Emerging Markets

I am often struck by how frequently debates over trade – and, more broadly, globalization – don’t bother to mention what strikes me as the most salient fact about contemporary globalization, namely that it has been marked by an enormous amount of government intervention in the foreign exchange market and a huge surge in the sale of US financial assets to emerging market governments. Rather than trading US made goods for goods made in the emerging world, the US has – over the last say thirty years – financed the growth in its imports from the emerging world by selling US financial assets. That has to have had an impact on the composition of output in the US - -and the distribution of gains on globalization. It has favored those who generate financial assets (and import goods) over those who produce goods, for example. And it seems increasingly difficult, at least to me, to maintain this pattern is entirely the product of the operation of free markets. Not so long as key governments are intervening so heavily in the foreign exchange market – and hoarding most of the oil windfall. Take the most extreme example: China. If 2000, China exported around $250 billion worth of goods, and its government bought about $15 billion of foreign exchange in the market. In 2008, China is on track to export about $1400 billion worth of goods, and its government is on track – at least judging from the April data -- to buy about $900 billion of foreign exchange in the market. Yet the popular discussion of trade and globalization rarely also mentions the enormous rise in government intervention in the markets – and the surge in the sale of US financial assets to emerging market governments. Take a look at Eduardo Porter’s argument for responding to the pressures associated with globalization by expanding the scope of America’s social safety net. Or look at Tyler Cowen’s passionate defense of globalization. Neither mentioned Chinese intervention in the foreign exchange market. Both also left out any mention of how rising oil prices have dramatically increased the foreign assets of the not-so-democratic governments of the world’s oil-exporting economies. They aren’t alone: most discussions of the difficulties of selling trade to the American public don’t mention the unprecedented rise in government intervention in the foreign exchange market. And for that matter, most discussions of the difficulties explaining the benefits of sovereign wealth funds to the American public don’t mention that many sovereign funds are a by produce of one-sided government intervention in the foreign exchange market. To flesh out my intuition, I went back and looked at US goods trade with the emerging world – setting Mexico* aside – since 1978. * Mexico is part of NAFTA along with Canada, and splitting the two seemed a bit strange. Moreover, Mexico has allowed its currency to float more freely than most emerging economies. It is striking that the US doesn’t export much more, relative to the size of its economy, to the emerging world now than it did in 1980 – or, for that matter, in 1997. It just so happens that US exports to the emerging world (excluding Mexico) were 2.6% of US GDP in 1980, in 1997 and in 2007 (they are a bit higher in 2008). US imports from the emerging world by contrast fell from 3.9% of US GDP in 1980 (when oil was high) to 3.7% of US GDP in 1997 and then rose to 6.2% of US GDP in 2007. It is also striking that the US now imports a lot more from the emerging world than it exports. Paul Krugam is right. US imports from the emerging world are no longer small, and they have been growing rapidly. So how has the US balanced the rise in its imports of goods from the emerging world? By selling debt to the emerging world, and recently by selling debt to the governments of the emerging world. My estimates of the growth of the emerging world’s dollar reserves (which require making an assumption about the currency composition of the countries that do not report data to the IMF; see the notes at the bottom) suggest that the growth in the sale of US financial assets to the emerging world has exceeded the growth in US imports from the emerging world. Why does this all matter? Well, economically, I suspect that the US debate over globalization would be quite different if US exports to the emerging world had grown together with US imports. The winners from globalization woud not be as obviously tied to the financial sector. The shift from central bank reserves to of sovereign wealth funds won’t change the distribution of winners either: the financial sector expects to take a far bigger cut on the sale of US financial assets to sovereign funds than it gets from the sale of US debt to central banks; and bigger feeds managing money for sovereign funds than for managing the funds of more cost-conscious central banks. No one has argued that the main benefit of globalization is that it allows America’s bankers to sell US debt – and increasingly shares of American companies – to governments in the emerging world. But that is a fairly accurate description of current trade and financial flows. Incidentally, Broda and Romalis’ analysis of the distributional consequences of US trade with the emerging world not only predates the rise in food and energy prices, but it also doesn’t look at the distributional impact of rising US exports of financial assets to the emerging world. That strikes me as an important oversight: Dani Rodrik has argued that trade tends to increase the price of things that are exported even as it reduces the price of imports more than it reduces the overall price level. And it is pretty clear that the US is currently "exporting" a lot of financial assets to the emerging world. A quick point of clarification: the rise in US imports from the emerging world over the past several years hasn’t been driven primarily by the rise in the price of oil. Stripping OPEC out of the data doesn’t change the picture much. At least not yet. The data ends in 2007 -- a year when oil averaged $70. It will average much much more in 2008. US imports from OPEC are set to soar. *I added Mexico to this graph as well; trade with Mexico isn’t the central story of the past ten years. And one aside. US imports to Europe, Japan and the NAFTA countries have increased significantly since say 1980. US exports to Europe, Japan and the NAFTA countries, by contrast, haven’t increased that much relative to US GDP. The two periods when US exports to the advanced economies fell relative to GDP – the early 80s and the early part of this decade – both followed periods of dollar strength. Exchange rates do matter. However, most of the rise in US imports from Europe, Japan and the NAFTA countries came before 2000. The increase in US imports since say 2000 has all come from the emerging world. That is an important change. Imports (of goods) from the emerging world have gone up significantly relative to US GDP. Exports (of goods) to the emerging world haven’t gone up. Exports of financial assets have. A major surge in US exports to the emerging world – one that matched the surge in US imports from the emerging world over the past few years -- could change this pattern. DeLong is hopeful. I wish I could be as optimistic. Chinese policy making seems frozen, with policy makers unable to decide whether to raise rates (to tame inflation) or cut rates (to curb speculative inflows); or to decide whether to allow the RMB to rise (to curb inflation) or to hold the line (to support exports). Chinese policy makers currently seem to agree on little other than the need to tighten controls on lending and capital inflows. The appreciation of other Asian currencies has stopped. I don’t currently see the kind of consensus globally needed to really address an imbalance as large as the one that has been allowed to build up. * Two general technical notes. One: I opted to look at goods trade because I found a longer time series that included more countries. Most US service exports go to the advanced economies, so my sense is that including services wouldn’t change the basic story much. I also believe that tax arbitrage tends to increase the stated US deficit in goods trade with Europe while increasing the US income surplus -- as US and European firms use transfer pricing to shift profits to low-tax European jurisdictions. As a result, I suspect the "true" US trade deficit with Europe is smaller than the data indicates. Two: My estimates for the sale of US financial assets to emerging market governments are based on my work estimating dollar reserve growth rather than the US data. The US data -- especially the US data prior to the forthcoming revisions (which will incorporate the survey data) -- tends to understate official purchases of US assets. My estimates hinge on two key assumptions: those countries that do not report data to the IMF have a fairly high dollar share of their reserves (around 70%), and the increase in dollar reserves predominantly finances the purchase of US assets, not dollar-denominated debt issued by residents of other countries. I also added in my estimates of the new inflows into the dollar assets of the Gulf’s sovereign funds. Here I make the opposite assumption, namely that the Gulf sovereign funds have a more diversified portfolio than the emerging market central banks who report data to the IMF.

