It was a real pleasure to welcome Brad to Exorbitant Chat. In a wide-ranging chat Brad and Meyrick discuss:
Biden administration efforts to re-shore chip manufacturing and EV production and battery supply chain and how this may impact relations with Europe and elsewhere.
Russian sanctions are clearly no threat to the dollar’s dominant reserve status.
China’s activities as dollar intermediary and lender to 3rd countries.
Global South debt restructuring looks very messy.
The US Current Account deficit is unlikely to fall and the funding of the deficit is likely to fall increasingly on autocracies, which proves the world is less fragmented than many have argued.
The impact of Japanese investor withdrawal from global bond markets was keenly felt in 2022, but will not have much impact in 2023.
Plus, 3 major potential shocks for global finance:
1/ Sudden stop in Russian exports of oil to the world. We still need Russian oil.
2/ Systemically important emerging market countries are concerning – particularly Egypt and Turkey.
3/ The world cannot accept even more dependence on Chinese manufacturing and a higher CA surplus. The potential for a 10-20% weaker CNY remains.
Transcript below.
Meyrick Chapman 00:12
I'm very pleased to have Brad Setser to join me today on Exorbitant Chat. Brad is the Whitney Shepherdson, senior fellow at the Council on Foreign Relations. His expertise includes global trade and capital flows, financial vulnerability analysis and sovereign debt restructuring (something I've had some tangential experience with myself). He's served as Senior Advisor to the United States Trade Representative from 2021 to 2022, where he worked on a resolution of a number of trade disputes. And he previously worked at the US Treasury from 2011 to 2015, looking at problems such as Europeans, financial crisis, currency policy, financial sanctions, etc. He's author of a number of books, Sovereign Wealth and Sovereign Power and with Nouriel Roubini, "Bailouts and Bail-Ins, Responding to Financial Crises in Emerging Markets", which suddenly looks as if it might be relevant again. So welcome, Brad, thank you for joining me.
Brad Setser 03:25
Thanks for inviting me.
Meyrick Chapman 03:34
Now, it won't surprise you that a number of the questions I ask you are related to the increasing polarization of global finance, or at least the perceived polarization of global finance. And I wonder if we could start with a couple of lowballs, to encourage, well, well, to start by asking you particularly about the US government's moves to encourage approved supply lines along with or towards friendly nations. The Biden administration's introduction of the Trusted Digital Ecosystems. I think I've got that description right. And the Inflation Reduction Act itself, both kind of proscribe non approved foreign actors in favor of friends, particularly domestic friends, or domestic producers. And I was wondering whether tinkering with free trade raises all kinds of issues for friends, and quite a few issues perhaps, with non friends who may become even less friendly. Is this the type of policy simply a one way valve where international trade is gradually choked?
Brad Setser 04:52
So far, the answer to that question is unambiguously "No". Trade has actually been quite strong through the pandemic, and the driver of global trade unambiguously has been US demand. So it's it's simply not the case, as an empirical matter, that trade has been choked off that this, these policy steps have stood in the way of an expansion of trade.
Brad Setser 05:19
Now, to be fair, a number of the key provisions of the Biden administration's new industrial strategy are only now being implemented. And so I think their their impact would only be expected to get to be demonstrated in a forward looking context.
Brad Setser 05:39
But I think there's a set of less than obvious factors that are at play here. And I think it's useful to differentiate between semiconductors and the Inflation Reduction Act, the Clean Technology, the electric vehicle subsidies, because I think the global effect will be different.
Brad Setser 06:07
With semiconductors, obviously, the US has made a strategic decision that it wanted a much higher share of the production of the most advanced semiconductors in the world to be done in the United States. And to be honest, that may/will mean less of the production of the world's most advanced semiconductors will be done in Taiwan. The extreme concentration of advanced semiconductor production in Taiwan was appropriately in my view, viewed as a strategic vulnerability. That meant that there was or there is money for Intel to try to catch up with TSMC. The US is subsidizing Intel's move to be a fab that makes chips for everyone, not just that makes chips for Intel. And I think the US is quite committed to the notion that there should be a US firm with US production at the leading and cutting edge of semiconductor production technology, which wasn't the case two years ago. It still isn't the case now. It will only play for it play itself out going forward. And there's a associated commitment to increase the US share of semiconductor production and some of the lagging nodes in memory chips, some of the automotive chip technologies.
