand, not that many of them directly affect a large part of oil production, right? So I think you’re getting pricing that suggests maybe some probability of the U.S. increasingly cracking down on Iranian oil and increasing the sanctions, but difficult to do and not necessarily something the administration’s going to have a very high incentive to do, kind of in the realm of everything that out there in the region how important low oil prices are to them. And I think you’re mostly getting some pricing of maybe there’s some tail risk that this really becomes a much wider conflict. 

And you know, you remember something like 9/11; economies and markets bounced back quickly, but you got basically a risk-premium move when it happened. So I think there is a probability of that being priced in, but not a very high one, and so far markets have been pretty resilient and they’re saying it would take a pretty significant expansion to be meaningful. 

MALLABY: Brad, the war has also brought attention to Egypt’s inability to comply with its IMF program. Currency is falling. Inflation is high. They now have some geopolitical leverage in Egypt. How do you think this plays out? 

SETSER: Well, Egypt was in an extremely difficult position before the conflict played out. Its debts have reached significant levels. Debt interest to revenue is about 50 percent. It has not had access to the international bond market for some time. And it was trying to get by with a no-money IMF program, which is one of the recent innovations where the IMF lends you less than you have to repay the IMF and leaves the economy short on foreign exchange. You can tell, I suspect, that I’m not a big fan of no-money IMF programs. (Laughter.) 

So you could sort of—and in this context, Egypt was unwilling to actually let its currency float, which is why the IMF was withholding the second slug of financing. It let its currency depreciate once, but then it was just sort of locked in. 

And the other big thing Egypt needs to do is kind of sell military assets. Now, the IMF has penciled in some huge number for military asset sales. I think those numbers are wildly unrealistic. From what I’ve been told, military assets are valuable if they’re owned by the military and have access to cheap military credit; they cease to be as valuable the moment they are placed in private hands. So if you want to privatize, you typically have to accept a discount. 

But it is kind of heading to a moment of decision where the existing program would have to be reevaluated. I think there’s three paths going forward. 

One is, you know, Egypt’s strategic significance is all the more obvious. The Europeans are giving more money. The Gulf countries, which have been somewhat more miserly than was perhaps expected when the program was formulated, could open their wallets. And that combination can sort of address the underfinancing of Egypt’s program. 

Other, second option, is the inevitable muddle-through option where no one gives enough money to really put Egypt decisively on a better path, but the IMF accelerates its review, gives the IMF enough money—gives Egypt enough money to make it through the next few weeks, and we kind of hope for everything to get better. 

And then I think the third possibility is that there is some negative spillovers, the negative spillovers are sufficiently big enough that the IMF reevaluates the program, and we are in a different world—one where, inevitably, the next Egyptian program considers a bond restructuring. 

I think we’re probably headed to the first option. 

MALLABY: Doug, you, like Brad, were recently at the Bank/Fund meetings in Marrakesh. To what extent do you think the Egypt situation—I think Brad said fully 50 percent of Egypt’s government revenue was being used on debt service, which is an astonishing number. Is this sort of symptomatic of a wider looming problem in emerging markets? You know, in the background we’ve got the fact that, you know, China splurged—(audio break). 

REDIKER: (In progress following audio break)—reflective of emerging markets broadly. So let’s take Egypt and by extension Argentina, put them aside a little bit, because if you start with them then, first of all, you’re going to be very upset where it ends up, but also it’s not necessarily reflective of emerging markets overall. 

It is, however, reflective of what I’m calling political dominance, which is basically a case where it’s not fiscal dominance or monetary dominance; it’s just we’ve had the political imperative to write checks under various scenarios—whether it’s the MDBs or the IMF or bilaterals or China providing development finance—become dominant, not because you’re looking at the economic prospects of the country but because you’re looking at the political imperative to do so. And now what you’ve got is interest rates around the world that are a hell of a lot higher than when that debt was originally issued, and then countries are looking and saying, gee, what do we do now. 

And so in the case of Egypt, to go back to that even though I said it was an outlier, what’s happened really is you’ve got bigger numbers. So I’m going to say basically that Egypt has had the same set of problems that Brad outlined—and I could go into it in greater detail—for a long time, but the numbers are just much bigger now. Same thing with Argentina. Same thing with everybody else, but Egypt and Argentina are off the charts in terms of how big they are. Which puts the IMF and the MDBs and the bilaterals in a position where they have to figure out: What were we doing for the past twenty years? 

For the past twenty years, China was providing bilateral finance, whether it was through the Belt and Road or through other means, to a lot of countries on what were seen to be very attractive terms. No strings—well, no strings until the strings actually have to actually be paid back. And so now the U.S. and its allies, but largely the U.S., is trying to catch up. But in the meantime, these countries have a hell of a lot of incurred debt. They don’t know how they’re going to refinance it. You’ve got a Common Framework which is under the G-20, an idea that the Paris Club and China—China being the largest single bilateral official creditor to low-income and emerging-market countries—would coordinate, agree on a common set of principles on how to address debt in these countries. You’ve got countries now looking at the experience with that and seeing it has not been a good one. So they can’t go to what used to be the Paris Club. It wasn’t easy, but it was straightforward—relatively straightforward. And they’ve got nowhere to go. 

