Brad Setser is a senior fellow for international economics at the Council on Foreign Relations, where he works on macroeconomics, global capital flows, and financial crisis issues. Brad has previously served as the deputy assistant secretary at the U.S. Treasury, working on Europe’s financial crisis, currency policy, financial sanctions, commodity shocks, and Puerto Rico’s debt crisis, and was the director for international economics on the staff of the National Economic Council and the National Security Council. As a returning guest to the show, Brad joins Macro Musings once again to discuss dollars swap lines and other solutions to the global dollar shortage, the recent implications of COVID-19 on global trade imbalances, and how China should respond to the effects of this crisis.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Brad, welcome back to the show.
Brad Setser: Hi, it's great to be back on.
Beckworth: Yes, very different circumstances. We were talking before the show got started how in the previous time we were together, we got to do a show, go to lunch, it was casual, it was fun. Very different circumstances. You are holed up in New York City, is that right?
Setser: I am, yes.
Beckworth: Yes, and I'm here holed up in my home base in Nashville. I commute between Nashville and DC.
Setser: I didn't know that.
Beckworth: Yeah, yeah. So I spend two weeks a month in DC, and I work two weeks from home, but obviously now I'm stuck in Nashville. It’s been great in terms of spending time with the family, a whole lot more pick-up basketball games, football, catch, trash talking my kids, but other than that, it's working from home. But how are you holding up in New York City, you are in the epicenter of the virus outbreak in the U.S.
Setser: Not only is New York now the epicenter in the U.S., it's arguably one of the epicenters globally. So far I've been able to stay relatively safe, but I'm also being very cautious.
Beckworth: Yeah. Is it easy to get food, supplies like that? Have you found that challenging?
Setser: It's still possible, I think the line for electronic queues for grocery deliveries are getting steadily longer, but no real difficulties.
Beckworth: Okay. Well we're glad to hear that you are doing well despite the challenges that you face. And we're happy to get you on a show, because we have been talking about on previous shows, which have all focused on this pandemic, COVID-19, they've all been talking about the challenges, the issues, the policy responses. And one of the big policy responses the Fed has done is to open up and extend the dollar swap lines, as well as set up a new repo facility for foreign central banks.
Beckworth: And I want to drill down into that, because we've touched on it in previous shows, but we haven't spent a lot of time really fleshing it out, what it all means. And you had a great article that I'm going to use to motivate our discussion today. And that article was titled *Addressing the Global Dollar Shortage: More Swap Lines, A New Repo Facility for Central Banks, More IMF Lending?* Now this came out before the Fed actually established its new repo facility for central banks, so either you were prescient or influential, maybe they were listening to your work, but you're the perfect person to talk about this as we get into the show.
Beckworth: And I want to begin by reading something from Claire Jones, who writes for Financial Times at FT Alphaville. She had a great opening to a piece that she wrote on this topic. And it's a great way to start this conversation off. And she says, "The global financial crisis should have served as a salutary lesson in the dangers of dollar dominance in global finance. It didn't. Over the past decade, the volume of dollar loans to, and dollar denominated debts issued, by companies outside the U.S. has continued to balloon." Then she goes on to highlight the BIS numbers, 12 to 13 trillion dollars outside the U.S. You can also add to that some dollar liabilities issued in the U.S. to foreigners. You can come up with a pretty large number of dollar denominated liabilities held by foreigners outside the U.S.
Beckworth: So this is a big deal, and I want to begin by noting some of the similarities and differences, kind of a bird's eye view. We'll come back to maybe a granular level near the end of this discussion, but you start off with this great observation that in many ways the demand for dollars, the rush for dollars now, was similar to 2008, but in some other ways is very different. So maybe you can kick the conversation off by highlighting those differences and similarities.
