Brad Setser's Web Log: Reserves to protect against everything short of the Apocalypse

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April 14, 2005
Reserves to protect against everything short of the Apocalypse
That quote comes from the IMF's chief economist in today's Financial Times:

A number of emerging markets, especially in Emerging Asia, have built up reserves to protect against everything short of the Apocalypse,” Mr Rajan said, "The reserve build up is now undermining monetary control as well as the soundness of their financial systems.

I think it is far to say that most Asian emerging economies now have war chests far in excess of any reasonable estimate of what they need to avoid future financial crises. Indeed, the biggest risk most emerging Asian economies face comes not from the risk an international crisis may reveal that they have too few reserves, but rather from the risk that their rapid reserve growth will lead to the rapid expansion of money and credit and a domestic financial crises.

No where is that more true than in China, which just reported that its reserves rose by about $50 billion in the first quarter, to $659 billion. Since China's trade surplus tends to be larger in the later part of the year than in the first part of the year (a reflection of all the Chinese goods that appear in Christmas stockings, among other things) and China's exports are growing EXTREMELY rapidly, the pace of China's reserve accumulation is likely to pick up during the course of the year -- even if "hot money" inflows (at least $19 billion in q1) do not accelerate. Realistically, China's reserves are on track to hit $860 billion by the end of the year (more than Japan?), and perhaps even $900 billion (if hot money flows pick up).

China's reserves would then equal about 50% of its GDP. Just for the record, that is insane -- the central bank cannot use its balance sheet to subsidize China's export-led growth forever. It means an enormous fraction of China's national wealth is being kept in low-yielding US dollar denominated assets that are sure to fall in value (in local currency terms) over time. Rather than chasing yield, China is chasing future losses -- and in the process, making it harder, not easier, to maintain domestic financial stability. China says it cannot adjust its exchange rate peg until its financial system is ready, but in my judgment, the longer it waits, the bigger the likely problems in its financial system (more on this later).

Suffice to say that CSFB is dreaming if it really thinks China will only have $1 trillion in reserves in the summer of 2008 (the Beijing Olympics). Unless it changes its currency policy -- really changes its currency policy (a 3-5% move in the renminbi doesn't count), China should hit $1 trillion in reserves sometime in 2006.

A small aside. China's reserves rose by $95 billion in q4 and about $50 billion in q1. But that total includes the rise in the value of China's euro denominated reserves in q4, and the fall in their value in q1. If China keeps 80% of its reserves in dollars, its "underlying" pace of reserve accumulation was around $85 billion in q4, and $55 billion in q1. If it keeps 60% of its reserves in dollars, its "underlying" pace of reserve accumulation was only $75 billion in q4, and was $60 billion in q1. While I don't really know, my guess is that dollars make up closer to 80% of China's portfolio than 60% -- in part because I do think "hot money" inflows into China slowed in q1, and thus China's underlying pace of reserve accumulation really did slow. It would not surprise me if hot money inflows pick up again later in the year.

Posted by brad at April 14, 2005 12:16 PM

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Comments
Off topic to a point, but apply the following thinking to government (and corporate) model adjustments and the chaos that these gurus are winding up; back on topic, apply this to reserve adjustments and then extrapolate; seems as if a financial bomb is being built with chaotic blackbox-tools that no one understands. Reminds me of the story about the first atomic fusion "chain-reaction" in Chicago during WW11; great story if youve never heard it)!

IT observer Stan Kelly-Bootle described in 1995 the impact of VisiCalc and its descendants: "The PC soon blossomed as the Uzi of creative corporate accounting," he wrote. "The What-If moved to Why-Not, indicting the spreadsheet as the chief culprit in the 1980s S&L scandal."

Kelly-Bootle was talking about the ease with which we slide our assumptions toward their optimistic limits, inching good numbers up and bad numbers down until we get the result we want—failing to admit that the result is based on multiplying a series of less-than-even chances.