So they’ve got high debt, higher refinancing costs, markets that are closed to them; China’s not lending the way it did before, and if it is it’s certainly not without strings; and a disincentive to go to the official process, previously the Paris Club, now the Common Framework. So a lot of countries are saying we don’t know what to do now, which is why when Brad raises debt restructuring, I don’t think that’s the first port of call for the IMF and for governments. I think they like the idea that they have access to capital markets. But increasingly, there are very few other options for them to get through. 

I’m going to raise one last point, which is the option that economists would say is not being discussed openly enough is fiscal consolidation. Now, in the case of Egypt or Argentina, they’re well beyond the point where they can change their fiscal policies and suddenly become sustainable. But in general, what we haven’t heard is: Hey, sometimes you got to tighten your belt, and you got to go back to the old-school IMF orthodoxy, and engage in fiscal consolidation. At the IMF meetings I did not hear a lot of talk about that, and that surprised me. 

MALLABY: Karen, I want to stick on this question of emerging markets just for a minute because it seems to me not only important in itself in terms of, you know, lives and livelihoods in large chunks of the world, but also for U.S. foreign policy. There’s a rising sense that this is a challenge that the U.S. needs to rise to—that, you know, Janet Yellen has been talking about more resources for the World Bank; the undersecretary for international, as Doug was just filling me in before we came in here, has been saying things about IMF reform; Jake Sullivan has talked about a new Washington consensus. And some of what is on the table in terms of a new international economic policy for the U.S. is precisely that there has been this divergence in performance between the rich world and the emerging world since COVID. So overall, the world, according to the IMF, is three percentage points of GDP below where the projection would have been pre-COVID, so there’s been a loss in growth relative to the projected baseline. But the U.S. is actually higher in terms of output, and it’s the emerging markets that have really fallen behind. And my sense is, you know, six, nine months ago, investors didn’t expect this. You know, I heard people saying emerging markets are super cheap, that’s the—that’s the bargain to go into. 

So in your profession there must be a debate about this, right? Which—how worried should one be about the trends that Doug talks about versus, you know, which bits of the emerging world are actually going to be fine and turn out to be good investment bets? 

KARNIOL-TAMBOUR: No, I’d say there’s—one thing I’ll say is that, you know, people who in my profession do what we do, trade markets, there has been this shift where the countries that we’re used to looking at and thinking of as emerging markets are actually not really the emerging markets that are even being discussed in, you know, these conversations about the IMF. Like, for all intents and purposes, some of them are developed—it’s almost comical people still consider Korea an emerging market in some circles—and some of them are just very, you know, large middle-income. You’re not talking about Brazil, you know, as part of any of this conversation we just heard. So I think that limits our scope relative to, you know, years ago, where a bigger share of the world, to some extent, was in our scope. 

The second thing I would say is that if you kind of take China aside completely, right, as, like, a totally different beast—but it can totally dominate the data. So if you look at the period of great growth and people coming out of poverty, a huge part of that miracle was China. So if you kind of take China completely aside, look at everybody else, it’s still very hard to see the rest of the emerging markets monolithically at this point because there’s a few really big things happening that are pushing through them with very big differences how they’re pushing through. 

One huge one is what’s happening in the commodity markets. And so if you look at what’s happened in the last few years there was just huge commodity winners and losers, and countries found themselves either in a disastrous commodity situation—you know, Russia invades Ukraine and they kind of find themselves the ones that are getting squeezed to not be able to get the energy that they need—or as huge winners, that suddenly they produce something that is kind of creating a boom for the country they didn’t realize before. I think that’s going to continue shifting because, as we move down the path of transitioning our energy systems and so on, we’re going to find that new countries can be energy superpowers in a way they weren’t before, whether that means that they make metals that we need or suddenly they’re actually solar superpowers. So this is a big thing that countries are trying to find themselves in. And they don’t want to end up like a South Africa that this is a thing that squeezes them; they want to end up a winner on this. And all this is a little bit out for debate. 

Second one is, I’d say, broadly speaking, the influence of China. So they’re the countries that actually China became more of an engine for, that they actually created some of the growth in these countries, and they have had to handle the fact that China has been significantly slowing and that’s not going to be an engine anymore. 

Then the flipside is I think the biggest opportunity for a lot of these countries, basically, as countries like the United States say, well, I don’t really like what globalization did to my map and I want to redo all of my supply chains, the obvious candidates to benefit from that are China competitors, right? So the question of people like India or Mexico, they don’t have almost any downside from China slowing. It’s not like Mexico was benefitting from China expanding. But they clearly are benefitting from tensions with China and wanting to kind of get out of the China business. 

So as you look through them, you know, the range from what I would call, like, a significant disaster in a South Africa that’s both political, and energy sensitivity, and, like, every possible thing, you know, going really poorly, all the way to countries that are really poised for big opportunities like an India or a Mexico, the differences start becoming really stark. And I think you’re going to increasingly not be able to think of them as one thing. 