That more or less is the conclusion of this week’s Economist. I agree. Back in 2003 when the dollar started to depreciate, many emerging economies opted to maintain dollar pegs and follow the dollar down. The resulting increase in their reserves -- and holdings of US Treasuries -- altered the monetary transmission mechanisms in the US. The dollar was stronger than it otherwise would have been, notably against the Asian currencies. And US rates were lower than they otherwise would have been. Moreover, long-term rates didn’t rise when the Fed started raising rates, keeping financial conditions looser than they otherwise would have been. And as the revised data from mid-2004 to mid-2006 comes out, it is increasingly clear that ongoing central bank purchases of Treasuries and Agency bonds are part of the explanation for the persistence of low long-term rates. The Economist: "Emerging economies shared some responsibility for America’s housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fueled America’s bubble." The housing bubble and residential construction boom obviously have ended. The US economy has slowed sharply. And the US has cut rates. The result is that a host of emerging economies are now importing both a weak currency and loose monetary policy from the US. Countries that peg to the dollar can easily have a looser monetary policy than the US -- higher rates of inflation and the same nominal interest rate can produce lower real interest rates -- but have difficulty maintaining a tighter policy. Raising rates while maintaining a de facto dollar peg would tend to attract speculative capital inflows. Ask China. Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative ("global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative") largely because of very high rates of inflation in the emerging world. The recent acceleration in the rate of inflation in the emerging world reflects -- I suspect -- the enormous acceleration in reserve growth among the world’s emerging economies that took place last year. Such reserve growth has been hard to sterilize, so it has bled in very rapid growth in the monetary supply of many emerging economies. The Economist: Even if the Fed’s interest rate suits the American economy, global interest rates are too low. In turn, the unwarranted stimulus to demand in emerging economies is further pushing up commodity prices; so too is speculative buying by investors seeking higher returns than from bond yields, which are still being depressed by the emerging economies’ build-up of reserves. This stokes inflationary pressures in America and Europe and makes life difficult for rich-country central banks. The rise in inflation in those countries that have built up the most reserves suggests that the US might just be a bit too big for the emerging world’s central banks to save. At least too big to support without significant costs. The Economist recognizes the risks of status quo. Loose money in America and rigid exchange rates in emerging economies are a perilous mix. But this week’s Economist also -- following an Economics Focus column of two weeks ago -- notes that moving off a peg is hard, a lot harder than some (unnamed) proponents of floating (a group that I suspect includes me) sometimes suggest. Admittedly, exchange-rate appreciation is not as simple a remedy for emerging economies as some claim: a rise in interest rates and the expectation of a further appreciation in the exchange rate could, perversely, exacerbate inflation by sucking in more capital; and setting the exchange rate free risks massive overvaluation. I do not disagree. Small and incremental moves invite additional speculative inflows that -- unless effectively sterilized -- add to money growth and inflation. Moving suddenly to a float, by contrast, risks a large and disruptive upward move. Exiting from a peg is hard. But the fact that so many countries waited so long to start moving away from dollar pegs -- and in China’s case moved very timidly in 2005 and 2006 -- has only made the ultimate exit harder. The gap between a true market exchange rate and the current nominal exchange rate of many key emerging economies (think of where a freely floating Saudi riyal would trade with oil at $130 ... ) is now quite large. The easy options disappeared when many key emerging economies didn’t take advantage of the dollar’s 2005 rebound to start to move off dollar pegs. A 10 or 20% revaluation wouldn’t necessarily end speculation on further appreciation. And a 10 to 20% move was far more than either China or Kuwait were willing to consider.

On Monday, Bob Davis of the Wall Street Journal argued that the world isn’t flat, or at least it “isn’t as flat as it used to be.” National borders matter more. Barriers to the free flow of goods – oil as well as grain – are rising. Barriers to the free flow of capital too. He is right. I actually think he didn’t push his thesis as far as it could be pushed. Consider energy. Most oil exporters sell their oil abroad for a higher price than they sell their oil domestically. That means that the same good has one price domestically and another price internationally. It isn’t hard to see why they have adopted this strategy: if opening up to trade raises export prices, it can leave those who consume the country’s main export worse off. Only exporting what cannot be sold domestically is one way of mitigating that effect. And for most of the oil exporters, it is one (small) way of sharing the bounty that comes from the country’s resource wealth. This isn’t new. Saudi Arabia and Russia have long sold oil domestically at a lower price than internationally. What is new is that a host of food exporters are adopting a similar policy. Argentina was perhaps the first. After its devaluation it taxed its agricultural exports – that was a way of raising revenue, but also a way of keeping food cheap domestically. As global prices have increased, Argentina has stepped up its restrictions on say beef exports – helping to keep Argentina’s national food affordable domestically. Argentina’s farmers aren’t happy. They prefer selling for a higher price abroad than selling for a lower price domestically. But with food prices rising, more and more countries seem to be adopting the same policies for their rice and wheat that Saudi Arabia and Russia have adopted for their oil. They only export what cannot be sold domestically at a price well below the world market price. That helps domestic consumers at the expense of domestic producers. It also is a way – per Rodrik ("if you are Thailand or Argentina, where other goods are scarce relative to food, freer trade means higher relative prices of food, not lower") -- of assuring that the consumers in a food exporting country aren’t made worse off by trade. Actually, in the current case, it is more a way of assuring that consumers in exporting countries aren’t made worse off from a shock to the global terms of trade that dramatically increased the global price of a commodity. But the principle is the same. Such policies have produced a more fragmented world. Beef is cheaper in Argentina than in the rest of world. Rice is cheaper in rice-exporting economies than many rice-importing economies. Oil is cheaper in oil-exporting economies. And so on. Then throw in the subsidies that many oil and food consumers have adopted to mitigate the impact of higher oil prices. China sells oil domestically at a price below the world market price. The Saudis are subsidizing food imports. That implies that the same good sells for a different price in “importing” countries – not just for a different price in importing and exporting countries. For all the calls to adopt a coordinated response that guarantees that exporters won’t take steps -- like taxing exports -- that hurt the importers as well discouraging increased production in the exporting economy, my guess is that the food crisis will produce more government intervention in the market, not less. Put it this way: after seeing various food exporting countries take policy steps that would reduce their countries’ profits from exporting to keep domestic prices low, is China’s government more or less likely to trust the market to deliver the resources the Chinese economy needs for its ongoing growth? Or will China conclude that it needs to invest and exercise some control in the production of the resources if it wants to guarantee the stability of its supplies? Then there are capital flows. Davis highlights the growing presence of sovereign wealth funds in global markets and -- – citing a forthcoming Council on Foreign Relations report by David Marchick and Matthew Slaughter -- the possibility that the US and Europe will respond to the rise of state investors by stepping back from their existing, fairly liberal, policies for inward investment. He also notes that many countries with sovereign funds looking abroad limit investment in their own economies. China is a case in point. Here I don’t think Davis goes far enough. Sovereign wealth funds are a lot smaller than central banks. Their assets aren’t growing anywhere near as fast. The overall increase in the presence of the world’s governments in financial markets is much broader and deeper than an analysis that focuses on just sovereign funds would suggest. MORE FOLLOWS There are two big reasons for the rise in the state in cross border capital flows. The first is that the state in most oil exporting economies controls the revenue from the commodity windfall. In aggregate, the oil exporters are sending more of the revenue globally from $120 a barrel oil back into global financial markets than they are spending or investing at home. Most oil exporters could cover their import bill with $50 or $60 a barrel oil. Some of this surplus goes into sovereign funds – but a lot is going into the hands of central banks. Think of the Bank of Russia, which manages Russia’s sovereign fund, or the Saudi Monetary Agency. The second is that many states are resisting market pressure for their exchange rates to adjust. China is the obvious example. That requires intervening in the market. Jim Fallows put it well. But saying that China has a high savings rate describes the situation without explaining it. Why should the Communist Party of China countenance a policy that takes so much wealth from the world’s poor, in their own country, and gives it to the United States? To add to the mystery, why should China be content to put so many of its holdings into dollars, knowing that the dollar is virtually guaranteed to keep losing value against the RMB? And how long can its people tolerate being denied so much of their earnings, when they and their country need so much? The Chinese government did not explicitly set out to tighten the belt on its population while offering cheap money to American homeowners. But the fact that it does results directly from explicit choices it has made—two in particular. Both arise from crucial controls the government maintains over an economy that in many other ways has become wide open. The situation may be easiest to explain by following a U.S. dollar on its journey from a customer’s hand in America to a factory in China and back again to the T-note auction in the United States. Let’s say you buy an Oral-B electric toothbrush for $30 at a CVS in the United States. I choose this example because I’ve seen a factory in China that probably made the toothbrush. Most of that $30 stays in America, with CVS, the distributors, and Oral-B itself. Eventually $3 or so—an average percentage for small consumer goods—makes its way back to southern China. When the factory originally placed its bid for Oral-B’s business, it stated the price in dollars: X million toothbrushes for Y dollars each. But the Chinese manufacturer can’t use the dollars directly. It needs RMB—to pay the workers their 1,200-RMB ($160) monthly salary, to buy supplies from other factories in China, to pay its taxes. So it takes the dollars to the local commercial bank—let’s say the Shenzhen Development Bank. After showing receipts or waybills to prove that it earned the dollars in genuine trade, not as speculative inflow, the factory trades them for RMB. This is where the first controls kick in. In other major countries, the counterparts to the Shenzhen Development Bank can decide for themselves what to do with the dollars they take in. Trade them for euros or yen on the foreign-exchange market? Invest them directly in America? Issue dollar loans? Whatever they think will bring the highest return. But under China’s “surrender requirements,” Chinese banks can’t do those things. They must treat the dollars, in effect, as contraband, and turn most or all of them (instructions vary from time to time) over to China’s equivalent of the Federal Reserve Bank, the People’s Bank of China, for RMB at whatever is the official rate of exchange. With thousands of transactions per day, the dollars pile up like crazy at the PBOC. More precisely, by more than a billion dollars per day. They pile up even faster than the trade surplus with America would indicate, because customers in many other countries settle their accounts in dollars, too. The PBOC must do something with that money, and current Chinese doctrine allows it only one option: to give the dollars to another arm of the central government, the State Administration for Foreign Exchange. It is then SAFE’s job to figure out where to park the dollars for the best return: so much in U.S. stocks, so much shifted to euros, and the great majority left in the boring safety of U.S. Treasury notes. .... At no point did an ordinary Chinese person decide to send so much money to America. In fact, at no point was most of this money at his or her disposal at all. These are in effect enforced savings, which are the result of the two huge and fundamental choices made by the central government. One is to dictate the RMB’s value relative to other currencies, rather than allow it to be set by forces of supply and demand, as are the values of the dollar, euro, pound, etc. ...This is what Americans have in mind when they complain that the Chinese government is rigging the world currency markets. ... Once a government decides to thwart the market-driven exchange rate of its currency, it must control countless other aspects of its financial system, through instruments like surrender requirements and the equally ominous-sounding “sterilization bonds” (a way of keeping foreign-currency swaps from creating inflation, as they otherwise could). These and similar tools are the way China’s government imposes an unbelievably high savings rate on its people. .... The other major decision is not to use more money to address China’s needs directly—by building schools and agricultural research labs, cleaning up toxic waste, what have you. Both decisions stem from the central government’s vision of what is necessary to keep China on its unprecedented path of growth. The controls on Chinese capital outflows – including the surrender requirement Fallows describes – have been liberalized. China’s banks are now being encouraged to hold dollar these days. But no one in China wants to hold depreciating dollars rather than appreciating RMB, so folks with dollars are still selling their dollars to the government if they can. Conversely, China is continuously tightening its controls on capital inflows. It is also tightening its controls on the banking sector – by raising reserve requirements and forcing the banks to lend funds to the state. Holding its exchange rate down has a host of subsidiary effects. It creates pressures for price controls (see the Gulf) to limit inflation. And in China, it means that the government has a de facto monopoly on outward capital flows. China now has the world’s largest current account surplus. That makes it - -and specifically its government – the world’s largest external investor. Ongoing inflows (despite the controls) only add to the funds that China’s government has to invest abroad. And the process for deciding what to buy remains driven by the state. Consider Richard McGregor’s description of the Chinalco investment in Rio Tinto. The Aluminum Corporation of China, or Chinalco, spent $14.1bn in conjunction with Canada’s Alcoa, a junior partner in the transaction, to buy into Rio’s UK-listed arm. Executed in a lightning share raid, Chinalco’s purchase is the largest ever single Chinese investment offshore. .... As a huge and growing consumer of commodities, China’s concern about the BHP takeover is unsurprising. Nor is Chinalco’s denial that the Rio raid had anything to do with the BHP bid. Such po-faced obfuscation is standard in corporate jousting around the world. Disentangling Chinalco from China, and China Inc, however, is a much harder proposition. BHP and Rio are dealing with a huge number of demanding shareholders. Chinalco’s investor relations are a lot more straightforward. Its overseas listed subsidiary aside, Xiao Yaqing, Chinalco’s chairman, answers to a single shareholder - the Chinese state. Mr Xiao himself serves at the pleasure of the ruling Communist party’s human resources arm, known as the "Organisation Department", which oversees all top executive appointments in state enterprises. ... Chinalco’s purchase was funded by the China Development Bank, a state policy bank, a shareholder of which is the country’s sovereign wealth fund, the China Investment Corporation. The sovereign fund, further, owns the largest Chinese investment bank, which is advising Chinalco. The ambitious CDB itself is no stranger to doing the state’s business offshore. It has been given crucial government mandates, most importantly to fund the expansion of local companies in Africa, primarily for resource projects. In short, you do not have to be a rabid conspiracy theorist to conclude that Chinalco is a front for China Inc. "Why does BHP really want to tempt the dragon? Chinalco has already made the message clear: they really do not want to see a merger," Geoffrey Cheng, of Daiwa Institute of Research in Hong Kong, told Reuters. "You’re not going against a corporation. You’re going against a nation." .... The second point is the more salient one - the perception that Chinalco represents "the nation" in this transaction. A world waking up to a new fact of life in the global economy, the phenomenon of Chinese offshore investment, is naturally going to see a tangled monolith. McGregor notes that different state bodies often have diverging interests -- so the assumption that China, inc functions as a monolith is wrong (see his article with Geoff Dyer) But his description of the various ways China’s state was involved in the Chinalco bid underscores is hard to reconcile with a world where the state has retreated from the market …

