Not just emerging markets

Dani Rodrik:

"Foreign borrowing can enable consumers and governments to live beyond their means for a while, but reliance on foreign capital is an unwise strategy. The problem is not only that foreign capital flows can easily reverse direction, but also that they produce the wrong kind of growth, based on overvalued currencies and investments in non-traded goods and services, such as housing and construction."

Rodrik was writing about the challenges facing developing countries looking for strong, sustained growth. But it is hard not to hear echoes of the United States experience over the past several years in his description. The influx of foreign funds that financed the widening of the US trade deficit during the last cycle clearly financed more than its share of "investments in non-traded goods and services, such as housing and construction."

The combination of low US rates and the depreciation of the dollar and the renminbi from 2002 to 2005 led to a surge in investment in tradables production in China -- China’s exports rose from around $270b in 2001 to over $1400b in 2008, a truly stunning increase that required enormous investment -- and a surge in residential construction and household borrowing in the United States.

The unique feature of the United States’ foreign borrowing is that the United States was borrowing, in no small measure, from other countries governments. Especially Asian central banks resisting pressure for their currencies to appreciate and the treasuries of the oil-exporting economies. Yes, there was a lot of borrowing from entities in London, but a lot of those entities themselves borrowed from US banks and money market funds. They weren’t generating large net inflows. And all the net inflow from the emerging world came from their governments, not private investors.*

That insulated the United States from the kind of capital flow reversals that traditionally plague emerging economies. Central banks have provided the US with more financing when private flows have fallen off, keeping overall flows (relatively) stable. That was especially true in 2006, 2007 and early 2008 -- back when private money was pouring into the emerging world. And it seems true once again. The strong rise in central banks custodial holdings at the Fed in May is almost certainly offsetting a fall in private demand for US assets. That is why the custodial holdings are up and the dollar down. Paul Meggyesi of JP Morgan, in an interesting note today:

"Central banks which control their currencies against the dollar are in some sense forced to take the opposite side of private trade and capital flows ... we are [currently] witnessing is a resumption of both global trade flows and risk-taking by US investors, who are re-entering those foreign markets which they were quick to exit as the global economy sunk last year. The result is that the US private sector balance of payments is deteriorating. Central banks are attempting to offset this by buying a greater quantity of dollars ... "

The United States benefits from this pattern, to be sure. It hasn’t faced the kind of destabilizing swings in net capital flows that other large borrowers have encountered.

But this stabilization has a price. It has left countries like China holding more dollars than they really need (or want). That itself is a risk, as the markets increasingly realize. Especially now that private money is now almost certainly flowing back into China, forcing China to add to its-already-large (too large) dollar stockpile.

And -- at least in the past -- it also allowed the US to avoid necessary adjustments. It, for example, is one reason why the housing and construction and consumption boom went on for as long as it did.

*The IMF’s data on this is clear. Private investors were moving money into the emerging world not out of the emerging world. This is especially clear if you adjust the 2006 data for the surge in "private" outflows from Chinese state banks investing SAFE’s money abroad. The outflow from the emerging world was all an official flow, and the magnitude of the official outflow exceeded the emerging world’s current account surplus.