Brad Setser 07:30
Europe has a somewhat similar policy, although perhaps less of a determination to be at the cutting edge of the advanced nodes, and more emphasis on automotive chips. That doesn't necessarily mean there's going to be less trade. It just means that we're moving from a world where there was an extraordinary concentration of production in Taiwan. And then the chips that TSMC made were shipped globally, to a world where there will presumably be more dispersion in global production at the advanced end. But most of the chips that will be made in the US will still be sent to Asia or elsewhere for testing process, as seen assembly into circuit boards in the white. So I'd be kind of shocked if the net result was less trade.
Brad Setser 08:24
And I also think it's important to recognize that we're not coming from a world of unfettered markets and moving to a world of subsidies. We're coming from a world of subsidies where Taiwan subsidized TSMC. quite significantly. There's an OECD study which documents that Taiwan participated initially in TSMC is capital structure. I've argued quite consistently that Taiwan supports all of its exports, but TSMC in particular, by intervening pretty heavily in the foreign exchange market. China clearly was throwing enormous sums at its semiconductor industry, Korea historically has provided a lot of government support for his chip industry. So we're kind of moving into a world where everybody more or less is going to be providing support for their chip industry with possible adverse consequences. But a clear short term or medium term gain in resilience, a more dispersed global production structure for semiconductors should be better equipped to manage a range of foreseeable shocks, including some of the scarier geopolitical scenarios.
Brad Setser 09:36
I would differentiate that a little bit with the electric vehicles and the clean technology subsidies in the Inflation Reduction Act. I think the goal there is not actually to US-shore all electric vehicle production, although certainly there are significant local content requirements in the Inflation Reduction Act that have created some friction with America's friends. I think the goal was to make sure that the transition to electric vehicles wasn't also a transition to Chinese made vehicles, given that China had built up a significant edge in some parts of the electric vehicle production market.
Brad Setser 10:26
Frankly, my gut tells me that Tesla's cost structure in China is lower than its cost structure in California. And that without some form of incentive, some form of friction at the border, a company like Tesla might prefer to produce for the US market in China. Some European companies are in the same boat, some of the indigenous Chinese companies are actually making pretty competitive electric vehicles. And everybody was relying in one way or another, on the Chinese battery production supply chain. Their dominance, not just over the batteries, but over the cells and over the battery critical materials, lithium and the like, that go into the battery. So the goal was to have a transition to electric vehicles, which took some subsidies to accelerate that transition for climate reasons to make sure the bulk of electric vehicle production is in the United States, or at least in North America, and to create a battery supply chain that is independent of China, but will necessarily involve trade with various partners around the world, particularly, you know, for critical minerals like lithium.
Brad Setser 11:41
Now, this clearly causes a set of problems for Europe. Problem number one is that, and I don't necessarily agree with this, but the electric vehicle subsidies were limited to auto vehicles made in North America. And then the batteries are limited to batteries made in North America, or with a free trade agreement partner. Europe is not a free trade agreement partner, although there's a debate about definitions there, which is kind of arcane, but maybe provides a little bit of, of wiggle room. So clearly, it kind of excludes European electric vehicles from benefiting from the US subsidies. I mean, by the way, China's subsidies were reserved for cars made in China, there was no imported car that ever qualified for China's Evie subsidies. So this is not unique to the US. And equally, Mercedes and BMW, which more or less are producing EVs at the high price points, which would be excluded from the subsidies. But it appears to be discriminatory. And in my view, is probably a little more discriminatory than it needs to be on the battery supply chain is restructuring. It's a challenge for European firms. And frankly, it's a challenge for the US based firms as well. No one right now has that China free battery supply chain.
Brad Setser 13:05
And there's an added challenge that Europe faces, which is that battery production is quite energy intensive. And energy in Europe is expensive. So right now we're kind of in a weird world where the US has carved out EV subsidies for North American production, where China has carved out Chinese subsidy EV subsidies for Chinese production. And Europe remains an open market, European EV subsidies are available to, you know, they're non discriminatory. And China has actually taken a pretty big share of the European market. My gut tells me that Europe is going to have to move a little more in the US direction, but it's going to be difficult.
Brad Setser 13:52
Equally, I think the US over time, and this probably requires some changes in legislation. Senator Manchin has important views on this, you know, this wouldn't have happened without him. I think there should be scope to allow EVs made a broader set of us friends, provided they have non-Chinese source batteries to qualify for the subsidies.
Meyrick Chapman 14:21
That's very clear, and actually a little a little more optimistic, I think, than perhaps I was expecting. So that's nice to know.
Brad Setser 14:29
I mean,
Brad Setser 14:30
I'm not Nouriel. I'm not doctor doom.