The head of the People’s Bank of China says that China is seeking to diversify its reserves. ``China is seeking to diversify its foreign exchange reserves,’’ Zhou said yesterday, without elaborating.  Of course, Zhou also said that the market now plays the dominant role in the determination of China’s exchange rate, a view which is hard -- in my view -- to square with record central bank purchases of foreign exchange. Diversification could mean one of three things: -- Adding new currencies to China’s reserve mix -- Diversifying the kind of dollar assets China holds -- Reducing the share of China’s reserves held in dollars One and two are possible without changing the dollar share of China’s reserves. Deciding to hold say a few New Zealand dollars need not imply a reduction in the overall share of China’s reserves held in dollars. Shifting from Agencies to corporate equities need not reduce the dollar share of China’s reserves. There is at least some evidence that China reduced the dollar share of its reserves – though there are enough holes in the US data that it is hard to know if the growing gap between China’s reported dollar holdings and its total foreign assets reflects a fall in the dollar share of China’s reserves or a growing gap between China’s total US dollar and what appears in the US data. But if China has reduced the dollar’s share of its reserves over the past two years, Europe really has cause to be annoyed. Growing Chinese demand for euros could have contributed to the euro’s rise and the RMB’s ongoing depreciation v the euro – a depreciation that does much to explain continued strong Chinese export growth. Korea recently disclosed that it has diversified its reserves – reducing the dollar’s share of its reserves to 65% and broadening the type of assets that it holds. The Bank of Korea reports that: Its investment portfolio last year included government and corporate bonds, asset-backed securities and common stocks. Investments in common stocks are managed by the Korea Investment Corp., the country’s manager of sovereign wealth funds. Investments in treasuries, bonds issued by state-run entities and corporate bonds took a lion’s share of its investment management ― treasuries accounted for 35.5 percent, bonds by state-owned companies 28.8 percent, and corporate bonds 15.4 percent. Investments in asset-backed securities accounted for 11.6 percent, followed by stocks for 1.3 percent. But the central bank noted that it has been increasing its securities investments. Investing in bonds is considered safer than stocks, but investing in stocks gives higher returns in the long-term, analysts say. ``We have been diversifying our investment portfolio to offset risks concerning foreign exchange by seeking products that give higher yields with the country’s foreign reserve holdings,’’ said the central bank. This confirms something that has long been apparent in the TIC data – namely that Korea was shifting out of Treasuries into riskier assets. If Korea can offer this kind of detailed disclosure, I don’t see why others cannot follow suit. By investment in state owed companies, I presume Korea is referring to government sponsored enterprises like the US agencies. That would be consistent with the US data on its holdings. The US data suggests that China has about equal amounts in Treasuries and Agencies. The US data though does not suggest that China has followed Korea’s lead and placed 25% of its dollar portfolio in corporate bonds and asset backed securities. Korea seems to have been more aggressive than China in diversifying both the currency composition and asset mix in its reserves, with mixed results. Buying riskier US assets probably hasn’t paid off; shifting away from dollars did. Korea though has also reduced its intervention in the foreign exchange market and allowed its currency to move more than most in Asia -- something that likely made it a bit easier to adjust the currency composition of its reserves. For what it is worth, I am now lowering my baseline estimate for the dollar share of China’s reserves from around 70% to a 65% to 70% range. The recent survey data just didn’t push Chinese holdings up enough for me to be confident that around 70% of China’s reserves are still in dollars. But barring better data/ a bit more disclosure on China’s part, I don’t have total confidence in adjustment my estimate downward either.

The data at the back of the IMF’s latest WEO (table A16) indicate that the emerging world’s savings surplus stems from a “glut” of savings, not a “drought” of investment. In 2007, the savings rate of the emerging world savings was almost 10% of GDP higher than its 1986-2001 average. Investment was up as well – in 2007, it was about 4% higher than its 1986-2001 average. However the rise in the emerging world’s savings was so large that the emerging world could invest more “at home” and still have plenty left over to lend to the US and Europe. That meets my definition of a “glut.” The big drivers of this trend. “Developing Asia” and the "Middle East." Developing Asia saved 45% of its GDP in 2007 -- up from 33-34% in 2002 and an average of 33% from 1994 to 2001 (and 29% from 86 to 93). Investment is up too. Developing Asia invested 38% of its GDP in 2007, v an average of between 32-33% from 1994 to 2001. Investment just didn’t rise as much as savings. The Middle East also saved 45% of its GDP in 2007 – up from 28% of GDP back in 2002 and an average of 25% from 1994 to 2001 and an average of 17-18% from 1986 to 1993. Investment is up just a bit -- at 25% of GDP in 2007 v an average of 22% from 1994 to 2001. It is historically unusually for an oil importing region to be saving so much when the oil exporters are also saving so much. Usually a rise in the savings of the oil exporters is offset by a fall in the savings of the oil importers. The enormous rise in Chinese savings even as China’s oil import bill has soared (along with oil export revenues and oil exporters’ savings) implies a bigger fall in the savings of other oil importing economies. Government policy has played a big role in the high savings rates in both regions – whether the undistributed profits of Chinese state firms (a policy choice) or large fiscal surpluses of the Gulf financed by the undistributed profits of the Gulf’s state oil companies. It isn’t an accident that the emerging world’s savings glut has coincided with a rise of state capitalism – and a surge in demand from states and state enterprises for “flying palaces.” I suspect the emerging world’s savings glut largely reflects a glut in government (and SOE) savings. Dr. Delong has argued that this savings surplus will persist for a long time, keeping US and European rates low and keeping housing prices in both the US and Europe higher than otherwise would be the case. Krugman’s fear that home prices need to fall significantly to bring the price-to-rent ratio closer to its long-term average won’t be borne out. Possibly. However, I don’t think it entirely implausible that savings rates in both Asia and the Middle East might start to converge toward their long-term average. What goes up sometimes also comes down. An end to the emerging world’s savings glut would not be such a bad thing either. It would mean than the young and poor were supporting global demand growth – not the old and rich. That makes more sense to me. Update: some type-os were cleaned up after the initial post.  PGL’s commentary on this post is also worth pondering, even if I am not fully convinced (see the comments).