There are two ways that spreadsheets, as we know them, distort our thinking and lead to bad decisions. The first distortion is the use of point values and simple arithmetic instead of probability distributions and statistical measures. So far as I know, there's no off-the-shelf spreadsheet product—certainly none in common use—that provides for input of numbers as uncertain quantities, even though almost all of our decisions rest on forecasts or on speculations.

There are add-on products that incorporate uncertainty into spreadsheets, and many of them are quite good. Products of this kind that I've favorably reviewed over the years include DecisionTools Pro from Palisade and Crystal Ball Professional and CB Predictor from Decisioneering. It's not too hard to appreciate the difference between products that incorporate uncertainty and those that don't: On the one hand, you've got, "We predict a $1 million profit in the first year"; on the other, "The expected Year 1 profit is $1 million, but there's a 30 percent chance of losses for the first two years." These different statements will lead to quite different discussions.

The second distortion caused by conventional spreadsheets is more subtle. It's described in a 1980s paper, written by university researcher Jeffrey Kottemann and others concerning what they called "Performance, Beliefs, and the Illusion of Control." The paper described an experiment in which subjects were asked to perform a planning task using different tools, some of them with elaborate what-if capability and others without it.

The subjects whose tools invited them to imagine alternative scenarios believed they were doing a better job—even though statistical measures of their results showed no improvement in the actual quality of the forecasts. Those subjects did, however, take longer to perform the task. Isn't that the worst nightmare of those who must justify IT's return on investment—spending extra money on a more time-consuming product that yields absolutely no measurable improvement?

Spreadsheets: 25 Years in a Cell

Posted by: w at April 14, 2005 12:56 PM

What's the probability of an Apocalypse?

Posted by: Ryan Darwish at April 14, 2005 01:43 PM

Interesting, Re: A number of emerging markets, especially in Emerging Asia, have built up reserves to protect against everything short of the Apocalypse,” Mr Rajan said, "The reserve build up is now undermining monetary control as well as the soundness of their financial systems.

>> Mr. Rajan seems to like that word apocalypse, re 2004:

And, finally, I will suggest what I consider the main conclusions of my analysis.

So, first, the threats to globalization. As we all know, the international economic integration of the late 19th century went catastrophically into reverse. How likely is it that this present move towards integration, similar in many respects but more limited also in many, how likely is it that it will suffer the same fate? To answer this question, one needs to take account of differences and similarities between these two epochs.

The breakdown last time was, I argue, the consequence of the combined force of international rivalries, economic instability, protectionist or anti-liberal interests—sorry, protectionist interests and anti-liberal ideas. How likely are the same >> Four Horsemen of the Apocalypse to return? The first international rivalry, the first cause of the breakdown was the collapse of harmonious international relations as rivalries among great powers and the rise of communism and fascism fragmented the globe and fomented war. But today I would argue the situation is different in four fundamental respects.

First, there is for the moment a single undisputed hegemon, the U.S., and it seems to me little chance of a war among great powers in the near future, except conceivably between U.S. and China over Taiwan. But China is not, I believe, powerful enough to be a rival of the U.S. for the next two or three decades.

Second, all the great powers seem to have abandoned the atavistic notion, still very powerful a hundred years ago, that prosperity derives from territorial gains and plunder rather than from internal economic development and peaceful exchange.

Third, all the great powers now share a commitment to market-led economic development and international economic and political integration of some kind.

And, fourth, global institutions and habits of close cooperation reinforce the basic stability of the political order.

All these are indeed powerful differences between the world of a century ago and today's. But against this, we must note one obvious parallel. As I've already alluded to, the breakdown of the early 20th century order occurred in large part because of the pressures to accommodate rising powers in the global economic and political order. The rise of China will in time inevitably create great pressures. If the U.S. remains wedded to notions of global primacy rather than of a shared global order, conflict with a rising China would seem almost inevitable.