A Rush for Dollars: Similarities and Differences to 2008
Setser: Sure. I think the basic reality for many years has been that the dollar is used to denominate a lot of assets and a lot of liabilities all around the world. So trade finance between India and Africa may well be denominated in dollars. And a lot of banks around the world, and increasingly asset managers, have tried to make money by running matched dollar books. So they borrow dollars, they lend out dollars, they try not to have a currency mismatch, but they act as dollar based intermediaries. And a lot of those dollar based intermediaries are not American banks or American financial companies.
I think the basic reality for many years has been that the dollar is used to denominate a lot of assets and a lot of liabilities all around the world.
Setser: We learned this in the global crisis, because there were a number of large European banks, in particular, that had been taking in dollars and then using the dollars to buy mortgage backed securities, typically, but also other kinds of asset backed securities. Now some of those dollars they got from big central bank reserve deposits, some of those deposits they got from their corporate clients around the world, some of those dollars they got by issuing dollar denominated bonds. But some of them they got by borrowing short term money from U.S. money market mutual funds, and some they got through cross currency swaps. So if you have euros, you can swap those euros for dollars, and then you lend out the dollars or buy dollar backed or based assets.
Setser: Going into the global financial crisis, a lot of European banks had been making a lot of money by running big dollar books. They didn't hold a lot of equity capital. And when the value of dollar mortgage backed securities started to fall, some of their creditors lost confidence and started to pull their deposits, their commercial paper, their funding sources, out of those banks. That posed a problem. It posed a problem for those banks, but it also posed a problem for the United States, since these intermediaries were part of the U.S. financial system. They were issuing commercial paper to U.S. money market funds, and buying U.S. asset backed securities.
Setser: So while technically European banks, they were a part of the U.S. system. And so in the crisis, the Fed opened up facilities, the term auction facility, that European banks could use, and did use. They were some of the biggest users, that only came out after the crisis.
Setser: And then over time, the Fed realized that, "Hey, we can provide dollars to the European Central Bank, the Swiss National Bank, the Bank of England, and then those entities, their home central banks, can provide a dollar lender of last resort to these institutions." That was the origin of the swap lines in the crisis.
Setser: Now I think two things have changed since 2007 and 2008. And I sort of modestly disagree with Claire Jones here, because I think the European banks and European bank regulators, to a degree, did learn some of the lessons from 2008. So European banks have smaller dollar books now, and those dollar books are funded from more stable sources. So there's less reliance on the part of European banks. Not no reliance, but less reliance on cross currency swaps and commercial paper bought by U.S. money market funds.
Setser: But other financial institutions around the world, and judging from the work of the BIS and others, Japanese banks in particular, but also Canadian banks, have significantly increased their dollar lending, and they've often financed that dollar lending through either the cross currency swap market or, for Japanese banks, through repo in the U.S., and the U.S. banking system.
Setser: So in some ways, you can say the dollar funding need has migrated from its European epicenter in 2008 to a new epicenter, which is in East Asia and Japan, in particular.
Setser: The second important change is that over time, with zero rates around the world, and the corporate savings glut in East Asia, Asian insurance companies, and to a lesser degree European insurance companies, started buying more and more U.S. corporate bonds. And in order to limit their currency risk, they typically hedge those bonds. And by hedging, they would enter into the cross currency swap market for hedges. And while there are some differences, the basic economic structure of that investment is that the insurance company is borrowing dollars short term, they're technically swapping it, but by swapping, they obtain dollars and they have to roll over those cross currency swaps every few months, and then they bought longer dated U.S. corporate bonds. So that replicated some of the basic risk in dynamics that were present in the European banks, but in a set of institutions that aren't called banks.
Setser: I don't really like calling them non-banks, because that's too broad. The center here is clearly the insurers, and then a set of asset managers in Asia, which are managing insurance money, and managing pension funding. And then a little bit in Europe, but I think it's really a phenomenon concentrated in Asia.
Setser: Now don't forget that there's all of these dollar denominated trade finance, all this dollar denominated project finance, that is also supported through these dollar funding markets throughout the world.