In a recent FT oped on China, Ken Rogoff had a great one-liner:"Those who think inflation is caused by too little pork rather than too much money are wrong."Replace pork - culturally inappropriate for many high-inflation emerging market economies - with a more culturally neutral food, and his statement captures the core debate in a host of emerging economies right now. The Gulf, Russia, Argentina, Hong Kong, China and no doubt others are trying to determine whether the recent rise in inflation reflects a rise in commodity prices (fuel, food) or inappropriately loose monetary policies. Stephen King of HSBS isn’t as pithy as Dr. Rogoff, but he framed the issue quite nicely last week:Broadly, there are two competing explanations for the rise in emerging market inflation. The first is what I’d call the "bad luck" explanation. Those living in emerging markets have, on average, lower per capita incomes than those who live in the developed world. Proportionately, more of their income is spent on basic items such as fuel and food. The prices of these "basics" tend to move around in volatile fashion in response to bad harvests, occasional wars or the onset of disease. As a result, inflation rates within emerging economies move up and down a lot more than their equivalents in the developed world. High inflation in one year could easily be followed by low inflation the next year.The second explanation is monetary in nature. Inflation is rising because monetary conditions are simply too loose. And because people in emerging markets spend most of their income on the basics, it’s no great surprise that the prices of fuel, food and other essentials go up. This is not a case of bad luck. It is, instead, the outcome (perhaps unintended) of a series of earlier monetary policy decisionsMost of the high inflation emerging economies either peg to the dollar or intervene heavily to manage their exchange rate against the dollar. Ben Bernanke though can not really be blamed the rise in inflation these economies. No one forced the Saudis - just to pick an example -- to peg to a depreciating dollar and cut domestic rates even as domestic Saudi inflation rose. The Saudis could have dropped their dollar peg. Bernanke’s mandate is to pursue policies that support price stability and employment in the US - not to balance the monetary policy the US needs with the monetary policy the rest of the dollar zone needs.  Right now Bernanke has his hands full with the US.   Moreover, it is almost certainly the case that the monetary policy the US needs is quite different from the monetary policy the rest of the dollar zone needs.  The Gulf clearly has decoupled from the US, and up until nowl, so has China. As a result, China and the Gulf are importing a very expansionary US monetary policy at a time when their economies are growing rapidly and inflation rates are picking up. Stephen King (HSBC) notes that inflation is the almost certain outcome in countries that peg to the dollar during a phase of catch-up and rapid productivity growth. Their real exchange rate needs to rise. If the exchange rate cannot appreciate, then inflation will shoot up.What, though, if the authorities prevent the nominal exchange rate from rising? In these circumstances, the only other option, ultimately, is a rise in the so-called real exchange rate via a higher domestic inflation rate relative to inflation rates in other countries. Suppose, for example, that Chinese domestic prices and wages are rising 10 per cent per year whereas British prices and wages are rising at around 4 per cent per year. Under these circumstances, the Chinese worker’s buying power over the rest of the world’s output will be improving over time relative to the British worker’s (through Chinese eyes, British goods will appear cheaper and cheaper).The US slowdown and associated series of rate cuts have just made the cost of dollar pegs a lot more visible now. And - as King notes - inflation tends to generate a lot of social and political strain.rising inflation can easily lead to an unfair redistribution of income. Some will end up a lot better off. Others will be a lot worse off. The social tensions associated with this process can easily lead to political turmoil. Inevitably, politicians try to keep the lid on this pressure cooker by imposing price and wage controls, but then, of course, they’re heading straight back to the 1970s.Even more developed parts of the dollar zone are felling to the strain.William Pesek doesn’t think a dollar peg still makes sense for Hong Kong. I agree. Cutting rates in the face of rising inflation and rising home prices only fuels the current boom.That is why I would add another risk to King’s list. A host of emerging economies are in effect adopting highly pro-cyclical policies right now.In the Gulf, loose fiscal policy - spurred by strong commodity prices - has been combined with loose monetary policy and a weak exchange rate. All push the boom on. Tourism and property development are booming along with the petroleum sector. And rising inflation also creates pressure to loosen fiscal policy (why should living standard be falling when oil is high?) which only adds to inflationary pressures and pushes real rates down further. January inflation was up in Saudi Arabia. SAMA cut rates. Real rates moved into even more negative territory. The Saudis have kept lending rates higher than deposit rates. But with inflation at 7% now and in my view set to rise toward 10% over the course of the year, the expected real lending rate is still quite negative.   The underlying pace of growth in the money supply, even with Chinese style rising reserve requirements, remains quite fast.And in China low - or negative - real interest rates (See Justin Lin) have fueled an investment boom and contributed to the enormous (though now stalled) run up in Chinese stock market prices, along with higher real estate prices. The rise in the stock market could in turn help support consumption (the classic wealth effect). And all this has happened even as an undervalued real exchange rate, especially an undervalued exchange rate relative to Europe, has supported the export sector. The boom in exports and investment has been highly correlated.The risk of course is the pro-cyclical policies on the upside will be replaced by pro-cyclical policies on the downside, and the excesses of the boom will deepen the bust. So in some deep sense, the question is whether the great emerging market inflation of 07 and 08 will be followed by a big emerging market bust in 09 or 10, a bust that will have its roots not in a collapse in external capital inflows but rather in the domestic excesses in the boom years?

A lot of milestones have been passed in the last few days. Most aren’t positive for the United States. Nouriel Roubini is no longer the only economist putting the eventual toll of the financial crisis at close to a trillion dollars. It takes about $100 to buy a barrel of oil that could have been bought for about $20 a few years back. It takes $1.50 (a bit more actually) to buy a currency that could have been bought for 80 or 90 cents six years ago. George W. Bush efforts to push the Gulf to democraticize aren’t going anywhere. In some sense they cannot go far when Ben Bernanke is encouraging US financial institutions to look to non-democratic governments for additional capital. The US financial system no longer seems like a model for the rest of the world. Apparently SIVS are only one category of potentially troublesome off-balance sheet conduits. Read Dr. Feldstein’s important oped. US banks and broker-dealers rather clearly lacked sufficient capital to sustain the risks they were taking. The absence of lending by US and European banks has led private equity firms to encourage some of their large investors to lend them money directly. It isn’t, though, clear to me what ADIA gains financially by lending to a firm that it already likely managing ADIA’s money. Any gains on the debt will come out of its equity returns. There is an overarching logic that ties these developments together. A weak US financial system needs low rates and time. Low rates contribute to a weak dollar. A weak dollar - especially in a still-sort-of-strong global economy - contributes to higher commodity prices, at least in dollar-terms. Or high commodity prices contribute to a weak dollar. No one is quite sure. High oil means the big Gulf funds have more money. It also means American consumers have less money - and either have to consume less or save less. Gulf "liquidity" substitutes for US liquidity. Pressure on the dollar means more exchange rate intervention in Asia. China is once again cracking down on hot money inflows. Rising reserves and faster RMB appreciation create pressure for China to seek higher returns, and either to expand the CIC or let SAFE invest more aggressively.But rather than launching into (yet) another lengthy post on sovereign wealth funds, let me just highlight two excellent articles on sovereign funds - the William Mellor and Le-Min Lim’s Bloomberg feature on the challenges facing the CIC and Landon Thomas’ New York Times profile of ADIA. Thomas’ article offers the best analysis of ADIA I have seen. His estimate of ADIA’s size -- "for now bankers, former employees and analysts familiar with the fund estimate its size at $650 billion to $700 billion" -- strikes me as about right. That is big. But is also only a bit more than China is likely to add to its foreign assets this year. $10b in monthly FDI inflows, hot money flows, a large trade surplus even with $100 oil -- it all adds up. The Bloomberg story on the CIC also provides an excuse to highlight Victor Shih’s excellent blog, Elite Chinese Politics. Dr. Shih is one of many experts quoted in the Bloomberg story. It probably is a good idea for the US to get to know its creditors a bit better.The formative experience of my professional career came in the late 1990s, when I worked as a staff economist at the US Treasury. I spent a fair amount of time thinking about how the US should use the leverage created by the United States’ ability to act as a lender of last resort to cash strapped emerging economies. Or, more accurately, the ability of the US to lend along with a standing coalition of other creditor countries through a well established international institution to cash short emerging economies. The US didn’t lend to make money; it lent to help avoid systemic trouble - trouble that would rebound back to the US - and to shape, along with other large contributors to the IMF, the policies that emerging economies adopted during their crises. Policy conditionality stems from a need to assure the country’s ability to repay, but in practice that inevitably meant making judgments about the "right" economic policy to assure payment. The US today is not in the same position emerging economies were then. The expected fall in US output is tiny compared to the falls in emerging economies. Relative to US GDP, the likely financial losses in the subprime crisis are also far smaller than the losses in many emerging economies. The US has benefited enormously from its capacity to borrow in its own currency, and thus to pass the risk of dollar depreciation onto its creditors. Central banks willingness to add to their dollar reserves has helped to provide the financing that allows the US adopt counter-cyclical rather than pro-cyclical macroeconomic policies despite running large deficits. No emerging market had a similar luxury. Nonetheless, the headlines of the past few days have given me a somewhat better sense of how many in the emerging economies must have felt in the 1990s.