MALLABY: Brad, one more thing on this divergence between emerging markets and the developed ones. You know, my first reaction when I saw those numbers on the underperformance of emerging markets was to say this is surely a question of just fiscal capacity, right; that in COVID it was possible for the country with the reserve currency, the U.S., to just hit the system with so much fiscal stimulus that of course growth wound up being higher than projected, whereas if you had less fiscal space because you’re an emerging economy you couldn’t do it. But the IMF, you know, puts also this thing in a context of, like, how long would it take for emerging markets to converge in terms of GDP per capita with the developed countries. It used to be—in 2008, the projection was it would take eighty years to converge. Now that’s moved to 130 years, so a jump of more than 50 percent. 

So this is not just a fiscal story, which would be a brief story. It seems to be a view that something more profound is going on. Can you explain to us what that might be? 

SETSER: Not entirely. (Laughter.) I tend to think the fiscal story is not a bad first approximation. I mean, I also think that Europe has substantial fiscal capacity. This notion that only the U.S. is the sort of only, uniquely, country able to do fiscal stimulus when a pandemic strikes just seems to me to be off. We did more of it, but others certainly did some of it. 

Look, I think if you go back over a long span of time, there is not a uniform convergence ratio over time. There have been long periods of time, in fact, when the advanced economies have gotten richer and the poor countries have not grown fast enough to catch up—the 1980s, for example; most of the 1990s. The period when China was growing exceptionally rapidly and that pulled all the commodity-exporting emerging economies along was a great period for emerging economies, and convergence was helped by the fact that, you know, the aughts were a really bad year for the advanced economies. So you had very rapid convergence over a brief period of time. 

I actually think the break when you look at it is probably around 2015, pre-Trump, and it’s much more tied to a downshifting in China’s overall growth from ten/eleven to, like, seven, and to the initial swing in commodity markets from sort of oil at 110 (dollars) and you could produce as much iron as you possibly could and China would buy it to a period when commodity prices were much lower or the U.S. was generating incremental supply, not resource-exporting Latin America or Africa. So I think Africa really actually had a—had a good period of time up until 2015, and after that has really kind of stalled. 

Obviously, the risk going forward is that stall continues. And I do think the combination of a pullback in Chinese support for infrastructure lending, volatile but not necessarily always structurally high commodity prices, high for long U.S. rates which have effectively priced all of Africa out of global financial markets, creates a very, very challenging environment for most countries in Africa to grow. And I also think it is imperative, as, like, sort of been discussed at the IMF and World Bank meetings, but there isn’t yet nearly enough money to actually do enough to make a difference. But I personally think the only solution is a reconceptualization of the multilateral development banks, a doubling of their lending capacity in a short order, because it is not realistic in a high for long world for private investors who want 10, 12, 13 percent to finance clean-energy projects that are risky and return 6 (percent). So either we’re not going to do the projects or someone in the public sector is going to have to mobilize the funds. 

REDIKER: Or China’s going to do that. 

SETSER: China’s pulling back. But China is— 

REDIKER: No, I know. I’m just saying that’s the other alternative. 

MALLABY: So, Doug, maybe you can help us again see this in the larger foreign-policy context. One could say that the biggest Western success after Russia’s invasion of Ukraine was that the developed world came up with a unified response; the biggest Western failure was that emerging markets by and large refused to support it. And maybe—not necessarily, but maybe—that’s connected to the fact that in the developing world you had an increase of 95 million people in the number of people in extreme poverty. So do you agree with Brad that, you know, doubling down on the Bretton Woods institutions and just building up the sense of U.S. presence in emerging economies is kind of a strategic imperative? 

REDIKER: Yeah. In general, I do agree with that. I think—I’m not sure it’s going to happen, but I think it’s the best way to accomplish our foreign-policy goals through economic means. 

I think for the past several decades we ignored development finance. We left the— 




SETSER: Do you need water? Yeah. 

KARNIOL-TAMBOUR: I apologize. 

REDIKER: We left the landscape open. We did HIPC. We did MDRI. So those were two major global initiatives that effectively wiped the slate clean for low-income developing countries of their debt. And we basically said the private sector is going to fill those gaps. So remember that point, because at that point the private sector investors were the silver bullet. They were the U.S. answer to development finance. What happened instead was the private sector did, in fact, come in to some degree, but China said: Are you kidding me? Wait a minute. You’ve just made all these countries debt-free and we’re here with a big checkbook to write? Thank you very much. And the U.S. took its eye off the ball. Private investors came in. And the reason I keep going back to private investors is because—so I don’t forget the point later. This administration in the U.S.—not unique to this administration, but in general American administrations—haven’t figured out if private capital is the answer to our problems or if it’s to be demonized. So if you look at a lot of voices in this country on low-income emerging-market debt, they are quick to say let’s restructure, right? These guys are vultures, these guys are terrible investors, and so let’s just wipe them out or restructure them, however you want to define it. But actually, the American premise was that private capital would be a disciplining force and that it would be the answer to the lack of U.S. official bilateral or multilateral development finance. It worked out a little bit. China came in. 