Meyrick Chapman 14:33
The sanction regime, if we can turn to another aspect of the evolution of the polarization. The sanction regime that was imposed on Russia seems to show some features of a coherent dollar doctrine that I mentioned earlier, with regard to the Biden administration, and it's resulted in some new version of "our currency, your problem" or at least that was the intention. The US seems happy to risk and move away from dollars that this policy may prompt. Yet, oddly, there are very few signs that dollar dominance is declining at all. In fact it in many respects, it looks as if the dollar is now more important than it ever was. Is that your impression?
Brad Setser 15:21
I certainly think the dollar remains quite central to the global system. You know, in my description of the Biden administration's doctrine around the dollar, I focused on the strong dollar policy. There's another component, which is that the Biden administration actually does want the dollar to remain quite central to global transactions, all else equal. And I think, important reflection of that desire, but also one that didn't require a lot of diplomacy, or heavy lifting was the fact that the sanctions imposed on Russia Central Bank, were G7 sanctions and covered all G7 currencies, critically, including the Europe. And so I never actually thought those sanctions were any significant threat to the dollar for the following reasons. Russia more than any other major economy had tried to sanction-proof its reserves because it anticipated or was aware of, the risk after Crimea 2014/2015 sanctions, and it had done so largely by moving into the, to the euro, to a lesser degree by moving into the Chinese yuan. But relative to any major global economy, Russia's dollar share, going in to 2022, was quite low. And for the dollars that it did hold, those dollars were largely held outside the United States. That doesn't mean they're immune from US sanctions, they're just one step removed from the direct incidence of the sanctions.
Brad Setser 17:07
Even a non-US custodian will touch the US when it clears. So it's very hard to be completely free from the dollar from US-based sanctions. In any case, when the bulk of the reserves that were frozen, were in euros, and the conclusion, at least I drew is that Russia had sought to protect itself from US sanctions by diversifying into the euro. But it ended up with less liquid assets, lower yielding assets and no additional protection. So as long as the US and the Europeans act together, I don't think there's any real threat to either the centrality of either currency in the global monetary system.
Brad Setser 17:55
That said, there are consequences. One consequence is that Russia's trade is increasingly denominated in Chinese yuan. Another consequences China is very conscious of the scope of and the reach of US and European sanctions, and is much more actively looking to re denominate the currency used in its trade towards the yuan; develop settlement mechanisms that are a little bit more sanctions-remote. But frankly, they're having some trouble. I mean, there's the Saudis love to talk about shifting the dinar, using the yuan and their trade, particularly when MBS is a little irritated President Biden, but actually using the yuan is a different thing. And so far, there's very little evidence that the Gulf countries have preferred to be paid in yuan, than to be paid in dollars.
Meyrick Chapman 18:51
That's very interesting. And it's also it strikes me as perfectly obvious that that an economy such as Saudi that's pegged to the dollar, it's going to find it extremely difficult to shift a large amount of, of its trade of its oil trade away from the dollar.
Brad Setser 19:10
But well,
Brad Setser 19:10
I mean, the irony is that the CNY isn't entirely divorced from the dollar either.
Meyrick Chapman 19:15
Exactly. Yeah, that's exactly right.
Brad Setser 19:19
There's a funny I, at least, you know, I find a funny story about how Russia and India were using the Qatari Riyal to escape the dollar. When of course, the Qatari Riyal is pegged one-to-one, well, not one-to-one, but you know, tightly pegged to the dollar, it's effectively a dollar.
Meyrick Chapman 19:37
Well, it reminds me of the Niall Ferguson concept of Chimerica, which still kind of pertains and will still hold at least as far as the currency markets concerned. And that's relates to my next question, which is about the Chinese banking system which is assumed a role as provider of dollar loans to third party countries from really from the global financial crisis onwards until, until last year, at a very high level. This lending seems to have been wound back aggressively after the Russian invasion of Ukraine. I'm just it just reminds me of the Japanese experience of bank lending to third countries in the 1990s. And when that was withdrawn, as the Chinese seems to have been withdrawing quickly, that set the scene in the 1990s for the Asian Financial Crisis. And I wonder what kind of risks will emerge from Chinese lending withdrawal to to third countries? In dollars, I'm thinking rather than
Brad Setser 20:42
Yeah, I mean, it is one of the ironies that that China's effort to diversify its foreign assets away from the US Treasury market resulted in China using the US dollar to denominate a lot of loans around the world. So, it, it reduced the share of China's aggregate assets and treasuries, but it didn't actually reduce its aggregate use of the dollar.