Shanghai, Mumbai, Dubai doesn’t really quite work. The CIC is in Beijing, not Shanghai. Singapore has committed more funds to troubled banks than Mumbai. Abu Dhabi, Saudi Arabia and Kuwait have a lot more cash than glitzy Dubai. But Andrew Ross Sorkin’s alliterative phrase captures a deeper truth. A group of banks that previously had advised most US companies that they had too much equity and too little debt have found themselves short on equity. And a group of banks that in the non-so-distant past argued that state ownership was a barrier to development are now themselves partially state-owned. The most money the IMF ever lent to the emerging world in a quarter? $13.7b - in the third quarter of 2001 (Turkey and Argentina ... ) That is just a bit more than the $13.4b lent out in the fourth quarter of 1997 (Asia). The IMF also lent out $10.9b in the second quarter of 2002 (Brazil) and $9.6b in q3 1998 (Russia and Brazil). And yes, two of the four biggest quarters for IMF lending came under the Bush administration’s watch. Foreign policy concerns trumped market fundamentalism.Capital infusions from emerging market governments to US and European banks smarting from losses on US mortgages in q4? $28.4b, by my count.The list includes: $7.5b Citi/ Abu Dhabi investment authority (ADIA) $5b Morgan Stanley/ China investment corporation (CIC) $4.4b Merrill/ Singapore’s Temasek (with an option for another $0.6b)$11.5b UBS/ Singapore’s GIC and some combination of Saudi royals. I left out Barclays/ China Development Bank (CDB) since Barclays was looking to finance a big acquisition, not to cover big losses. I left out CITIC/ Bear since that deal was structured as a swap, not as a capital infusion. If the banks haven’t yet put the worst behind them and are still seeking more capital -- as seems likely, given today’s Wall Street Journal story indicating that Citi and Merrill are looking for more capital from sovereign funds -- total emergency capital infusions into US and European banks over the next year from the emerging world should rather easily top the $29.6b or so the IMF lent to the emerging world in the four quarters during the Asian crisis when it lent out the most -- q4 1997 to q3 1998. The funds committed by emerging market sovereign funds in the fourth quarter already top the $22b the IMF lend out during the four quarters from mid-2001 to mid-2002, but that $20b was followed by another $17b or so over the next year, producing a two year total of around $40b. If the numbers the Journal mentions this morning are accurate, total capital infusions from emerging market sovereign wealth funds then will truly be comparable in scale to the funds the IMF provided to emerging economies. Reverse bailouts are, I guess, one consequence of reverse globalization. Capital now flows from the emerging world to the advanced world. Back in 1997, investors worried about hidden losses in the emerging world - and central banks that had fewer reserves than they claimed. Now they worry about hidden losses in the US and Europe. And governments in the emerging world are now bailing out private banks in the advanced world, particularly those banks who originate-and-distribute business model ran into severe trouble.   Originating and distributing to your off-balance sheet SIV didn’t really disperse the risk.   Reverse globalization seems to have spawned reverse privatization. Talk about a change. The big story of the past five years, in my view, has been the reassertion of the state in global markets.Large central banks and investment funds now drive the flow in much of the foreign exchange market.  Hedge funds used to strike terror into the hearts of emerging market governments. Now most hedge funds are looking to manage the money of emerging market governments. Sovereign funds have displaced pension funds as the key source of funds for the "alternative fund management" industry. State ownership of banks used to be considered inefficient. Now banks that have not already sold a stake to China’s government worry that they will be at a competitive disadvantage relative to those that have.And interestingly enough states with the most financial firepower these days are also not democracies. That too is something of a change -- one that also may have important long-term consequences.Bill Clinton argued back in 2004 that it was hard for the United States to enforce its trade law against its bankers. It is presumably equally difficult to press for political reform -- notwithstanding the FT’s recent leader arguing against finding "expedient allies" in autocratic governments -- in governments that are bailing out your banks. Especially since it isn’t at all clear that a democratic majority in the Gulf or China would be willing to take the risk associated with investing in a major US financial intermediary. It is striking to me that no democracy has yet committed funds to invest in a big bank or broker-dealer.One last note: Assurances made back in 2005 and 2006 that the well-capitalized US financial system provided a buffer against the range of risks associated with quite visible macroeconomic imbalances now ring rather hollow. Forcing the financial intermediaries at the core of the system to hold more capital right now would be counter-productive, as they apparently lack enough capital to support their current balance sheet. But it does seem -- in retrospect -- that many failed to hold enough capital to support all the on and off-balance sheet risks that they were taking. I hope their regulators have taken note.