In addition to these political pressures, China's rise will force uncomfortable economic adjustment on the rest of the world, and these are indeed already creating protectionist pressures in a large number of countries. It is not, alas, impossible to envisage a spiral of mutual hostility that undermines the commitment to a liberal international economic order.

http://www.imf.org/external/np/tr/2004/tr040922a.htm

Posted by: w at April 14, 2005 02:06 PM

What's the probability of an Apocalypse? Ask Paul Volcker:
www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html

Posted by: touche at April 14, 2005 02:14 PM

Just say this and thought it tied into topic:

Posted by: Elaine Supkis at March 24, 2005 04:14 AM

Reserve currency: means dollars buy oil. You can't buy oil directly except via dollar denominations. This is great power which we squandered not once but twice. When we inflated the dollar back in the seventies when oil shot up in price, we pretty much took back, so to speak, what we sent out.

Posted by: w at April 14, 2005 02:49 PM

nonsense. you can perfectly well buy oil in any hard currency you like. the companies that sell oil have currency converters on their computers like everyone else and have the same access to foreign exchange markets as anyone. Just because exchanges quote the price in dollars doesnt mean that if you have e.g. euros you cant buy oil.

Posted by: steve kyle at April 14, 2005 03:04 PM

Take a look at this old bit, related to oil & currency:

http://www.currentconcerns.ch/archive/2003/04/20030409.php
A New American Century?
Iraq and the hidden euro-dollar wars
by F. William Engdahl, USA/Germany

Recycling petrodollars
Beginning the mid-1970’s the American Century system of global economic dominance underwent a dramatic change. An Anglo-American oil shock suddenly created enormous demand for the floating dollar. Oil importing countries from Germany to Argentina to Japan, all were faced with how to export in dollars to pay their expensive new oil import bills. OPEC oil countries were flooded with new oil dollars. A major share of these oil dollars came to London and New York banks where a new process was instituted. Henry Kissinger termed it, ‘recycling petrodollars’. The recycling strategy was discussed already in May 1971 at the Bilderberger meeting in Saltsjoebaden, Sweden. It was presented by American members of Bilderberg, as detailed in the book Mit der Ölwaffe zur Weltmacht.[1]

OPEC suddenly was choking on dollars it could not use. U.S. and UK banks took the OPEC dollars and relent them as Eurodollar bonds or loans, to countries of the Third World desperate to borrow dollars to finance oil imports. The buildup of these petrodollar debts by the late 1970’s, laid the basis for the Third World debt crisis in the 1980’s. Hundreds of billions of dollars were recycled between OPEC, the London and New York banks and back to Third World borrowing countries.

By August 1982 the chain finally broke and Mexico announced it would likely default on repaying Eurodollar loans. The Third World debt crisis began when Paul Volcker and the U.S. Federal Reserve had unilaterally hiked U.S. interest rates in late 1979 to try to save the failing dollar. After three years of record high U.S. interest rates, the dollar was ‘saved’, but the entire developing sector was choking economically under usurious U.S. interest rates on their petrodollar loans. To enforce debt repayment to the London and New York banks, the banks brought the IMF in to act as ‘debt policeman’. Public spending for health, education, welfare was slashed on IMF orders to ensure the banks got timely debt service on their petrodollars.

The Petrodollar hegemony phase was an attempt by the United States establishment to slow down its geopolitical decline as the hegemonic center of the postwar system. The IMF ‘Washington Consensus’ was developed to enforce draconian debt collection on Third World countries, to force them to repay dollar debts, prevent any economic independence from the nations of the South, and keep the U.S. banks and the dollar afloat. The Trilateral Commission was created by David Rockefeller and others in 1973 in order to take account of the recent emergence of Japan as an industrial giant and try to bring Japan into the system. Japan, as a major industrial nation, was a major importer of oil. Japanese trade surpluses from export of cars and other goods was used to buy oil in dollars. The remaining surplus was invested in U.S. Treasury bonds to earn interest. The G-7 was founded to keep Japan and Western Europe inside the U.S. dollar system. From time to time into the 1980’s various voices in Japan would call for three currencies — dollar, German mark and yen — to share the world reserve role. It never happened. The dollar remained dominant.