Brad Setser 21:08
I think it's important in thinking about China's role as a provider of, of largely dollar liquidity to differentiate between two separate roles. One is that the Chinese banks, the same commercial banks, are they if you go by the Chinese data, they put a fair amount of hard currency just on deposit in the global banking system. It's widely thought that the large day commercial banks and the PBOC do cross currency swaps. So they give you dollars they take in yen, they hold the yen in short dated JG B's. And then the dollars are available to Japanese financial institutions to invest on a hedge basis globally. I think that's a relatively straightforward form of dollar intermediation. And if China withdraws from that role, and it causes any real disruption, you know, the US and US financial institutions can step in China's providing a couple 100 billion, I would guess in dollar liquidity in this form is not a magnitude that is so big, that it is beyond the capacity of the countries but the financial systems in the countries that are receiving though that dollar liquidity to find alternative sources, or if there's truly a lot of disruption to reactivate the Fed swap lines and have the US play the role of dollar lender of last resort, which is a role that the Fed has clearly demonstrated is is willing and able to play in moments of stress.
Brad Setser 22:42
There's a separate role that Chinese dollar lending is playing, that's providing dollars to back projects, in some cases, to back budgets in low and middle income countries. And that pullback is much much more difficult for the countries that receive those loans to manage. There is actually a shortage of funding dollar funding, both from Chinese policy lenders and the global capital markets across frontier markets, the weaker EM credits, the low income countries, which in the first instance means payment difficulties. But it also means less funds, less, less investment, fewer new hydro dams, fewer new roads, fewer grand and some people might say it's a good thing railway projects in Africa. Probably fewer natural gas power plants, but also fewer solar, big utility sales solar. So I do think there is a an issue created by a forward looking shortage of new financing, because China actually was kind of playing a useful role. They overdid it, that went too much the credit quality deteriorated. But there is a need for infrastructure funding long term infrastructure funding. But the immediate problem is that China lent money and it can't get, you know, the countries that it lent it to pay it back. And the you know, the typical structure of a Chinese policy bank loan is kind of there's an there's an Ex-Im China Ex-Im has a more concessional facility and some projects will be blended a little bit of concessional a little bit more market rate borrowing. But the bulk of China's external lending to the frontier markets to Africa to Ecuador, is kind of LIBOR plus 200, Libor plus 300, and LIBOR, it's ratcheted it up with the Fed. So that's really become quite burdensome, quite expensive. So there's this building set of debt distress that we've all seen around the world.
Meyrick Chapman 24:43
Yeah, yeah, indeed. I know you've done quite a bit of work on emerging market restructuring, and in fact, you've recently written or not, maybe not that recently, but not that long ago you wrote you wrote on Zambian debt restructuring. And I suppose as a follow on to the previous question and discussion, it's clear that there's going to be years of restructuring needed in the Global South. And it's going to be, it looks to me as if it's going to be very messy with and I think I think you would agree from what I read on your work, that there's almost every single restructuring we enter where Belt and Road lending or some Chinese lending is concerned, is going to have idiosyncratic features, which just can't be kind of rolled across different countries. So yeah, that's this is this is looks really a messy, messy situation.
Brad Setser 25:44
No, I mean, I agree. I mean, there's there's almost always a slight variation and the structure of China's exposure. But we also like, even for kind of a standard case where the loans the Chinese loans or just project loans, they're mostly from Ex-Im. And if they're not from Ex-Im, they are backed by a co short guarantee. So they would all be considered official bilateral. Even in that case, we don't have a clear template for restructuring terms that that the relevant Chinese lenders are willing to accept. The Paris Club, the traditional bilateral creditors, the big the G7, plus side of countries, G10-ish if you want to be more more accurate, more or less move to concessional lending after HIPC (Heavily Indebted Poor Countries Initiative), more or less. So for those countries maintaining concessional terms, on their exposure to low income countries, which also isn't that big after HIPC, it isn't that big of a deal.