Sovereign wealth funds are hot.   A senior JP Morgan Chase banker, quoted in Time: "SWFs ... are the new 'it' girl of global finance. Everyone wants a piece of them."  Almost every investment bank is looking to sovereign wealth funds as a new source for of deals and management fees -- if not for a bit of emergency funding to shore up their existing capital base.   Central banks -- which tend to try to minimize the fees they pay on investments in safe assets -- haven't generated half as much as much excitement. The research arms of the world's investment banks have quickly reached a consensus that sovereign wealth funds will get big fast, providing long-term support for at least some risky assets   (Merrill's analysis is typical) Sovereign wealth funds manage at least $2 trillion now, and perhaps a bit more.   We don't know because the biggest fund also happens to be the most secretive. Estimates of ADIA's size are all over the map -- I personally doubt ADIA has $875b (more on that later).  Plus the dividing line between central bank reserves and a sovereign wealth fund can be rather thin:  Russia's oil stabilization fund and the non-reserve assets of the Saudi Monetary Agency are often counted as sovereign wealth funds even though they have fairly conservative portfolios.  The Saudis have some equities, but far less than most investment funds.  Russia's oil stabilization fund is managed far more conservatively than say Switzerland's reserves!But even if sovereign wealth funds will end 2007 managing a sum that is closer to $3 trillion than $2 trillion, they won't grow to $8 trillion by 2011 -- as Merrill now estimates ("By 2011, assets under management at SWFs worldwide are projected to grow almost fourfold to nearly $8 trillion")-- without getting close to a trillion a year in new assets to manage.   Such an increase isn't entirely implausible.   Central banks are on track to add at least $1 trillion to their reserves this year, and perhaps substantially more.  Sovereign wealth funds will likely be given an additional $150-250b to manage this year, depending on whether China's Finance Ministry uses the funds it raised from its big bond sale to buy an additional $100b of foreign exchange from the PBoC for the China Investment Company in late 2007 or early 2008.  If the emerging world's governments continue to accumulate foreign exchange at their current rate and a large share of their burgeoning foreign assets is managed by investment funds that pay juicy investment banking fees and relatively little is managed by cost-conscious central banks, Merrill's forecast isn't at all implausible.   Indeed, scarcely a week goes buy without the announcement of a big new investment by a sovereign wealth fund in a troubled financial institution -- along with a rumor that China's investment corporation will in some way support a large bid for Rio Tinto.  Yet the whole hubbub over sovereign wealth funds seems to miss what strikes me as a crucial point – namely that a key set of countries doesn’t seem nearly as likely to ramp up their overseas equity investments quite as rapidly now as seemed likely six months ago.  Russia’s new national welfare fund will be far smaller than the budget stabilization fund, and -- at least until a new President is elected and Mr. Putin changes jobs -- will only invest in bonds.   It plans to move cautiously.  And it may end up investing more at home than abroad (though that raises another set of issues) The China Investment Corporation will only have about $67b to invest abroad; the majority -- $133b -- of its initial $200b in funds will go toward buying the Chinese state’s existing stake in Bank of China, China Construction and the Industrial and Commercial bank of China from the central bank and toward recapitalizing the Agricultural Bank of China and the China Development Bank.   Those funds likely won’t start to be deployed until 2008 – and there is no guarantee that the CIC will get more funds in the near future.  It first has to figure out how to keep the "wolves" from eating up its existing funds.The Saudis – who export significantly more oil than Kuwait, Qatar and Abu Dhabi and thus have a significantly larger ongoing “flow” of new funds – have shied away from high profile investments.   Most of their oil revenues are still parked with the Saudi Arabian Monetary authority, and SAMA still seems to be managing its funds (relatively) conservatively.   No doubt the Saudis have significant “private” investments as well – but so far they have flown under radar screen. Japan is once again considering the creation of a sovereign fund, but no decision has been taken.   The most serious proposal would use the interest income on Japan's existing reserves to finance the sovereign wealth fund.   That implies a very gradual shift in Japan's portfolio.   The new fund also would likely invest quite conservatively: it would be more like Norway's government fund than the Dubai funds. The big splashy deals have come from the existing funds of the small gulf states, Singapore's GIC (which is acting more like Temasek by the day -- even if India considers them separate funds rather than different parts of Singapore's government) and the Chinese banks.     The Emirates and Qatar have roughly $115b a year in oil revenue (based on 3.5 mbd of exports) with oil at $90 a barrel -- and, given that these countries import bill is rising fast, their aggressive funds will have something like $50 to $60b to invest in global markets in 2007 if oil stays around $90b.  The Kuwaits and Norwegians will have comparable sums to invest -- though they will likely be invested a bit more conservatively.    Libya -- another state with few people and lots of oil -- is set to join this club.  The Libya investment authority will soon have $40b to invest (mostly from existing reserves). If oil stays high, it could get far more over time. But the ultimate size of sovereign wealth funds will be limited if the far larger potential flows from Saudi Arabia and Russia are managed primarily by the central banks.   The really big oil revenue streams are not currently being handed over to aggressive sovereign wealth funds.And the really big sums coming out of China is still being invested fairly conservatively.  Say the CIC places $67b in global market next year, and the Chinese banks – who are likely to be more aggressive than the post-Blackstone CIC – do another $50b in deals.   That still works out to about $120b – or somewhere between a quarter and a fifth of a conservative estimate of the 2008 increase in China’s foreign assets. On current trends, the true super-powers of global markets will remain the big central banks -- those with $100b or more to place every year.   The central banks of China, Russia, India, Brazil and Saudi Arabia will combine to add roughly $850b to their reserves this year -- far more than that the five largest sovereign wealth funds will add to their portfolio in 2007.  Much of the increase in the assets of the investment will come in the fourth quarter, and likely won’t be invested until 2008.   ADIA, KIA, the CIC and Norway’s government fund should all have around $50b to invest next year.   That is a lot -- but it doesn't add up to anything close to $1 trillion either.    For all the attention sovereign wealth funds have attracted over the past few weeks, their investments are still a fairly small share of total official asset growth.   The Wall Street Journal reports the sovereign funds and state banks have invested about $20b in US and European financial firms this quarter:In the fourth quarter alone, sovereign-wealth funds and banks from Asia and the Middle East invested $18.9 billion in Western financial firms, according to Morgan Stanley research.Let's assume that these funds have invested another $10b in non-financial firms, bringing their total investment up to around $30b.   That is still only about 10% of the total increase in official assets in the fourth quarter.  Unless something changes -- whether a big fall in private capital flows to the emerging world or a dramatic change in the way China, Russia, India, Brazil and Saudi Arabia manage their state assets -- 2008 will probably be roughly similar.   Central bank reserves will grow far faster than the funds managed by sovereign wealth funds, and decent chunk of the funds managed by sovereign wealth funds will be invested relatively conservatively.  Frankly, that is something of a relief.     I don’t think the US or Europe are ready for a world where emerging market governments do $1.2 trillion of “deals”  rather than buy $1.2 trillion of bonds.   $1.2 trillion is the equivalent of 3 Citi/ ADIA sized deals a week every week of the year, or two UBS/ GIC/ unnamed Middle Eastern investor deals a week.  It is equal to a CNOOC-Unocal sized transaction every week of the year. I understand the desire of many emerging market governments to hold a more diverse portfolio.  Holding low-yielding bonds denominated in depreciating dollars cannot be a fun – even if such holdings are a necessary component of a development strategy based on using the central bank’s balance sheet to support exports.   I also suspect that their desire for a significantly more diverse portfolio is incompatible with a world where they are adding to their assets at their current rate. There is one additional -- and quite controversial -- angle that is worth mentioning.The majority of the growth in official assets is coming from countries that are not democratically governed.   China and the Gulf combined will likely add around $700b to their "official" portfolio, broadly defined.   Russia, which is a bit more transparent and a bit more democratic, will account for another $175b.   Other less-than-fully democratic governments (Libya for example) will account for another $50b.    Sum it all up and the foreign assets of non-democratic governments could rise by close to a trillion dollars in 2007.   That worries me.     The rise of state capitalism doesn't just represent a shift in financial power from the market to the state, and from the US and Europe to the emerging world.   It also represents a shift in financial power away from democracies.

In James Clavell’s Noble House, there is a scene where a fictional Scottish trading house operating in colonial Hong Kong ends either a run on its bank or a run on its stock (or maybe both – I forget) by obtaining an emergency loan from China’s communist government.  The loan didn’t come directly from China’s government – it came though the Hong Kong branch of Bank of China – but it clearly required Beijing’s approval.      Clavell's novel was set in a time when China’s government was still really communist.   1949 wasn’t a distant memory in the 1960s.   The world has changed since then.   Chinese Communist have turned into capitalists.  And fiction has turned into fact.   Last week, a capitalist icon turned to government – and not its home government -- for help in a time of stress.   About two weeks ago Citi's top executives boarded a private plane to fly half-way around the world to cement the sale of a decent chunk of Citi's equity to the Abu Dhabi Investment Authority (ADIA). Depending on your point of view, Citi’s recapitalization is structured so that ADIA either gets a generous coupon before it is obligated to buy Citi's stock, or the generous coupon is a way of disguising the discounted future sale price of Citi’s stock.   See ALEA for the real details (hat tip Naked Capitalism).   ADIA’s investment is structured to stay below the 5% threshold that requires Fed approval (for a bank), let alone the 10% threshold that requires CFIUS (Committee on Foreign Investment in the United States) review.   Still, it is hard to believe that Citi’s new CEO won’t pay a visit to ADIA along with Prince Alaweed soon after being selected.    He (or she) might even get flown over in a private A380 rather than Citi’s corporate jet … Citi got into trouble, at least in part, from off-balance sheet activities that were not exactly transparently disclosed.    So perhaps it is fitting that it turned to one of the world’s least transparent investment funds – one owned by a rather untransparent government – for help.      It wasn’t all that long ago that Wall Street – Citi bankers included -- were scouring the emerging world for state-owned companies that could be sold to private investors in the US and Europe.   Now the world’s investment bankers seem to be scouring the US and Europe for private assets that can be sold to government investment funds and state-owned companies in the emerging world. Privatization is out.   Selling private companies – or big chunks of a private company -- to another country’s government (partial renationalization?) is in.   Back when there was money to be made selling state-owned firms in the emerging world to private investors in the US and Europe, investment bankers argued that one major threat to global prosperity was political opposition to privatization.   Any country that bowed to domestic political pressure and didn’t sell off its telecoms, banks and utilities risked being left behind.   Now that there is money to be made selling private firms to state investors,  investment bankers argue that one of the biggest threat to global prosperity – or at least “market liquidity” --  is political opposition in the US and Europe to selling stakes in US and European private companies to emerging market governments. The financial world’s uber-capitalists have been brought to heel by the world’s new financial superpowers.  Or perhaps the state in the emerging world itself became uber-capitalist?  Abu Dhabi Inc (10% of the world's oil reserves split -- unequally -- among less than 500,000 people) has very attractive profit margins so long as oil can be sold at close to $90 a barrel.  The leaders running some emerging market governments may now have more in common with top bankers on Wall Street and in the City than the democratically elected leaders now running the governments of the world's advanced economies ...   