From a narrow standpoint, the Petrodollar phase of hegemony seemed to work. Underneath, it was based on ever-worsening economic decline in living standards across the world, as IMF policies destroyed national economic growth and broke open markets for globalizing multinationals seeking cheap production outsourcing in the 1980’s and especially into the 1990’s.

Posted by: at April 14, 2005 03:21 PM

touche-

Volcker's answer is not very satisfying. It merely reflects growing malaise stemming from a sober assessment of global economic conditions.

I would take issue with you on all four of your points.

"First, there is for the moment a single undisputed hegemon, the U.S., and it seems to me little chance of a war among great powers in the near future, except conceivably between U.S. and China over Taiwan. But China is not, I believe, powerful enough to be a rival of the U.S. for the next two or three decades."

Undisputed hegemon? This position could only suggest a viewpoint anchored in a Post-WWII Cold War conceptual framework. A cursory review of any credible news source would reveal anything but undisputed. Failure to recgonize the form, nature, and representation of the adversary has changed is why the chage is sometimes levied that generals are often fighting the past war rather than the current one.

"Second, all the great powers seem to have abandoned the atavistic notion, still very powerful a hundred years ago, that prosperity derives from territorial gains and plunder rather than from internal economic development and peaceful exchange."

This is far from a self evident conclusion. There are many opinions to the contrary, one of which is one of the main drivers of current military engagements is the strategic control of vital assets, oil in particular. There are many well written books on the subject, one of them being Resource Wars.

"Third, all the great powers now share a commitment to market-led economic development and international economic and political integration of some kind."

I would not say Putin's recent actions regarding Yukos and lately BP would be much support for this statement. Nor would recent reports of the escalating conflict between China and Japan over oil exploration ion the East China Sea.

"And, fourth, global institutions and habits of close cooperation reinforce the basic stability of the political order."

Sure, witness the UN Oil for Food issue, the US unilateral decision to invade Iraq, Sudan, nuclear Pakistan and India, and staggering global economic imbalances.

Posted by: Ryan Darwish at April 14, 2005 03:34 PM

I have to reply to my own post and add a comment (also forgot to sign my name):

Re: OPEC suddenly was choking on dollars it could not use. U.S. and UK banks took the OPEC dollars and relent them as Eurodollar bonds or loans, to countries of the Third World desperate to borrow dollars to finance oil imports. The buildup of these petrodollar debts by the late 1970’s, laid the basis for the Third World debt crisis in the 1980’s. Hundreds of billions of dollars were recycled between OPEC, the London and New York banks and back to Third World borrowing countries.

So, keep that thought of "OPEC suddenly was choking on dollars" then with the latest talk of asset pricing inflation:

"Asset price inflation is just as bad as any other form of inflation," said Thorsten Polleit, chief economist for Germany at Barclays Capital in Frankfurt. "It ruins the value of money." Polleit said ECB would have to raise its benchmark rate to 3.5 per cent to curb the excess liquidity in the region.

>>Thus if we are choking with too much cash in the system, the obvious result is to raise interest rates and increase the value of the dollar -- in theory, but, if there is far less debt today and fewer places for loans, as in the above 70's & 80's example, then IMHO, excess cash will continue to feed the oil and reserve currency dichotomy, i.e., currency arbitrage will fuel recession in the form of slower growth linked to higher future debts....but then again, I need some fresh air.

Posted by: w at April 14, 2005 03:36 PM

New theory.

Global hyper-protectionism, where currency hedging is used as a tool to build up massive oil reserves (for the future), altering supply and demand and thus generating scarsity. Meanwhile, asset pricing inflation artifically increases global wealth, which becomes more and more linked to oil scarsity and thus global inflationary pressure, which in time results in less oil consumption which results in greater supply and we all hold hands and live in peace....LOL!

Posted by: w at April 14, 2005 03:57 PM

Again and again the point about China's enormous reserves comes up. And again and again someone brings up the point--what other choice do they have? If we assume that the Chinese leadership values stability above all else, then a slowing economy that leads to rising unemployment is the worst option. Who can replace the American consumer and his dollars?