Brad Setser 26:52
China didn't lend typically on concessional terms to low income countries. So for China to go from quasi-commercial terms (I mean they weren't market terms, but they weren't concessional) to concessional terms, which is what clearly is needed. That is a big shift for China. It's I think it's made more complicated by the fact. Now there's this little mystery it's kind of one of the things that obsesses me about where China Ex-Im and where CDB get their dollars and what interest rate they pay on their dollars. The World Bank's IDA (International Development Association) concessional lending arm is almost fully funded out of equity, not out of debt. My sense is that Ex-Im and CDB are actually funded with debt they have to pay kind of LIBOR or $1 rate on their deposits and on their dollar funding to whom Good question, but presumably, they're getting it from a domestic source and they're paying let's assume $1 funding right? And so for them to move to concessional terms would probably imply negative carry a bit of a financial loss, they've clearly been very reluctant to do it. So for the basics, there isn't a template. And then when you get into other cases, you have complexities. Budget financing from the China Development Bank in Sri Lanka, swap lines and deposits from the PBOC to recipient central banks and swap lines Sri Lanka swap line and some deposits in Pakistan. So there's there's gonna just be a continuous set of difficult issues that have to be resolved. But now there's not even a template for handling what would be the most straightforward, easy issues in part because I think, you know, the Chinese have just rejected the IMF debt sustainability analysis in Zambia.
Brad Setser 28:41
To be fair, the bondholders haven't exactly embraced it, either. It was, was a debate implies that rather demanding set of concessions from creditors. But if you until we know what China can accept, on the baseline lending project lending to a country that can't repay, that needs, concessional terms, it's going to be very hard to handle the more complex forms of China's exposure.
Brad Setser 29:12
And then they're also there. They're just cases where the Chinese have looked like commercial creditors intent on extracting dollars out of the country independent of the consequences for the country or other creditors. I mean, there was during the Ecuador program period, China took a billion dollars out because of the timing of its initial restructuring, and the steep amortization schedule on this initial restructuring. When bondholders were locked in for five years, so there's a set of kind of accumulated financial grievances which to be honest China did, did not the relevant Chinese policy banks Ex-Im/CDB did take a lot of money off the table at a time when the rest of the world was putting money in. And that's that's kind of the baseline expectation is that Ex-Im/CDB/others won't use new IMF funding, or concessions from bondholders to pull principal off the table.
Meyrick Chapman 30:20
Yeah, yeah, big worry, a big worry. Just turning to the US current account, which has been in fairly persistent deficit now for over a generation. And you once wrote, although I think it's fair to point out and you might not agree with this statement, but you once wrote that financial globalization has reduced the risk associated with the US persistent large external deficits, mostly, most, most pertinently the current account deficit. So doesn't pause or I mean, you may not, there may not be a pause in globalization, but there's certainly people who are pointing to that and saying that globalization has peaked. So does that mean that the risk associated with the US deficit has increased?
Brad Setser 31:11
Well, it is accurate that I was summarizing, I think Alan Greenspan's argument at the time, I mean, Alan Greenspan had had a view that with more globalization, you would define the size of a current account deficit, not relative to the national economy but relative to the world. And so that there would be, over time, less of a correlation between national savings and national investment, that countries with high investment needs would tap global markets, not their own savings. And countries with excess savings would lend to meet investments needs over the world. So there would be tremendous dispersion, and much bigger current account positions around the world. I think it's fair to say that Greenspan's description of the world was a little bit inaccurate at the time. What he called financial globalization as a mechanism for financing the US current account deficit, his argument, assume this kind of vast global capital market populated by private actors. Yet at that time, the big sources of demand for dollars around the world and US bonds were large state institutions; China's central bank, Japan's central bank, Taiwan central bank, the Saudi monetary agency, the Russian central bank, at the time, some of the sovereign wealth funds. So global reserve managers relation was more than funding, the current account deficit at the time wasn't actually being funded in a unfettered open market by 1000s of autonomous private actors. It was been funded by like 30 big central banks intervened very heavily to manage their currencies.
Brad Setser 33:02
So I did have a different take on that at the time. I do believe that the deficit of from like 2005 to 2008 was too big, it got to be about 5% of US GDP. It corresponded not with a big fiscal deficit, but with a deficit in the household sector. And so in aggregate, the US had not just be selling debt to the world, but it had to be selling mortgage backed debt to the world. And as we all know, a bunch of European banks got caught up in that trade, taking in dollar deposits globally, buying US mortgages, and then that blew up and became the proximate cause of the crisis.
Brad Setser 33:44
Current account deficit didn't go away. After the crisis, it did come down to about 2% of US GDP at its lows. And, and after 2014, the composition of financing shifted to Asian insurers. So a little bit more private actors, although even private actors aren't completely divorced from central banks, Taiwanese insurances I've written, were getting a lot of swap funding from the Taiwanese government. But you know, Japanese insurers, European insurers, were playing and other asset managers were like the dominant source of financing for the US current account deficit for a more modest current account deficit over a period of time, that sort of felt sustainable.