The FT notes, in today’s leader, that the G-7 hasn’t been able to agree on the massive, co-ordinated intervention needed up hold the dollar up against the euro. The euro, and commodity currencies such as the Australian dollar, are bearing the brunt of the dollar’s fall and the erosion of their trade competitiveness.  These are the nations with something to gain from G7 or IMF management of the dollar’s fall, but even if they could agree amongst themselves, it is unlikely they could muster support for the massive, co-ordinated, global intervention that would be needed to hold the dollar up. The funny thing is that the emerging world has been able to muster support for massive, global intervention needed to hold the dollar up – the IMF estimates that global reserve growth is set to top $1 trillion in 2007, and judging from the first two quarters, that may be an underesimtate.     And even more surprisingly, they have managed to do this without any formal coordination.  There is no real analogue today to the G-7 of the 1980s (see HSBC’s Stephen King in yesterday’s Independent).  The big emerging economies don’t sit down with the US in the G-20, for example, and agree to intervene to hold the dollar up while the US takes steps to put its financial house in order.   But they nonetheless intervene on a far larger scale – both relative to US GDP and their own GDP – than the G-7 ever did in the 1980s.    So how can this system be sustained in the absence of formal coordination?  After all, Barry Eichengreen argued back in 2004 than every individual country in the dollar financing cartel had an incentive to cut back on its dollar holdings before others do– and as a result, the Asian central bank cartel financing the US would prove to be unstable.  I would point to two things.First, so long as China resists allowing its currency to appreciate – a policy that requires that China buy tons of dollars in the foreign exchange market and invest tons of money in the US – any emerging economy that allows its currency to appreciate against the dollar also allows its currency to appreciate against the RMB.   That has a real cost.  Ask India.  Or Thailand.   Those emerging Asian economies that have allowed their currency to appreciate now generally run current account deficits, not surpluses – and many are seeing a very rapid rise in their imports from China.   As a result, even countries with higher upfront sterilization costs than China are still intervening to resist pressure for their currencies to appreciate.  Ask the Reserve Bank of India how many dollars it has bought over the last month.   And then ask the Bank of Thailand. Call it coordination without any formal coordination.  Almost every emerging economy is – or has – intervened over the past year to prevent their currencies from appreciating.   And they all have done so without demand anything from the US in return, and by and large, without talking to each other either. Second, high oil prices – and policy inertia in the oil exporting economies.      The oil exporters have a ton of cash with oil trading in the $85-90 range, even if many now need $40 oil – if not a bit more -- to avoid running an external deficit.    Taking in $85 a barrel and spending $40 on imports leaves $45b a barrel to invest globally.   It is – in that narrow sense -- equivalent to taking in $65 and spending $20. The oil exporters don’t really have to worry about Chinese competition -- so that can hardly explain their continued willingness to peg to the dollar. So why have they joined the dollar financing carterl?   Inertia probably plays a bigger role than most would suspect.   The GCC countries haven’t agreed on what should take the place of their dollar pegs in the run-up to their now-likely-to-be-delayed yet again monetary union.  And so long as they peg to the dollar, they have an incentive to hold dollars – at least the bigger countries.  Selling risks driving the dollar and thus the GCC currencies  down.To be honest, though, the asset allocation of some Gulf countries investment funds now looks to be adding to the pressures on the dollar.  I would be bet a lot of money that a smaller share of today’s oil surplus is held in dollars than was the case in 2004 or 2005.  We more of less know this is true for three countries: Russia, Kuwait and Qatar.   The portfolio allocation of these countries consequently may be adding to the problems their central banks are now facing with inflation.  And, if is widely suspected, some investment funds have reduced the dollar share of their portfolio, inertia alone consequently is no longer a fully satisfactory answer.   Other policies have changed faster than the peg.I suspect part of the answer is that the some GCC countries – the Emirates for example -- is effectively run by a set of property magnates.  Big property investors haven’t exactly been hurt by higher inflation, negative real rates and the resulting surge in demand for property.   Especially not when a lot of the increase in inflation comes from higher rents.  Higher rents and rising property prices help the property-owning sheiks -- particularly since they also tend to own the major property developers.    And the sheiks are the ones calling the shots. Here though I am probably speculating a bit too freely about the Gulf's political economy.   Suffice to say that the Gulf's continued willingness to peg to a depreciating dollar is a mystery, one that calls out for further investigation.We do know though that a lot of countries haven’t made their willingness to intervene heavily to hold the dollar up contingent on any changes in US policy.   That has reduced the need for formal coordination.    We also know, I think, that the early defectors from the dollar financing cartel are currently paying a bit of a price –  as they have allowed China to undercut their products in the global market.  China’s ability to punish defectors by taking some of their global market share also reduces the need for formal coordination .  Finally, the oil exporters aren’t spending all the funds they are taking in, and even if they are putting a smaller share of the flow into dollars, they are still adding quite significantly to their dollar portfolio.  That too helps finance the US deficit. Three final points:   One: It isn’t as if Europe and the advanced commodity exporting economies lack the resources needed to intervene on a sufficient scale to make an impact.   China’s 2007 intervention in the foreign exchange market – counting funds shifted to the CIC – is likely to be well above 15% of China’s GDP.   I haven’t done the math, but 15% of the combined GDP of the European Union would generate a sum closer to $2 trillion than $1 trillion.   Academic theory on this isn’t totally clear, but I personally suspect intervention on that scale would have an impact on the dollar.   Europe just doesn’t think it is in its interst to borrow a ton of euros and sell them for dollars.   China, by contrast, still thinks it is its interest to borrow a ton of RMB and buy euros and dollars.  And China is likely to take far larger losses on its euros and dollars than Europe would on its dollars.   Two: This implies that China now provides a very large amount of financing to the US right now.  CITIC’s $1b investment in Bear is offset by Bear’s investment in CITIC, and even if it wasn’t it amounts to less than a typcial business day’s worth of China’s likely purchases of US bonds.   It isn’t unrealistic to think that Chinese state investors – the PboC/ SAFE, the CIC, CITIC, CDB and others – will aquire between $350 and $400b of US assets in calendar 2007.   The vast majority will still be bonds.   (These calculations assume that total chinese foreign asset accumulation will be close to $500b)Three: the earlier talk of the need for a new Plaza to bring the dollar down in an orderly way has effectively been superseded by talk of a new Louvre to keep the dollar from falling further.   But in reality, the world could need both a new Plaza and a new Louvre.   A Plaza might still be needed to bring the dollar down against many emerging currencies, though in all honesty the needed adjustment in the dollar could happen absent any Plaza II if China decided to let the RMB moved more.   And a Louvre might be needed to keep it from free fall.   The problem I have with the emerging world’s current intervention is that it is – by and large – designed to keep the dollar from falling at all.   The original Louvre came after the Plaza.  The new emerging market Louvre -- today's massive intervention to support the dollar -- has come about without there ever being an emerging market Plaza. 