So now, to your question, basically, Sebastian, yes, at this point private capital is not sufficient to fill the gaps that are needed. So the question is, how do you do it? And I think multilateral development banks—the World Bank—IMF is a different institution; its mandate is different. As you made reference to, Jay Shambaugh gave a speech basically telling the IMF to get back to is core mandate and stick to balance-of-payments imbalances, conditions-based lending, and get away from some of the other climate finance sort of things. But with the other hand, they’re saying: Let’s empower the World Bank. Let’s empower the MDBs. I do think that it is the best tool the U.S. and its allies have to advance our interests, is to supersize all of these institutions. I’m not sure the U.S. Congress is ready to do so. But if I were able to write, you know, the plan, this would be a core if not the central thesis, which is get those institutions that are actually mandated to do these kind of projects in those kind of countries and give them a lot more capital to go out and do it. 

MALLABY: We’re going to go to members in about five minutes to join the conversation, but I want to sneak in at least one or two questions about China. 

We noticed this morning that Xi Jinping has visited the central bank. First time he’s ever done that, apparently, perhaps, you know, portending a switch in the intensity of focus on the economic challenges in China. There’s been a general sense that the level of policy stimulus as the sluggish, disappointing recovery from COVID has proceeded has been surprising. We know from the Japan case in the 1990s that if you don’t support demand when you’re faced with a property slump and an investment slump, you know, you can have a lost decade. (Laughs.) So, without suggesting that China’s going to make the same mistake as the Japanese, what are you expecting from policymakers in China in the next few months? 

KARNIOL-TAMBOUR: I mean, I think the biggest thing is that they’re staring this decision in the face and they may feel that what we see as a lost decade is actually the right policy choice and make it actively. I think they’re coming out of a world where they felt that the most important thing they needed to deliver was a certain level of growth, and they were going to deliver that come hell or high water. And you know, the easiest way to make sure you deliver it is to say: Take this money, lend it, build something. I don’t care what it is. Make sure that gets done. And then you can pretty much guarantee growth at any level you want, if you force people to go and really create the economic activity. And they did it over and over again, right? Like, one sector got overindebted; let’s go to the next one. We’ll just make sure we keep building somehow. 

I think they’re having a deep change of heart to say, wait a minute. And part of it is the geopolitical tensions, more of an almost war mentality. Like, we need the kind of growth that we need in order to win in this battle. We don’t need any kind of growth; we need to work certain sectors and certain areas. We need to be winners in certain things. And I think they’re much more saying that means accepting, you know, very low, sluggish growth for a while. As long as the right kind of growth from their perspective is what’s going on, maybe that’s OK. That’s a very significant shift. I mean, we’ve just been in a world for a long time where pretty much the one thing you can count on is Chinese policymakers will make sure that Chinese growth is high because they got to make that work. Has big implications for its neighboring countries, big implications for global commodity markets. And I think that’s what’s most likely, that they’re just going to sort of say this is what we want. You hear it when Xi talks about, you know, dirt and how young people should approach the economy. I think they’re going to say this is—we’re willing to accept this. 

MALLABY: So, Brad, if the government went in that direction and was willing to accept low growth—it’s not just low growth, right? You’ve got two quarters of deflation. You’ve got this huge overhang of debt, which only gets worse in the context of deflation. You’ve got worries that—and this is, again, a bit like Japan—the banks are not reporting the full numbers in terms of the amount to bad debt on their balance sheets, partly because during COVID they were given explicit permission not to mark down any of the loans which were not being serviced by the small- and medium-sized enterprises as part of the kind of COVID support policy with Chinese characteristics. So how much of a risk do you see in the debt overhang in China? 

SETSER: Well, I guess maybe I was—spent too much of my youth reading a book called Red Capitalism, which was a story of China’s state banking system coming out of the 1990s. 

MALLABY: Can I just say, many of us have a misspent youth, but reading, you know, Red—(laughter)—sorry. 

SETSER: Mine was more misspent. (Laughter.) 

But the basic thesis of that book was that China had a long history of having bad loans sitting on the books of the state banking system, and the miracle of China’s growth in the years after the WTO was that this mass of unrestructured state-enterprise loans sitting on the balance sheet of the banks and moved to the asset-management companies but never classically written down and dealt with in a normal advanced-economy bank resolution didn’t get in the way of rapid growth. 

So there is a sense in which China is a little different, and large losses in the real-estate sector—unrealized—haven’t prevented China from extending huge amounts of credit to the manufacturing sector this year. So if you want to make an optimistic set of arguments, it’s that China really is different. 

I think the analogy I prefer is not Japan. And I don’t know if this analogy I do prefer works, but the analogy I like is Spain with a current-account surplus. Why Spain? Because Spain, before the global financial crisis, had an economy where construction was about 20 percent of GDP, roughly the same level as China. There were real questions about the health of the Spanish banking system for a while. It turned out that in Spain almost all the mortgages were paid, unlike in the United States. Full recourse, floating rate, people put a lot of money down. The banks, even in a property market crisis, had a large mass of performing assets. I think that probably carries over to China. 

The trouble in Spain were the loans to the developers. Clearly, the property developers in China—those not backed by the state—are effectively bust. They need to be restructured. There are unrealized losses there. Although a meaningful part of the developers’ liabilities are not to banks, but they are to their suppliers. And there’s an open question about how that specific problem is resolved. And then there’s a set of bad debts tied to the local finance investment vehicles, the infrastructure financing corporations that local governments set up left and right. Some of which are going to be money good, some of which are going to be money bad, with losses to investors. Some of which will be bailed out by the provincial government with maybe support from the government in Beijing. 