Beckworth: Okay. Very interesting. So just to summarize, the two big changes or developments that you see, one is the epicenter of the dollar needs has migrated from Europe to Asia more, with some residuals still in Europe. And then the nature of the dollar funding needs are more in the non-financial corporate sector, with some banks still needing it as well.
Beckworth: Something else that I learned preparing for the show is that the growth of these dollar liabilities outside the U.S., at least according to BIS data, that most of it ... And this is implicit in what you've just talked about, most of it is due to advanced economies. So it's easy to think, if you have a look at the data, that maybe it's the emerging markets who are wanting all these safe assets, dollar denominated assets. But really, most of the growth in that BIS series, looks like it's coming from advanced economies. Europe in 2008, now Asia, Japan. Is that right? And what does that tell us about this global dollar cycle?
What Demand for Dollar Denominated Assets Tells Us About the Global Dollar Cycle
Setser: That's broadly right. I mean there's different categorizations for Korea and Taiwan. I tend to think that they belong among the advanced economies.
Setser: But I think on the insurance side it's Japan, Taiwan, Korea, a little bit Thailand, a little bit Europe. And then on the banking side it's Japan, still significant amounts in Europe, but a little bit more balanced. Canada. Korea plays a small role there too. But in general, the biggest dollar based intermediaries are financial institutions and more advanced countries with more sophisticated financial systems, and often they’re creditor countries. There are countries that act in the global financial system as lenders, rather than as borrowers.
But in general, the biggest dollar based intermediaries are financial institutions and more advanced countries with more sophisticated financial systems, and often they’re creditor countries. There are countries that act in the global financial system as lenders, rather than as borrowers.
Setser: There are a lot of emerging markets that are still borrowers. Turkey, famously, South Africa, Colombia. But they don't tell to have the kind of short term need to raise dollars for their financial institutions, so their financial institutions can buy U.S. assets. They tend to borrow dollars long term through the sovereign bond market or through the corporate bond market.
Beckworth: Okay. So Brad, as you look at this development over the past few decades, do you see this as becoming more pronounced? Is dollar funding needs becoming a bigger part of our global economy?
The Future of Dollar Funding in the Global Economy
Setser: That's a complicated question. There was a really large run up in dollar funding needs, ahead of the global financial crisis, because there was so much European, largely European demand for U.S. relatively safe, or thought to be safe, U.S. securities. And so European banks, in a sense, were intermediating between, to simplify a little bit, the United States borrowing need at that time, we were running quite large current account deficits. And reserve managers around the world, who were building up lots of dollar reserves.
Setser: Now those reserve managers wanted a safe place to put their dollars and they wanted a little bit of yield, and there weren't actually as many treasuries available then. So they often put their dollars on deposit in European banks. And then European banks would take dollar credit risk. So that was the dynamic, and there was big run up, and then after the global crisis, there was a fall.
Setser: There's been a second run up that's really, in my view, started in 2014 or so, tied to Asia's search for yield, as Korean, Taiwanese, and Japanese banks, and insurers, couldn't get the kind of return they wanted in their home market. Remember, Japan's had zero interest rates.
Setser: And the Bank of Japan has been buying more Japanese government bonds than the Ministry of Finance was issuing. So the insurers needed some place else to put their money, and the banks in Japan, they couldn't make money lending to Japanese companies. Japanese companies are sitting on a lot of cash, they're not borrowers. So Japanese banks started running bigger dollar books, because that's there they could make money, particularly because U.S. companies were willing to borrow, to do buybacks in some cases, U.S. private equity companies were willing to borrow to take companies private, and so on. And then Asian insurers who couldn't invest in their own market, there were not enough assets looked abroad for yield. And you would get hedged yield in the United States. And so you really see a significant run up in these exposures in the last five years.
