Stephen Jen - the anti-Roubini (and the anti-Setser)

The odds of a US recession:

Nouriel Roubini: 90%

Stephen Jen: 13% 

I know my comparative advantage does not lie in gauging whether or not a sharp fall in residential investment will spill over into a broader slump in consumption spending.   I leave US economic forecasting to others.  I will say that 13% seems low – there is presumably about 1 in 10 chance of a recession in any given year.  And 90% seems a bit high for any bet against the US consumer. 

I certainly cannot improve on Krugman’s description (via Delong) of the state of the debate about the US economy: The dispersion in credible views about the likely course of the US economy is unusually large.

Alas, Dr. Jen didn’t limit himself to the U.S. economy. When Dr. Jen declares that the era of big time global reserve growth is over, well, those are fighting words.  I may be agnostic on the state of the US economy, but I am not agnostic on reserve growth.   

Stephen Jen and Charles St. Anaud note in their most recent weekly: 

“The official reserves of most countries have reached saturation levels: further increases are no longer unambiguously desirable from those countries perspectives.”

I agree.   But I also thought China’s reserves reached saturation levels in 2004 – and its reserves have since doubled.  Saturation alone hasn’t (yet) been sufficient to induce policy changes.  Jen and St. Anaud:

“We expect central banks to become less interventionist, and for most of the future increase in reserves to come from the interest earnings on a reserve stock of 4.7 trillion; a 5% annual return translates into US$235b.” (emphasis added)

Central banks’ external interest income is certainly set to soar.  If around 2/3s of reserves are in dollars, interest payments from the US to the world’s central banks would be close to $200b a year.  If you borrow from the world, eventually you do have to pay interest on your debts.  That was the point of one of my recent posts. 

I just have trouble with notion that “most of the future increase in reserves” will come from “interest earnings.”   

In the first half of 2006, the annualized pace of global reserve growth was around $700b.  So $235b would be a big fall.   I am still working on the q3 data – it looks to be off the first half pace, both because Russia repaid the Paris Club and because China went to extraordinary lengths to hold its q3 reserve growth down.   But it won’t be anything close to $50b either. 

Let’s apply Jen’s logic to the key test case: China.   Will most of China’s future reserve growth really come from its interest earnings?

The interest income on $1 trillion should be about $50b a year.  If that is going to account for “most” of China’s reserve growth, something has to give. The IMF forecasts that China’s reserve growth will be closer to $250.  

And I -- like Nick Lardy -- think that $250b is on the low side.  So long as the US consumer holds on, China's monthly trade surplus looks set to climb to around $20b a month in 2007.  Lower oil should push the surplus up a bit, and Chinese export growth has recently surprised on the upside.   Interest and transfers and so on have added about $60b a year to China's surplus recently.   Add $60b to a $240b trade surplus and you get a 2007 current account in the vicinity of $300b.   Throw in $50b in net FDI, and you are looking at some potentially big numbers in China's basic balance.  $350b wouldn't surprise me ...

I consequently suspect that China's reserve growth will top $50b in 2007 by a rather significant margin.   I also rather suspect that Jen’s CNY forecast is not consistent with anything like $50b in Chinese reserve growth either …

Jen's argument is -- to my mind -- way overstated.   That said, I actually agree with his overarching point:  as reserves keep rising, more and more countries will start adding to “Sovereign wealth funds”  rather than just pile up funds in the central bank.

Many countries are already taking steps in that direction.  Russia’s finance ministry is assuming management of Russia’s oil fund from Russia’s central bank– likely the first step in an effort to invest Russia’s external wealth more aggressively.  To keep its reserve growth down, China seems to be increasingly willing to allow its state owned companies to keep their export earnings abroad.   It certainly seems to be keen to allow ICBC to keep the $20 it recently raised offshore.  Call it a backdoor sovereign wealth fund – one managed by state owned firms.  I would think that the Saudis would consider setting up some kind of "Sovereign wealth fund" rather than continue to park its spare cash with SAMA.    The latest data indicates the Saudis added $23b to their foreign assets in q3 -- these assets are not formally called reserves, but they seem to be managed in a relatively similar way.

The question is one of timing.  I don’t think reserve accumulation is gonna fall from a $700b annual pace in the first half of 2006 to a $235b annual pace any time soon … 

And in some sense, what counts -- from the global point of view -- isn't whether countries add to their central banks reserves or to their sovereign wealth fund.   It is whether the governments of emerging markets are still willing to finance the US.   

That is where Dr. Jen has been right.  So far, they have been.   The dollar block has held.