During the Asian crisis currency reserves were insufficient to defend currency valuations and first Thailand and then other Asian countries were forced to float their currencies and watch their values plunge, making it impossible for them to repay their dollar loans. This scenario is completely missing in regard to China today.

It is hard to imagine China finding the need for its' reserves short of the Apocalypse! What do you do with hundreds of billions of US dollar bonds? And remember this is what is left over after China has bought billions of dollars worth of oil, gas, steel, copper, zinc, grains, turbines, aircraft, and on and on.

Money is a medium of exchange and a store of value. What will the Chinese be able to exchange their dollars for and what value will they get for them? My guess is that they hope that the game can go on long enough that when it stops they will be strong enough to take the blow. Think of the United States after WWII.

Posted by: Mark Stehle at April 14, 2005 04:02 PM

I'll lend my support to Steve Kyle's comment. China would be able to buy more oil today if it had invested all of its reserves in euros in 2002, and then watched them rise in line with the oil price (at least til recently). Euros are a liquid asset, and if you want to trade euros for oil, it is not hard.

What matters for the US is the willingness of our couterparties to sign long-term contracts to deliver oil in the future that are denominated in dollars. We can still do that, last I checked. The currency that is used to denominate Russia's oil and gas sales to Europe is not of huge concern to the US. I don't buy the Iraq/ Iran = threat to US hegemony just 'cause they wanted to sell a bit of oil in euros thesis.

Posted by: brad at April 14, 2005 04:51 PM

Mark asked:

"who is going to replace the US consumer" --

my quick answer:

the chinese consumer. With consumption less than 50% of Chinese GDP, there is lots of room for consumption in China to rise. That, as much as anything, is the great hope for the world economy. A sustained rise in Chinese consumption (and yep, a fall in Chinese savings) that occurs as US savings starts to rise ...

Posted by: brad at April 14, 2005 04:53 PM

This blog seems to fit here (also):

http://www.mosler.org/wwwboard/messages/2311.shtml

MIT Economist Rudi Dornbusch. UC Berkeley's Brad Delong summed up Dornbusch on how psychology in currency bubbles unfolds ahead of a currency crisis, with Dornbusch noting four distinct stages.

1. Enthusiastic investors and speculators chasing immediate short-term returns cause the anomaly to last for longer than economists expect.

2. Puzzled by the failure of prices to return to fundamentals or of unsustainable policies to generate a crisis, highly-intelligent economists evolve theories explaining that *this* time it really isn't unsustainable.

3. Fortified by these theories, yet more investors and speculators chasing short-term returns flood into the market, causing the anomaly to last for *much* *much* longer than economists had originally expected.

4. The supply of greater fools comes to a sudden end; the crash comes; the crisis comes.

Delong argued (last September) that we are in stage 2. Fed Governor Bernanke has theorized the US current account deficit is a by-product of a global savings glut implying this time is different...unsustainable is sustainable.

While I am not suggesting a dollar crisis is inevitable, the more markets snub the significance of the widening US external imbalance for the dollar, the more the odds are the adjustment will be disorderly.

When? Well clearly not right now and probably not Friday when US Treasury releases capital flow data for February are published. Especially when stages 3 and 4 have yet to be reached. And surely not when the un-Teflon euro has a possible French "non" vote in the EU constitution May29 sticking to it.

Throughout the dollar's decline, bullish US economic fundamentals have been a parachute for the dollar and more recently a thruster for a dollar bounce since the Fed became alarmed about inflation. However, the outlook for above-trend growth in the US led by consumer spending and assumptions about firm pricing power are increasingly questionable. If anything, the outlook for growth and prices is more uncertain now than at anytime since the US economy allegedly flirted with deflation. And at no time since have officials at the Fed and market pundits been so confident on the outlook for the economy and interest rates. So much so that the Fed has hand held the market through 6 rate hikes, clearly spelling out its intentions so as not to surprise anyone.