Setser: But I don't think it's a constant story. I think there have been periods of buildup, where risk has built up through these structures. And unfortunately, we went into the COVID-19 pandemic after a period where risk had been building up.
Beckworth: Okay, let me phrase my question this way. Is there any reason to believe the footprint of the dollar will retract, get smaller, or will this crisis just further its reach, its scope, its ability for the Fed to influence global economic conditions, or the dollar at least to influence global economic conditions?
Setser: I don't think the dollar's going to cease to be an important global currency any time soon. I think whether the reach of the dollar is to some degree a function of characteristics of the U.S. economy? We still run current account deficits, our companies have wanted to borrow money, and to some degree, it's a function of policy choices that have limited the reach of possible competitors. And I don't think that's really about China. China is not yet a competitor in the financial sense. I think that's really about the ways that Europe has limited the global reach of the euro by not providing the kind of safe asset that is provided by the U.S. Treasury, and to some degree it’s been a self-reinforcing cycle, where European banks act globally in dollars, because they can, and because they can make more money lending in dollars, than they can make money lending in euros at home.
I don't think the dollar's going to cease to be an important global currency any time soon.
Setser: So to a degree if the crisis leads to big changes in Europe, you could imagine a world where a lot of these global banking functions are carried out, not exclusively in dollars, but more a mix of global currencies. But I don't forecast that happening. But it is a possible future.
Beckworth: Yeah. I look at the fact that the Fed has opened up all these new dollar swap lines. So it extended to other countries, some emerging markets. It also has this new repo facility for central banks. In my mind, what the Fed effectively has done is its sent a signal that says, "Look, any time there's another crisis like this in the future, these effective branches of the Federal Reserve will be opened up again for business." And I wonder if that kind of implicit understanding sends a signal to businesses, to investors around the world, that it's okay to have more dollars on your balance sheet. So you know, for example, if I'm in Argentina and I want to take out a mortgage that's funded by dollars because it’s got better financing terms, I'm more likely to do that, because I know if push comes to shove, there'll be a dollar swap line or some way for my government to get access to dollars easier than before.
Beckworth: I'm just wondering if these moves which are very important, further solidify the reach of the Fed.
So to a degree if the crisis leads to big changes in Europe, you could imagine a world where a lot of these global banking functions are carried out, not exclusively in dollars, but more a mix of global currencies. I don't forecast that happening. But it is a possible future.
Dollar Swap Lines and the Future of the Fed's Policy Reach
Setser: Look, in the short run, the Fed has avoided a disaster. And in the process, saved some countries and some institutions from the consequences of relying on dollar funding when their central bank can only supply limited amounts of dollars.
Setser: In some cases, hey, let's be honest, Japan, Taiwan, Korea, they're sitting on a lot of reserves of their own. They would have been in a position to support their own institutions, but without these kinds of facilities, they would have had to have sold treasuries and agencies to do so, and that would have added to the selling pressure in the Treasury and agency market. Which is something the Fed frankly didn't' want.
Setser: So I think there is some risk that whenever you provide short term funding or liquidity, you protect institutions that were overly reliant on those forms of funding from the full consequences of those decisions. But I think if you're worried about that risk, the time to address it is after the crisis. And the way to address it is through tighter regulation of the Asian life insurers, the Japanese banks and their dollar books, and the like. I don't think the Fed could, essentially, let things rip abroad to punish people for their global use of the dollar.
In the short run, the Fed has avoided a disaster. And in the process, saved some countries and some institutions from the consequences of relying on dollar funding when their central bank can only supply limited amounts of dollars.
Beckworth: No, I completely agree with that, Brad. I'm thinking long term too, here. Just the long term consequences. We're in the middle of a war, you have to make decisions, you have to face the immediate risks. And so I completely support the Fed's actions, I think they were warranted. In fact, I've had discussions with guests prior to the crisis where we've called for the Fed setting up these dollar swap lines. It just seems like the possibility is there, that the Fed may find itself more powerful than ever in the future, because more dollars are being used. And the Fed itself will face attention, because it has domestic mandate, but it has a global reach, and that global reach may have just strengthened. But we'll see afterwards. And as you said, there may be ways to actually solve this through regulation.