I think the net result of that is not that the big five state commercial banks are at any real risk of failing. I think they can continue actually to be used as a source of backstop financing for the weaker parts of the financial system. But in Spain, the weaker regional savings institutions—the cause—were in real trouble. They ultimately had to be bailed out and recapitalized. So my operating thesis is that the regional provincial banks in China will ultimately have to be backstopped in some way. And that will likely have a fiscal cost. My operating thesis is that because of China’s state structure, that can be done without the famous Lehman-style moment. But it is a long process of financial rehabilitation and recovery. 

MALLABY: So in distinction to many past World Economic Update meetings, where we talked about the U.S. and Europe and kind of hardly got to the emerging world, we flipped the pattern this time. But if people have got questions on either Europe or the U.S., I’m sure we’d love to answer them. So I’m going to invite members. Right here in the front, Tara. There’s a microphone coming. Please identify yourself for the—for everybody else. 

Q: Thank you so much. My name is Tara Hariharan. I’m from NWI. 

My question is actually split up for the three of you and brings us back to the U.S., and specifically to the outlook for long-term Treasury yields and interest rates. So, Karen, how are we to read the economic resilience we have right now in the U.S.? And how do you see this basically affecting the steepening of the yield curve? Doug, how are we to read the shambolic political situation we have right now in the U.S., the fact we still don’t have a speaker and the fact that fiscal— 

REDIKER: Thanks, Tara. Thanks. 

Q: I had to ask you that question. And how fiscal is going to affect the yield curve going forward. And, Brad, how is China’s Treasury strategy, as well as the BOJ potentially doing a shift in Japanese investor strategy, going to affect long-term Treasurys? Thank you. 

MALLABY: Wow, three questions in one. I should have said, this is on the record. (Laughter.) 

KARNIOL-TAMBOUR: You know, let me start by saying—I think everyone knows this—but the situation we’re in is—it’s not normal to run a fiscal deficit this big when the economy is tis strong. It just doesn’t happen. And both because the government doesn’t usually choose to spend this much when the economy is great, and also because to finance those bonds what you usually get is basically a recession economy where you get a steep yield curve. And, you know, rates are low, long-term rates are higher, and it seems like a good idea to buy these bonds and get that yield. And so it’s a very strange situation to be running this high of a deficit with the economy this strong.  

And the truth is that a lot of what’s allowed it to happen without rates rising until relatively recently is a bunch of mechanical stuff, more or less, that allowed the U.S. to issue primarily T-bills to fund these huge deficits. And, again, if you look around the world, nobody else is running huge deficits and issuing T-bills to fund it, right? Because no one would let them. It’s not like the Brazilians can come and say, I’d like to run, like, a 6 percent of GDP deficit and issue it all on three months paper. Like, this is not—nobody’s going to allow that. (Laughter.) The United States is uniquely privileged in being able to do that. But even the United States is not planning on continuing this, right? Like there’s a clear plan to move towards doing the normal thing, which is issuing bonds in order to fund the big deficits. 

And it’s going to be hard to issue those bonds. I think yields have now moved to the point where they’re starting to be reasonable for buyers that are not the Fed itself, which is obviously not price sensitive, or the banks that already dealt with, you know, Silicon Valley Bank-type blow up and don’t really want to take duration risk, certainly with no yield curve. I think yields have moved a lot in the last, you know, very short number of business days, to make it much more plausible. But you’re going to keep having this grinding impact where the U.S. has to issue a tremendous amount of debt. And they haven’t had to actually get buyers yet. They’re just starting to actually have to get buyers, to say I’m willing to buy this paper, so. 

MALLABY: Politics, Doug. Very simple. 

REDIKER: So can we talk about Argentina instead? (Laughter.) Look, if you’re asking me how do—how does this end? No one knows, right? I mean, I don’t—I didn’t look at the news this morning, that was intentional, to see what happened in the House thing last night. I can give you the somewhat optimistic scenario, which I hold a one in twenty chance might take place. (Laughter.) But that is non-zero. Which is that the Republicans become so frustrated that their inability to find a consensus 217 vote speaker that they do cross the aisle, and that there is some form—I’m not saying that there’s a bipartisan, miraculous centrist that comes out of stage left or stage right and becomes the consensus speaker. But that it could be that the frustrations with the House Freedom Caucus people, or whoever the outliers are on the Republican side, become so much that enough of the center of the left and the center of the right find some consensus to allow us to move forward. 

That’s not a zero probability. As I say, if it’s one in twenty, that means there’s a nineteen in twenty chance it doesn’t happen. But, you know, what we did see going into earlier this year was McCarthy salvaged the debt ceiling issue by having some bipartisan outcome. The crazy part of all this is this is the House. It is not the Senate. It is not the White House. Whatever the House ends up doing on the continuing resolution, on the appropriations bills, whatever, is going to end up meeting the brick wall of the Senate and the White House anyway. So this is somewhat theatrics. But I’m desperately worried—the second part of your question which is not about just the politics, but the fiscal.  