Brad Setser 34:29
But we've kind of moved into a new world in the past two years, the current account deficit expanded quite significantly over the past two years. To some degree, that's a reflection of the size of the US stimulus, and it could come back down because of the stimulus effects. You certainly see that in some of the high frequency trade data, but the Fed's policy tightening in the US cumulative borrowing actually will have a non-trivial impact on the amount of interest the US pays the world. And the dollar is current strength also should weigh on US exports going forward. So I don't expect the current account deficit to fall. And I do think we're in a little bit of a different world. I mean, there's a lot of uncertainty, a lot of it depends on the price of oil. But as I've written, the big current account surpluses now are no longer in Europe, setting Norway aside, or at least, the EU. They're in Russia, they're in the golf, there's China's surplus went up, even though oil prices went up. And so for all the talk of geo political fragmentation, the aggregate global flow of funds, which happens in much more mysterious ways, for the time being, is from the big autocracies, China, Russia, Saudi Arabia, the other Gulf monarchies to the US, the UK and India intermediated in more complex ways, through financial institutions. Because most of the big surplus countries no longer want to accumulate reserves. Now, that makes me a little bit nervous, but I can't quite identify why I'm nervous. And that's it. I'm nervous, in part because I don't understand the the chain of intermediation. And since I don't understand the chain of intermediation, I'm afraid there's a weak link. But I also am just conscious of the fact that the world isn't as fragmented as some of the political rhetoric would imply.
Brad Setser 36:40
The US and the UK may not find this comfortable, but they're relying on in aggregate, China, Saudi Arabia and China for financing.
Meyrick Chapman 36:51
Yeah, so a lot of people would find that deeply uncomfortable, I think.
Brad Setser 36:55
But that mean, I think it's fair to say that the Chinese certainly the Russians, and the Saudis also find it uncomfortable that they're financing the US in the UK, so it's it's like a new version of Chimerica use Niall's framing. But one where neither side kinda likes what the outcome is opposed to the initial argument. And this was much more of a symbiotic relationship. It's a 'we can't break free' relationship, China can't find alternatives to its export machine to drive its economy. The US remains reliant on external funding for its deficits. It doesn't have the national savings to finance, domestic investment. UK in a similar place.
Meyrick Chapman 37:38
Yeah. Changing tack a little bit. You wrote a really interesting piece for me anyway, with Alex Xetra recently about the changing impact of Japanese investors on global markets, particularly bond markets, pointing out that they've been engaged in outright sales of foreign bonds throughout last year. The Fed, the Fed seems to have comprehensively rejected the policy orthodoxy of the era following the global financial crisis. And really, it's a it's an orthodoxy, I think, has been in place perhaps for 20 years. Now, it seems like Jerome Powell just doesn't want to go down in Wikipedia as the guy who undid all the good that Paul Volcker put in place. So just thinking about the policy that may emerge in the Bank of Japan, which has now got a brand new governor, Kazuo Ueda. I'm not used to hearing him his name pronounced, so I'm not even sure I got that right. But unusually, he's an outsider at the BOJ. And also they've made some adjustments to the yield curve control recently.Although they are intervening, they are printing money, at least base money. But I just wondered what your thoughts whereas Is this a is this a potential a potential hotspot in terms of financial stability?
Brad Setser 39:23
Well, that was kind of the question that Alex and I tried to delve into in that piece. I think my bottom line is that perhaps and I don't have complete confidence in this view. But perhaps the risks to financial stability are a bit overstated. But with a big 'but' and the 'but' is that with the current constellation of US interest rates, a flat or an inverted curve high hedging cost, the Japanese bid for foreign bonds is, for US bonds, at least a lot of bonds sort of similar position is it has essentially gone away, and it won't come back.
Brad Setser 40:09
But another component of the thesis is that the market had to adjust to that in 2022. And it isn't clear, there's a much bigger adjustment in store for 2023. So I think there are two components to this argument. And I'm quite keen to get reaction from financial market participants and others to these points, because I do think whenever there's a prospect for a big shift in monetary policy regimes and a big creditor country like Japan, you have to be cognizant of the potential risks.
Brad Setser 40:45
But our argument was, was essentially as follows. A large component of the Japanese bid for global bonds was a function of the flatness of the Japanese curve, and the relative steepness of other curves. And so that's another way of saying that Japanese institutional investors buying dollar bonds or buying French govvies, OATS, were typically hedged. So they were borrowing three-month money to buy in the US case 20 year corporate bonds or 10 year French government bonds. And collecting the difference between the rate they got on longer dated exposure and taking some risk exposure. And their short term hedging cost.