Beckworth: Let me ask a related question, but slightly different. How do we know when there is a dollar funding crisis or need? What indicators do we look at to tell us, "Oh boy, time for the Fed to turn on the switch for these dollar swap facilities?"
What Indicators Point to a Dollar Funding Crisis?
Setser: Look, I think the most straightforward is the cost of swapping for dollars, which is called the cross currency basis. So in normal states of the world, if you're a Japanese institution and you want dollars, the price of getting those dollars is very low. It's not zero, you have to pay a bit, but U.S. institutions ... And there's this confusion because it's called the cross currency swap or an FX swap, but from the provider of the dollar's point of view, you're just getting a dollar return. And you're lending out a dollar, you'll get the dollar back in three months, and in the interim, you're holding the foreign currency and you invest the foreign currency in a safe government bond. And you essentially take no risk. But when there's a shortage, the price of swapping for dollars goes up. And so when that starts to spike, that's a sign.
Setser: And then there are the standard measures of cost of dollar borrowing. Because the institutions ... Yes, swaps are efficient, but at the end of the day if you want a dollar and you're a Japanese bank, there are other ways of getting dollars. So if you can't get a dollar by swapping a Yen for a dollar, you can go out in other markets and try to borrow a dollar. So you start to see that the interest rate on dollar borrowing rise relative to yields on safe assets or relative to the Fed's target rate. Which makes things a little bit more complicated right now, because there are all sorts of other pressures on the banks, and there are all sorts of other pressures on government bond markets.
Setser: So in that context, the precise way you measure the funding stress matters. But essentially, you measure it through the way you would measure any type of financial markets trust, through your interest rates differentials. I think the other measure is how quickly the Fed swap lines were taken up. There's now close to 400 billion outstanding, which suggest that ... It's a couple days ago. Which suggests that this responded to a real need.
The precise way you measure the funding stress matters. But essentially, you measure it through the way you would measure any type of financial markets trust, through your interest rates differentials.
Beckworth: That's a great point. The demand's there for those dollars. Let me throw a third possibility out there. How about looking at the broad dollar index? Like on a daily frequency? That should tell a similar story, shouldn't it?
Setser: Yes and no. I think there has been a correlation between indicators of dollar funding stress and the dollar, broad price of the dollar, but I do differentiate a little bit between borrowing a dollar, which is what you're doing through a cross currency swap, and buying a dollar, which is what you're doing in the FX market. Technically, if you're a Taiwanese insurer, holding dollars already, and you wanted to hedge, what you want to do is borrow a dollar, hedge without a derivative, hedge straight up. You would borrow a dollar and then sell the dollar to buy Taiwanese dollars.
Setser: So I think we've seen two things which are both indicative of stress in the global financial system. During the most intense phase of financial stress, there was pressure on the dollar funding markets, and there was also a bid for the dollar. It is possible those are correlated, or there's a causal relation, but I also think it's possible that that's just a correlation.
Beckworth: Okay, fair enough. Let's move to your proposal which became reality. Walk us through what you see as the fixes for these dollar shortages. So we see some of them in place already, but you had a third option down at the IMF. I think you had three main items. You had the dollar swap lines, the standing repo facility, and then the IMF getting creative as well. So maybe walk us through that list, and if there's anything I left off, you can add that on too.
Brad's Proposal on How to Fix Dollar Shortages
Setser: Sure. So I start from the point of view that there are different kinds of dollar needs in the global economy. The needs of Taiwanese insurers are different than the needs of Turkish banks. And those differences need to be reflected in the way dollars are provided to the global economy.