You know, I mean, I can make a good case that the U.S. is privileged in that there are tools that we have that could address our continuing deficits and our outsized debt, for as far as the eye can see, in a way that other countries don’t have that luxury. Entitlement reform, tax policy, there’s a bunch of other things that we could do to right our ship. That we are an economy that is privileged enough to have that luxury. I am desperately worried. I don’t see how we’re going to get that done. So we’re all old enough to remember the super committee and Simpson-Bowles and all the other things that were going to solve our problems. But they didn’t. And so politicians being politicians, unless the fever breaks on both sides, where we say sorry, we’re populist, both sides are saying we’re not going to touch this, or this, or this, or this. 

If you don’t touch any of those, then we have a problem. And then what Karen was describing about we’re in the luxurious position of being able to borrow for, you know, 6 percent deficits at 5 percent for as far as the eye can see, at some point, there’s—I’m not saying a buyer’s strike—but there’s got to be a comeuppance. We benefit from the fact that there is no alternative. So just to be clear, there is no alternative, right? So we can do this for a long time. I’m just not sure that’s a good thing. 

SETSER: OK. (Laughter.) Oh, well, we may not be able to do it forever. There’s a puzzle in international financial flows right now. Maybe I’ll start with the Japanese component of the puzzle. The Japanese seem to love U.S. Treasurys, when Treasurys yielded two and a half or three. You might think, naturally enough, that Treasury at five would lead to higher demand, particularly since ten-year Japanese government bonds haven’t gone beyond one. That, of course, has been basically not true.  

Japanese investors who were buying Treasurys five years ago, were often buying those Treasurys by borrowing short-term U.S. dollars, typically buying it through the currency swaps market or through repo. And so they were effectively borrowing three-months U.S. money to buy ten-year Treasurys, or to buy twenty-year corporate bonds. When the yield curve inverted, it no longer made sense for Japanese investors to be U.S. intermediaries. You don’t borrow a three-month money at five and a half and buy U.S. Treasurys at four and a half and make money. So you saw that flow just disappear, gone. And it turns out that the proportion of Japanese investors who are just looking at the absolute yield differential are rather small. They’re not non-existent, they’re just small. 

MALLABY: You mean the differential between Japan and the U.S. as opposed to the short term— 

SETSER: The shape of the U.S. curve. So we’ve seen structurally a falloff in Japanese demand. Now, the positive side of this is that at a certain point long-term rates will get high enough that it will start to make sense for Japanese institutional investors to lock in six, if you can hedge it at five and a half, and you expect U.S. rates to come down. There are eventually self-correcting forces in the market, but the Japanese bid is not currently there in the way that it was there in the past. 

China. China isn’t adding to its reserves. It hasn’t added to its reserves for about ten years, by the way. Some people think China’s dumping its dollars. I wake up and I see reports like that every time the tick data comes out. What I see is a China that is adding to its agency holdings, trying to capture the juicy yield premium. I see a China that is making more use of offshore custodians. You don’t have to appear in the U.S. tick data as yourself unless you want to. You can put your money in Belgium, Luxembourg, the U.K. and in the other custodial center, and disappear. And I see a China that wants to hold more short-term paper, bills, deposits, maybe because they need to intervene, maybe just because they like the higher rates at the short end. 

But the net effect is that when maturing Treasurys are coming due, China is not reinvesting it back into ten year Treasurys. They’re either going out to the agency market or they’re going into the short end of the market. So in that sense, the two biggest structural foreign sources of demand for Treasurys over the past twenty years are, for slightly different reasons, currently not big bidders for duration. And, as Karen noted, we’re going to have to move from issuing bills to issuing some notes. So pick your bet. 

MALLABY: Right there. Thank you. The microphone just coming. 

Q: Thank you very much. Mahesh Kotecha. 

I was, like, I think some of us, you had mentioned you were there, in Marrakech. A big discussion there was on climate finance and increasing the capacity of MDBs, doubling it perhaps as you mentioned. But really, the bottom line was that there’s not enough money no matter how much MDBs multiply their capital by implementing the Bali G-20 reports and the India G-20 reports. There’s just not enough money for the kind of needs that you have long term in climate finance. And the shortfall were to come from private sector. 

So it’s not one or the other. It’s both. The challenge is how to get the private sector to come in with proper de-risking. And, that I believe, that multilaterals have no solution. The private markets must come up with one, it seems to me, because the MIGAs of the world have been, frankly, ineffective. So my question is, where will we find the de-risking for the kind of climate finance we need and attract private sector? 

MALLABY: Doug, you want to try that? 

REDIKER: Yeah, I mean, if I understood your question correctly, you were saying that the private sector’s got to take on that de-risking itself. I’m not sure the private sector can do that at affordable rates. I mean, these are going to be risky projects over a long term. And I think that there is a role for—and you’re right. MIGA and other similar entities have not been what they were created to do, right? These are institutions within the World Bank, or within OPEC, or others that were supposed to take some government multilateral de-risking onto the public sector balance sheet and allow the private sector to move forward knowing that their floor was capped. It hasn’t worked that way. It’s very complicated.  