Brad Setser 41:34
Though that particular trade is is to some significant degree, independent of the absolute level of Japanese yields, it's not totally independent of it. Because you wouldn't do this trade, if you could get a better return just by holding 10 year Japanese government bonds. But you did need the curves to be attractive, you needed to be able to borrow for three months, buy 20 year US US corporate bonds, and get several 100 basis points in compensation. And now with an inverted curve unless you're taking a lot of credit risk, you're not going to make money on that trade, at least on three months, six months, 12 month horizon. And there are a lot of legacy trades that were done on this basis that are now cashflow negative, but are difficult to unwind in real time because under like accounting rules, if a Japanese institution sells a bond, and that bond is underwater, it's trading price because yields have gone up is below par, they have to realize the loss from the sale. And so they prefer to take the flow cost of hedging the negative carry to realizing the capital loss from selling these instruments. So there are a set of institutions that as Alex and I interpret the data are essentially waiting until their bond or the investment trust they bought matures so they can unwind at par.
Brad Setser 43:13
But when they unwind at par, rather than trying to make money in an A flat or inverted U S curve, you know, they'll just buy 11 year Japanese government bonds and now get a little over a percent. So they're that structural bid has gone away. But it went away last year, the flows associated with that trade turn negative $200 billion negative from under a $100 billion positive. And it's not obvious that they'll get more substantially more negative. We're probably in a world where there's going to be those that pool of investments is going to be in a runoff mode. But there's a risk that some kind of financial shock could come along and a lot of institutions that are maintaining are willing to to absorb the negative carry will suddenly start unloading. So there is a risk there.
Brad Setser 44:05
The other component and our view, at least was that that is actually the majority of Japanese purchases of foreign bonds over the past 15 years is largely been a hedged trade. And you know, you can there's some technical things in the balance of payments that support that. The other component of the trade is the unhedged trade where you're just kind of naked ly going after higher yields abroad, without hedging. That trade remains attractive because dollar yields have gone up Euro yields have gone up. They've gone up more than Japanese yields have gone up. So if you're willing to take the currency risk, that basic trade, which is attractive, and even if yield curve control is adjusted, so currently, there's like it went from a cap of 25 to a cap of 50. It might go to a cap of a percentage point or 1.5. But there's very few people who think that an unconstrained Japanese yield curve would go to five, or four or three, you know, most people don't even think go to two. So if you're going to be between one and two, there's still a yield pickup, for investors buying US bonds unhedged, for buying Italian bonds unhedged, Spanish bonds unhedged. So in that sense, that component of the trade won't necessarily go away.
Brad Setser 45:32
Now, there are other people who have more, are more worried. And the argument goes more or less: there aren't many cases where pegged, or fixed prices are abandoned, or change, where the moving away from a peg that has been in place for a long period of time, didn't cause some kind of unanticipated financial risks. Larry Summers makes this argument quite frequently. And there's a good point there, Alex and I are very conscious of the fact that we may have missed something. But what we did try to do was kind of demystify, and disaggregate the flow out of Japan, and try to understand what drives different components and see if there's any single component, that it would be particularly likely to reverse in a enormously disruptive way beyond the kind of state we roll off that we're seeing now. And we didn't necessarily find it. But I mean, I am conscious that you know what we don't know.
Meyrick Chapman 46:34
Yeah, yeah. And speaking of what, I don't know,
Brad Setser 46:40
is the kind of thing that you in your old world, we're all used to have, like, you know, obsessive about since you got
Meyrick Chapman 46:44
Yeah, that's right. Yeah. But we were used to obsessing about phantoms usually. But I also wanted to ask you, perhaps as a parting question of what, what am I, what have we not touched on that actually does worry you. So if Japan doesn't particularly worry, but maybe if some unknown unknown pops up perhaps it should be but what what does worry does occupy your your thoughts?
Brad Setser 47:18
I guess there's a couple of different sets of risks that I guess I got, I think there are three big risks that I worry about. I don't have probabilities that I assigned to any of them, but they're just kind of shocks that I feel that are out there, that could be disruptive.
Brad Setser 47:43
One. And you know, so far, this risk hasn't materialized the implementation of the EU's decision to stop importing Russian oil. And now Russian product has been relatively smooth. And the result has been pretty much the desired result that the the oil still flows, it just flows along longer routes at higher cost to Russia and Russia gets less money. But I there's a part of me that is that continues to worry that there may come to be a time when Russia takes as a "I'll hurt myself, but I'll hurt you more" kind of move, not a purely economically rational move, that Russia takes several million barrels of oil and product a day off the global market, doesn't sell to India, doesn't sell the Turkey and really causes a scramble for barrels. And does so to kind of just add to the pressures around those countries who are providing support for Ukraine. So it's just a risk that I'm aware of i It hasn't materialized I have no reason to think it will materialize in the near term. But it is one of the things that does worry me, we still need Russian oil.