Setser: The Fed did go into the pandemic with standing swap lines, with a narrow set of advanced economy central banks. And it was obvious that those swap lines would be activated. And the Fed made the ... Priced that in an attractive rate. It didn't view them as something that countries and their financial institutions should shy away from using. The Fed lowered the price in order to try to expand take up.
Setser: I also said, and the Fed subsequently did this, that the broader set of countries that received swap lines in 2008, which importantly, include Mexico, Korea, and Brazil, should receive swap lines again. I don't think that was terribly controversial, because these countries had already qualified once. In most cases, they have strong political relationships with the Federal Reserve. And the Federal Reserve understands the monetary policy frameworks in these countries, and is comfortable holding these countries' currency as collateral, which is what you do in a swap.
Setser: The extension that I proposed, was that the Fed ... And this was something that was discussed back in 2008, it's an idea that's been floating around for a while, was that the Fed should also offer a repo facility for those central banks that have substantial amounts of dollar reserves already. And thus, don't obviously need a swap line. The most obvious case is China, but the same basic point applies to Taiwan, to Hong Kong, to India, to a number of large central banks in Asia, which are sitting on very large quantities of dollar reserves, and hold a lot of treasuries. And in a crisis, you don't really lend out a treasury, you lend out a dollar. So a repo facility is a way for allowing these countries' central banks to get a dollar directly from the Fed, rather than get a dollar from the U.S. banking system.
The extension that I proposed was that the Fed should also offer a repo facility for those central banks that have substantial amounts of dollar reserves already. And thus, don't obviously need a swap line.
Setser: At a point in time when the U.S. banking system is under a lot of under stress, bank balance sheets are expanding, and the banks, to be honest, probably didn't want the business, unlike in normal times. And the Fed didn't really want the central banks of countries like China or countries like Taiwan, to be selling their treasuries or agencies into the market at a time when a lot of private investors were selling treasuries to try to raise cash.
Setser: So a repo facility was just a way for the Fed to directly lend dollars to a set of large central banks, who had no shortage of treasuries. The U.S. is taking, essentially, no risk. It is providing dollars against the safest of all U.S. assets, a U.S. treasury. And because of that, at least in my view, it would be possible to expand the set of countries that could access this facility, including to sets of countries where the U.S. may be, for a range of reasons, less comfortable accepting that country's currency as collateral.
Setser: But that only works if you've got a lot of reserves already. So it doesn't work for those countries that went into the crisis with too few reserves. And for those countries that went into the crisis with too few reserves, seems to me that the logical place for countries to get reserves is the IMF, which was set up as an institution to lend reserves to countries in need.
Beckworth: But who would they be? What are some examples of those countries?
Setser: Well the obvious one is Turkey.
Setser: But I think South Africa, Colombia, in some circumstances, because the Fed swap line with Mexico is limited in size.
Setser: And because the swap line is really meant to provide short term funding to financial institutions. I think you could imagine circumstances when Mexico might draw on its existing credit line with the IMF.
So a repo facility was just a way for the Fed to directly lend dollars to a set of large central banks, who had no shortage of treasuries. The U.S. is taking, essentially, no risk. It is providing dollars against the safest of all U.S. assets, a U.S. treasury. And because of that, at least in my view, it would be possible to expand the set of countries that could access this facility, including to sets of countries where the U.S. may be, for a range of reasons, less comfortable accepting that country's currency as collateral.
Setser: If you think more broadly, there are a lot of smaller oil exporting economies that are going to need dollars. And Lebanon is facing a huge financial crisis, and if the Lebanese government could reach political consensus on the need to borrow from the IMF, it clearly has a need. So I think there's quite a large subset of countries that would potentially be looking to borrow from the IMF.
Beckworth: So you could catch all the countries, no one would fall through the cracks, either through the currency swap lines, the new repo facility for central banks, or the IMF. Does the IMF have a big enough balance sheet to support those countries that don't make the first two facilities?