When I was a banker doing emerging markets thirty years ago, we’d always go to MIGA, we always go to OPEC. Never once did we ever do a deal where they were involved because it was just—yeah, it was so clear that they didn’t want to take the risk either. So ultimately, if they don’t want to take the risk, why are you paying them to offload that risk? I don’t know. Until there’s a sea change in sentiment in which whether it’s the U.S. government, or other governments, or the institutions, the World Bank, the MDBs, where they say: We’re willing to take the first loss for real, and we’re going to make it easy for us to take that first loss, which then means you, the private sector, can go to bed at night knowing that you’ve got, you know, a cap on how much exposure you actually have.  

Unless the public is willing to take that first loss, I don’t know what the answer is. Because I agree, and I didn’t mean to suggest it was either/or. I think private capital is an enormous tool in the U.S./Western toolkit for climate finance, for development finance broadly. And I don’t know how we catalyze it unless, given the uncertainties of the world today—whether it’s the current situation in the Middle East, or Russia, or Ukraine, or broad-based uncertainty around the world—I don’t know how private capital goes in unless they’re asking for extraordinary returns, which then are uneconomic on the project or the country basis. So I’m at a loss, other than to change public sentiment at MDBs in the U.S. Congress and the U.S. political process, where we say we are willing to take that risk so that we can catalyze private capital to advance this broader agenda. I don’t know if we’ve got politicians who are willing to actually make that case or a public that’s receptive to it, but that’s got to happen. 

SETSER: Can I toss in some financial engineering? 

MALLABY: Yeah, go ahead. 

SETSER: So I do think we probably need a compart of the multilateral system that probably isn’t called a bank that is more of some sort of investment fund that is 100 percent equity financed that can be structured to take first loss investments. That’s really not at bank. It’s a fund, but not the IMF fund as a kind of fund. Separately, we put in—I think I got the numbers right—over time about twenty billion (dollars), maybe twenty-five billion (dollars) in paid-in capital to the World Bank, the IBRD, not IDA, over its history—$20-25 billion. That is nothing with the world’s greatest economy. Nothing. And we could split that cost with our allies. It is a tiny sum. 

We are sitting on a pool, with our allies, of 400 billion (dollars) in currently entirely unused SDRs. I know a lot of people think SDRs are funny money, but they can be converted into real currency through something called the IMF’s Voluntary Trading Arrangement. With a bit of creativity, 20 billion (dollars) in paid-in capital in the IMF, and 20 billion (dollars) in SDRs could be transformed into a development financing program on the par with the Belt and Road, or at least the first stages of the Belt and Road, without requiring the World Bank to raise a cent more in the private market. And it could finance a lot of green and clean investment at reasonable rates. There are feasible solutions. They just need the catalytic role of a bit of equity capital. 

REDIKER: Can I just point out? SDRs has always been a problem. SDRs are an IMF creation. And the IMF has been enormously proprietary in how those SDRs are actually allocated. So they’re limited to being used by central banks, other monetary authorities, and a small sliver of other approved institutions. But the World Bank and other MDBs are amongst those institutions that are approved. So what Brad is suggesting is something that if the IMF didn’t think we, the IMF, are the only ones that can be trusted to actually use these SDRs, and they said, well, you guys across the street, you may not be exactly like us, but you’re close enough let’s you use it for something like what Brad is discussing, it would, in fact, provide this enormous pool of capital. Might—you know, there’s financial engineering and then there’s, you know, lots of structures that would be required to get there. But what Brad is describing is a pool of unused resources that actually could be used if the IMF sort of let go on its proprietary control. And, here’s the tricky part, and if the U.S. Congress approves, which they seem disinclined to do so. 

MALLABY: Let’s see if there’s another question from the floor. Yes, back there. 

Q: Thank you. 

Following on some of the comments about Japan. I’m curious if you’d be able to connect the current trajectory of U.S. fiscal policy, particularly in an emerging environment of domestic industrial policy, a potential ramp up of defense spending, to your comments about Japan, obviously, with the BOJ meeting next week and, you know, kind of debates around upcoming changes to yield curve control policy, to what happens to long-term rates in the U.S. and—maybe not today, maybe not tomorrow, but at some point—the potential for yield curve control policy in the U.S. 

MALLABY: So just maybe to piggyback on that, Japanese growth is projected at 2 percent this year. Which is a heck of a lot better than Europe, and almost as good as the U.S. So pretty amazing for Japan. But inflation is—core inflation is above 4 (percent). So there is pressure on the BOJ to do something about yield curve control and allow rates to rise. Who wants to take a crack? Karen. 

KARNIOL-TAMBOUR: I can start. I mean, I think that Japan’s in an enviable position of being excited about seeing inflation. For them, 4 percent is—you know, they don’t want to come out and say this is great news, but it’s great news, you know? Like, after a long period of deflation. They are going to gradually have to figure out who’s going to buy Japanese government bonds. But my guess is that there’s a lot of pent-up demand, because no one’s seen the Japanese bond in quite a long time, right? (Laughter.) I mean, they’ve spent a long time not just not issuing new ones, the BOJ is buying them all, but literally taking them out of people’s hands. Like, if you have them, they’re buying, you know, faster than they’re being issued. So my guess is that there’s a decent amount of pent-up demand. And that in the period of kind of peak quantitative easing in Japan, they went to a lot of these institutions basically said: Go get out of Japanese government bonds. Go buy foreign bonds, instead. They threw everyone out of there. 