I am a bit of a balance of payments data geek.  I like to read the IMF's WEO from the back to the front.   The data in the statistical appendix often tells interesting stories.   Here are three that jumped out at me.A savings glut not an investment drought.  Global savings is estimated to be close to 23.6% of world GDP in 2007, up from around 21% in the 2001-2003 – and above the 22% average between 1993-2000.   Investment is up to, but with real rates low globally, the rise in investment likely reflects a rise in savings – i.e. a glut that has driven real rates down.Certainly there is a “glut” of savings in developing Asia – a group that includes China.  Savings is estimated to be 45% of developing Asia’s GDP – up 12% from its 1993-2000 average.   Investment is up too – at 38% of GDP in 2007, it is estimated to be about 5% higher than its 1993-2000 average.       But even with higher investment, developing Asia is in a position to lend a lot more to the rest of the world – 7% of its GDP in 2007, v. next to nothing from 1993-2000.     I tend to side more with Dr. Wolf than Dr. Roubini on this question.  I don’t think the US deficit is entirely the product of US policies (the US has brought it fiscal deficit down from its 2004 peak, though it is once again starting to rise).  It also has has been induced by the rise in China’s surplus.  Indeed, right now the rise in China’s surplus seems to be inducing deficits in Europe as well as the US.Continues There is also a savings glut in the Middle East.  Savings, at an estimated 44% of GDP in 2007 – is up about 20% from its 1993-2000 average.   Investment is up about 4%, not nearly enough to offset the rise in savings.    The dynamics here aren’t hard to understand.  Oil has soared.  Domestic spending and investment are growing rapidly – but not as fast as oil is rising.   Here I think the US should be looking a bit more in the mirror.   The US cannot do anything – apart from imposing countervailing tariffs – to get China to stop pegging to the dollar, or to adopt policies that would lower its national savings rate.   But the US certainly could adopt policies to reduce the United States call on global oil supplies.   The US remains a very energy-inefficient economy. State-led financial globalizationTake a look at Table A13.   The IMF estimates the emerging world will add $1085b to its reserves in 2007, and there will be an additional $132b in net official outflows (this mostly comes from a $112 outflow from the Gulf – think sovereign wealth funds).  That works out to a $1.2 trillion increase in official assets. That increase is far larger than the emerging world’s $700b estimated current account surplus.    The IMF estimates that net private capital inflows to the emerging world will total about $500b.    That total may be a bit high – the August turmoil slowed the pace of capital flows to the emerging world.   But there are some signs it has bounced back very strongly.  India, for example, is now struggling with huge inflows.  Russian reserve growth -- judging from this week's data -- looks to have resumed.Imbalances are usually defined in terms of the current account.   The US runs a big current account deficit, the emerging world and Japan a big current account surplus.  But they equally could be defined in capital account terms. Right now, there is an enormous gap between net private capital flows and the US deficit, creating a large “financing gap” that is filled by official inflows.    And, on the other side, the emerging world is now attracting net private inflows on the scale that the US needs even though it is running, in aggregate, a $700b surplus.IMF data makes it absolutely clear that the uphill flow of capital is not a private flow.   Europe joins Bretton Woods 2Dooley, Garber and Folkerts-Landau initially argued that Asian reserve growth would finance the US current account deficit.     That story – when augmented with a story about rising oil savings and the investment of the oil surplus in (offshore) dollar assets – describes the world from 2001 to 2005 rather well.   The US deficit rose from $385b to $755b (an increase of $370b).   That increase offset a $127b increase in developing Asia’s surplus and a $263b increase in the surplus of the oil exporters.     But as the dollar-RMB depreciated against Europe and oil-exporters started buying more European assets, the system evolved.   China started to run large bilateral surpluses with Europe.   And if 1/3 of the $1.2 trillion increase in official assets is invested in Europe, Europe is now receiving a $400b capital inflow from emerging market central banks and oil funds.     That inflow seems to have induced a swing in Europe’s current account balance – This swing doesn’t show up in the data for the Eurozone as clearly as it shows up in the data for the European Union as a whole.   That makes sense.   Eurozone banks take the inflow from Asia and the oil states and lend it to Eastern Europe.    But the overall result is clear:  the IMF now forecasts that the rise in the emerging world’s surplus will be offset by a rise in Europe’s deficit.Between 2005 and 2008, the IMF expects the US deficit to rise by about $30b (from $755b to $785-790b) and the EU’s deficit to rise by $175-180b (from $30b to $215-220b).Asia's surplus is expected to rise.  The IMF expects developing Asia’s surplus to increase $280b from 2005 to 2008, thank to China.   The oil surplus only rises by $30b.   By 2008, developing Asia has a signficantly larger surplus than the oil exporting economies.Obviously, though, that forecast depends on the price of oil, as well as the pace of increase in spending and investment in the oil-exporting economies.  I personally suspect the IMF underestimated the rise in spending and investment in the Gulf.   But they also may have underestimated the price of oil.  $90 a barrel even as the US slows is amazing.All in all, though, the IMF's balance of payments forecast makes sense.   Asian currencies are very, very weak relative to European currencies.   And Europe is unquestionably attracting more than enough official inflows to finance a growing external deficit  -- even if it is attracting far smaller official inflows than the US.

Chinese entry into the manufacturing of commercial vehicles and aircraft has the potential to reshape the competitive landscape in two industries still dominated by G8 nations.

John W. Bruns, the senior executive based in China for Boeing’s commercial airplanes division, says Chinese ventures to build large commercial aircraft present both opportunities and challenges for established aerospace firms.

michael pettisThe Chinese sovereign wealth fund (which, following convention I will call the CIC) is expected to be approved later this month or early October, before the October 15 meeting of the 17th National People’s Congress.  Much of its expected structure, however, is known and it has already made one very big and visible investment, the $3 billion it invested in the Blackstone Group IPO, which value began falling almost as soon as the deal was launched.  As of last week the market value of the investment had declined by $600 million, causing a great deal of complaints and criticism in China, not all of it rational.  The CIC has already been approved to purchase $200 billion from China’s central bank, the People’s Bank of China (PBoC).  The purchase will be funded by a RMB 1.55 trillion bond offering by the Ministry of Finance (MoF) with maturities of ten years or more.  Already about one-third of the money (RMB600 billion) has been raised, with all of the rest expected to come before the end of the year.  Given that China is accumulating reserves at the rate of $100-120 billion a quarter, it is probably safe to assume that if it is perceived as being successful (from the point of view of domestic political considerations, not investment performance) a lot more money will eventually be transferred into the CIC.One bit of good news is that the PBoC plans to use these MoF bonds as part of its open market operations to control the expansion of the domestic money supply.  This is good news to me because I think the use of central bank bills, which is what the PBoC mainly has used in its ineffective sterilization attempts, has been pretty much a waste of time.  They are too similar to money and way too liquid to have much impact in draining China’s ocean of liquidity.  The less liquid MoF bonds should do a better job.  Interestingly enough, the loss on the Blackstone IPO and the recent turmoil in the markets seems to have affected the CIC's investment strategy, as has the international outcry against non-transparent SWF's purchasing major strategic assets around the world.  During their meeting with German Chancellor Merkel's during her visit to China at the end of August, Chinese officials promised that the CIC had no intention of buying strategic stakes in big western companies.  In fact it seems that the original goal of the CIC – to maximize investment returns – has been put on hold.  This is probably a good thing because, it seems to me, the most valuable use of excess reserves is as a sort of stabilization fund that minimizes the changes in creditworthiness of the sovereign borrower.  Instead of maximizing returns – which is likely to be pro-cyclical and so will only increase volatility – the funds should be invested in ways that hedge Chinese risk, for example, by buying assets that perform best when conditions in China are likely to be at their worst, and vice versa.  Unfortunately that doesn't seem to be the alternative strategy.  It looks like the management of the CIC's investments, perhaps not surprisingly given the size of the honey pot, is going to be the result of a hodgepodge of competing ministries and claims.  This is what Xinxin Li has to say about it (see the September 20 entry for my blog at piaohaoreport.sampasite.com for a more complete excerpt):  A seven-person executive team has been formed, representing all the interested parties.  The Chairman of the Board is the vice secretary general of the State Council (China's Cabinet) Lou Jiwei, who invited the current deputy head of the National Social Security Fund (China's national pension fund) Gao Xiqing to be the CEO of the CIC.   The team also includes vice finance minister Zhang Hongli, the head of Central Huijin, Xie Ping, and a representative from the NDRC.  The PBoC is supposed to send a deputy governor to join the team, but the appointment is still pending.  A possible candidate is the current deputy governor Su Ning…This structure reflects the inter-ministerial nature of the CIC: it is not only a SWF seeking high investment returns, but a coordinator among different government agencies on China's overseas investment.  This will be a pretty big agency.  It will have 1,000 employees once it completes its expected takeover of a couple of other agencies involved in the management of domestic assets, and it will be supervised by a representatives from the State Council,, the National Social Security Fund, the MoF, Central Huijin, the NDRC and the PBoC.  Given that these different institutions have very different goals and interpret current conditions in China in very different ways, one can just as easily argue that the executive team is as likely to coordinate interests as to paralyze action. My concerns aren't allayed by the scope of the CIC's mission.   According to Li, “Central Huijin, the former investment arm of the PBoC, will be integrated into the CIC and continue to capitalize domestic financial firms. Another existing institution, China Jianyin Investment, will mainly operate in the area of managing domestic assets and disposing of non-performing loans.  In addition, the CIC will establish a new department for overseas investment.” It is also, apparently, expected to use its assets to fund the overseas expansion of domestic corporations.  It is hard to imagine that domestic political clout will not be at least as important a factor in deciding which domestic entities will be funded and on what terms as economic rationale.   My guess is that the CIC will start out investing largely in liquid foreign securities, which responsibility will be handed off to SAFE (State Administration of Foreign Exchange, the body that is responsible for most foreign exchange transactions of Chinese state entities).  Given the recent turmoil in the markets and the criticism the CIC has received for the Blackstone investment, I suspect that its first investments will be fairly conservative, although a lot of people from different banks are telling the CIC that the market turmoil is an excellent opportunity for a cash-rich entity to find great bargains.  I don't think the CIC is buying the argument, but who knows?  Lou Jiwei is supposed to be a pretty sharp guy and depending on how damaging the Blackstone criticism has been to his career prospects, he may be eager to score a goal or two as soon as possible.As the CIC grows, I would bet that an increasing amount of its assets is likely to be invested in strategic investments, which I suspect will include the financing of the foreign expansion of state-owned companies.  This may turn out to be the most highly politicized aspect of the CIC's future business.   With $30-40 billion a month pouring into China's reserves, it wouldn't be surprising if a steadily increasing amount of money , either held at the PBoC or at the CIC, is invested in riskier assets and strategies than in the past.  It is a little too early to get a bead on exactly how and where this money will get invested, but certainly anything that lifts the fog that surropunds Chinese finances should help clarify the direction of the global balance of payments.  I will try to stay on top of rumors and facts about the CIC and PBoC investment strategies, and of course would appreciate comments from anyone that knows anything.