Well what if the Fed got it wrong? The rise in oil and commodity prices have not been transitory as asserted through much of 2004 (no longer I add). And what if the US consumer has dropped. That's right. Dropped from too much shopping. Income gains is not supporting ever more consumption. Home ATM machines have been tapped about as much as consumers are will to take out and banks willing to lend. And boomers are starting to think about retirement (a bit late, but this is the generation that is intent on defying aging).

A slower US economy has no safety net in stronger Europe and Japan economies...they are on US-import-life-support. And where is China as an engine for growth if the US consumer starts to save, or worse is forced to save?

See (also): "Asset price inflation is just as bad as any other form of inflation," said Thorsten Polleit, chief economist for Germany at Barclays Capital in Frankfurt. "It ruins the value of money." Polleit said ECB would have to raise its benchmark rate to 3.5 per cent to curb the excess liquidity in the region.

Posted by: w at April 14, 2005 05:37 PM

http://www.pimco.com/LeftNav/PIMCO+Spotlight/2005/Powers+Spotlight+April+05.htm

Spotlight
April 2005
Bill Powers Discusses PIMCO's Latest Cyclical Outlook and Strategy

Q: A breakdown in the Bretton Woods II pact would clearly have significant implications for fixed income. How is this possibility affecting PIMCO’s portfolio strategy?

Powers: Our secular view puts the risks of the Bretton Woods II alignment front and center. Unlike Bretton Woods I, which was an explicit policy, there is not a global buy-in to Bretton Woods II. The current regime is motivated more by aligned self-interests than by an explicit pact to maintain this arrangement.

Clearly, there are a number of different elements that could change in the global economy that would reduce any country’s desire to continue the alignment. We have identified some of them and are going to great lengths trying to analyze these potential sources and probabilities of disruption.

One potential source of disruption is excessive Fed tightening, causing the economy to tip into a recession. That would disengage the U.S. consumer as the engine of growth for the mercantile exporting countries—Japan, China and others. The alignment relies on an engaged U.S. consumer who is well financed to buy overseas (largely Asian) goods, creating employment and growth in these countries.

Another potential disruption is upside surprises in inflation. The current trading range—4% to perhaps now 4.75% on the U.S. 10-year—is valid if inflation and price stability hold. Risks include the price of oil and other commodities, the pass-through of higher wages into the consumer price index, and other second round effects or upside surprises in growth leading corporations to be more aggressive in hiring and investing. If inflation surprises on the upside, the range will not hold, pushing us into a higher interest rate environment.

So far, Asian central banks have been steadfast continuing to accumulate dollar reserves funding the current account deficit. A change in appetite for dollar assets, for Treasuries or other U.S. fixed income, or a rebalancing away from the dollar, would undermine Bretton Woods II. There are other elements that could marginalize this pact as well. Among those are global turmoil, protectionism, or an increase in regulation on the investing habits of Freddie Mac and Fannie Mae. To that, add potential legislation affecting the investing habits of banks and hedge funds, and potentially successful G-7 pressure on China and Japan to adopt more flexible currency policies. All of these, or some combination of them, could result in discontinuity of the current Bretton Woods II regime...

We see the Bretton Woods II regime holding in the near term, certainly for the next few quarters...

Posted by: glory at April 14, 2005 05:40 PM

http://news.ft.com/cms/s/66a2bdce-ac83-11d9-bb67-00000e2511c8.html

Editorial comment
Imbalances worsen

Warning: global economic imbalances are getting worse. The US trade deficit rose to a new record $61bn (£32bn) in February. This was not supposed to happen. Global imbalances were expected to narrow as the economic cycle matured. Instead they are increasing. The International Monetary Fund is worried that this trend will continue, increasing the risk of a sudden adjustment at some point in the future.

The economic argument is familiar. The US current account deficit is not sustainable in the long run. If private investors lose faith that a gradual adjustment is feasible, or foreign central banks stop accumulating US assets, the dollar could fall sharply. This would probably prompt a similarly abrupt rise in US interest rates, which could kill off the US housing and consumption boom and explode over-leveraged financial institutions, with severe global consequences.

Posted by: glory at April 14, 2005 05:50 PM