So I think that we don’t know yet how hard it will be for them, but that they’re going to be comfortable having yields rise somewhat. And, you know, it’s almost comical to say, but yeah, if you buy on leverage and the steepness of the yield curve is the thing you care about the most, Japanese yield curves is not bad today. And it can only get steeper. And so I think that you’re in a situation where the U.S., if it wants to rely on Japanese as big buyers of our bonds, like Brad said, you’re going to have to have a steeper yield curve. It’s got to be competitive with whatever’s happening in Japan. And there’s a natural return back to, you know, people buying the domestic bonds that’s going to occur over some period. 

And that, in general, the move in Japan to modest tightening, I mean, you’re coming out of extremely easy policy. So you’re still talking about an economy that’s going to be in extreme stimulation for quite some time. These are not policymakers that are freaking out about how sticky inflation is, right? And you see it in the equity markets too, where you can look at Japanese companies and I’d say, on average, they have meaningfully lower earnings prospects than the U.S. or Europe. But that’s not—that’s priced. The U.S. is priced to have incredible earnings. So from a valuation perspective, we still have better deals there. 

MALLABY: Another question? Yes, I can see one over there. 

Q: Tim Kubarych from Harding Loevner. 

I was wondering what you thought about demography in the context of structural growth expectations. I’m kind of surprised at how many countries have declining population expectations, particularly China and their decelerating population growth, but also in places like Poland, all around the world. How does that affect your kind of view of long-term growth? And perhaps comment on productivity in that context. 

MALLABY: Who wants to have a shot at that? 

REDIKER: A big Brad question. (Laughs.) 

MALLABY: Well, it could be an excuse to talk about Italy, Doug. (Laughter.) Italian demographics. You know, it’s not just that likely they’re on vacation. (Laughter.) It’s a professional preoccupation too. 

REDIKER: OK, I didn’t see that coming. (Laughter.) So I’m not a demographics specialist. I do think your question though is correctly framed in raising China as the starting point. I’ll get to Italy in a moment. You know, China’s population is supposed to be below one billion in the next several decades. And there are those in Washington, certainly in the circles I travel in, that, you know, are arguing about peak China and whether we’ve reached it. And a big part of that is the demographics point. 

So Poland I think actually is an interesting one to raise because they benefit from the influx of Ukrainian refugees or migrants. And so, to some degree, there is this tension that Poland opened its doors and welcomed the Ukrainian outflows because of the war. And there is a question about what a country like Poland does after the war is over. Hopefully, the war is over at some point soon. 

Italy is a—Italy as a bunch of other structural issues. When I was at the IMF, we had a very famous, at least in my mind, presentation from the Italian mission chief one time. Who actually plotted on a very simple graph, said that Italy grew at—I’m going to get this wrong—but I think it was 6 percent in the 1950s. 5 percent in the 1960s, 4 percent in the 1970s, 3 percent in the 1980s, 2 percent—you get the point. It was literally a seventy-year steady trajectory. And part of that was demographics. Part of that was other structural issues. 

And now we’re at a point in Italy, which, again, is not a demographics point but since you asked all that, now you’ve got a dynamic in Europe where people look at 5 percent Treasurys here and they say, OK, I’m going to sell Europe. And selling Europe often means selling Italy. So Italy suffers disproportionately, because they’re a very large—I believe they’re the largest euro-denominated sovereign issuer in Europe. So if you’re going to sell anything, you’re going to sell Italy. And that puts pressure on BTPs. 

And then you’ve got Meloni, and Salvini, and the current government that basically are running a budget that is inconsistent with not only the Stability and Growth Pact, but any fiscal propriety that you could imagine. But, again, going back to my earlier point about political dominance, you know, this is politics over fiscal prudence. So a country like Italy is now under enormous stress in the BTP market. And all of the mechanisms that are supposed to address this—whether it’s the transmission protection instrument, or, you know, PEPP, or any of the ECB’s tools, actually don’t apply for Italy for one reason or another. And so, yeah, I’m worried about Italy, because until they get their political fiscal budget process revised, they are probably going to suffer asymmetrically in the bond market. And they are a country that cannot afford to do so. 

MALLABY: Do we have a last question or not? Because I have a last question. We’re going to have a quick rapid-fire round in honor of the SBF trial. (Laughter.) And the question is going to be for each of you. In ten years’ time, will crypto be, A, nonexistent, B, marginal, C significant? Karen. 


MALLABY: Marginal. 

REDIKER: I’m going to just go back—crypto or blockchain? 

MALLABY: Crypto. 

REDIKER: Marginal. 


SETSER: Well, I guess to be exciting I should say nonexistent. (Laughter.) 

MALLABY: OK. Thank you to all the panelists. Thank you to you for coming. Please note this video and transcript will be on the CFR website in due course. (Applause.) 


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