Brad Setser 49:02
Russia needs the export proceeds to but in a world where threats of escalation could play a role in the future evolution, hopefully towards some kind of eventual fair, just negotiated settlement that involves the withdrawal of Russian troops. That just it's just a risk that's out there.
Brad Setser 49:27
So the second one is I think there are a set of more systemically important emerging economies. So bigger in the financial sense than Pakistan that have large underlying vulnerabilities. Most notably, they have negative net reserves, all the reserves are borrowed, whether from their domestic banks or from foreign friends. So the Central Bank of Egypt has more liabilities than it has liquid foreign assets.
Brad Setser 50:00
The government of Egypt has a non trivial stock of public debt as well. Egypt is getting by on modest amounts of IMF financing in the expectation of future Gulf inflows. But Egypt in my view is not financially able to stand on its own, and probably won't be for three or four years, even in a good scenario. So that does worry me. I don't know that Egypt on its own, is big enough to generate a major shock. But it is, it is a risk hanging out there.
Brad Setser 50:35
And then Turkey just it's much bigger. You know, Erdogan has conjured up a lot of funding over the past 12 months, he seems to have more lined up to get through the election. But the Central Bank of Turkey just kind of its net international liquidity position just gets worse and worse. Tremendous amounts of foreign exchange, have been lent by the domestic Turkish banking system to the central bank, central bank has also gotten swaps from its strategic partners. Those swaps aren't terribly usable, they just inflate gross reserves. Now it's getting deposits, which are much more usable. The Government of Turkey is now placing euro bonds with its strategic partners to raise money. But there's an underlying current account deficit. As we all know, Lira rates are wildly negative. A normalization of rates would put some stress on the banking system. So there's no easy way out. And Turkey is a big economy. It's a big, financially unstable economy. And while it has been more resilient than anyone could have anticipated, and that the willingness of Turks to keep money in their domestic banking system, whether in FX deposits or FX linked deposits is a great source of stability. I do think that at some point, Turkey will hit limits, and that could be a source of risk.
Brad Setser 52:01
The other risk I always worry about is that I find China to be macro economically unstable. It's national savings rate is 45% of GDP. Maybe that was inflated a bit by the pandemic, but it's been 40 for a long time. And countries that save 40% of GDP either invest like crazy, which has been the Chinese model after the global financial crisis are one insanely big current account surpluses. Insanely big! Like, Singapore saves 45% of its GDP and runs at 20% of GDP current account surplus, the world will not cannot accept a 20% of GDP Chinese current account surplus it can accept 10% of GDP Chinese current account surplus when you kind of work through the mechanics. Yet, it isn't clear to me that there isn't pressure inside China as investment comes down to move towards an equilibrium that has an even higher current account surplus, an even bigger trade surplus, even more global dependence on China for manufacturers. So until China has structurally recalibrated its economy, so that it saves less, and doesn't have to rely either on a big trade surplus or kind of artificially juiced investment. I worry, and the concrete manifestation of that is that I and I'm way less worried right now, because of the dynamics around reopening sort of some positive momentum in the short run in China. But when China's stalls, I always worry that we could wake up and China will want a 10 or 20%, weaker CNY with consequences throughout East Asia. And that that becomes an additional source of geopolitical tension quite quickly.So that is another risk. It is a risk I have long worried about, but I haven't stopped worrying about.
Meyrick Chapman 53:57
Yeah, some pretty significant risks.
Brad Setser 54:00
And I'm sure there's undoubtedly some other ones out there. And, you know,
Meyrick Chapman 54:05
Yeah, it's somebody described to me that the people in who inhabit our world are simply continue climbing everyday the wall of worry. So this is the business part now, you know,
Brad Setser 54:17
Because if you if all you do is worry and just sit on cash usually don't make money, but right now, you kind of can kind of do
Meyrick Chapman 54:22
Yes, and has been for some time. This has been this has been tremendous, Brad, and thank you very much. And I hope we can catch up some other time. So thank you very much for taking part.
Brad Setser 54:36
You know, um, thanks for the invitation. It's been a lot of fun. And nice title for a podcast, by the way.
Brad Setser 54:42
Um,
Meyrick Chapman 54:44
Thanks.
Exorbitant Chat: Episode 3, Brad Setser