Setser: The IMF does have a substantial pool of uncommitted resources right now, several hundreds of billions of dollars. The IMF was scheduled to double the size of one of its back up facilities, the new arrangement to borrow from a little over 200 billion to a little over 400 billion at the end of this year. There's no particular reason why that couldn't be pulled forward. The necessarily approval in the U.S. from Congress has already been obtained.
Setser: The plan was that when the new arrangement to borrow increased in size, the backup, bilateral credit lines that the IMF now has, would fall in size. And Ted Truman of the Peterson Institute, a former U.S. Treasury official, suggested keeping those bilateral credit lines at their current size even as the new arrangement to borrow doubles in size. And if you did all of that, I think the IMF's lending capacity would truly be close to a trillion dollars.
Setser: So there is substantial scope for the IMF to provide a decent quantity of credit. And if you combine the resources of the IMF and creative use of the World Bank's balance sheet and the balance sheets of the multilateral development banks, I think you can mobilize the need of financing. The hard part comes from countries that went into this with too much debt. The IMF and World Bank are set up to lend you money, but they're also set up to assure that they get repaid. And there are some countries which may have an immediate need for cash to make up for, say, a fall in oil export proceeds, or a fall in remittances, or a loss of tourism income, combined with an increased need to spend on public health, that aren't in a position to take on more debt. And those countries will need some mix of concessional finance [inaudible].
If you think more broadly, there are a lot of smaller oil exporting economies that are going to need dollars. So I think there's quite a large subset of countries that would potentially be looking to borrow from the IMF.
Beckworth: Okay, so given the dollar swap facilities, the new standing repo facility for central banks, and the IMF facilities, we've got everyone covered. So the next question would be: What if this COVID-19 pandemic crisis continues longer than we thought? So what if we're not over by the end of the summer or there's a second flare up in the fall? Do we reach a point where we've stretched to the capacity of these institutions to provide liquidity to the global economy?
Setser: Well, the Fed is under no real constraint, so you could, in that circumstance, imagine the Fed's swap lines being continued for a longer period of time at some point, but I don't think it would be this fall. You might need to take additional measures to expand the IMF's lending resources. But I think the real issue, then, is less financing, and more the persistent slowdown in overall activity.
Beckworth: Okay. Well one of the things we've talked about earlier is the lasting legacy of these new facilities from the Fed, and I'd like to take that question more broadly. What do you think the lasting legacy of COVID-19 will be, particularly as it relates to global imbalances? So we had this discussion last time you were on the show about the state of global imbalances, and back then you discussed how its changed from ... The early to mid-2000's there was more a concern about China, it’s shifted over to Europe, Germany running large current account surpluses. So maybe summarize for us the state of global imbalances coming into the crisis and what, if any, changes you see coming out of it?
The State of Global Imbalances Before and After the COVID-19 Crisis
Setser: Well, I would say, going into the crisis, both Europe, really Northern Europe and Asia, really northeast Asia, were running substantial ... And by substantial I mean over half a trillion dollars current account surpluses. So building up foreign assets to that tune, running trade surpluses of that magnitude. And then main counterpart to that was the United States, to a lesser degree other parts of North America, although Mexico actually was swinging towards surplus because of its own economic slowdown even before COVID-19, and some emerging economies. Turkey, India, Indonesia, South Africa.
Setser: The immediate effect of COVID-19 is a contraction in trade, it's not a shift in the pattern of imbalances. So it is quite possible that surpluses and deficits on both sides will shrink, simply because there's less trade. I don't think we know that for sure, but I think that's a realistic possibility.
The immediate effect of COVID-19 is a contraction in trade, it's not a shift in the pattern of imbalances. So it is quite possible that surpluses and deficits on both sides will shrink, simply because there's less trade. I don't think we know that for sure, but I think that's a realistic possibility.
Setser: But then you start trying to think through the effect of having different components of trade shrink at different paces. So think of tourism. Tourism relies on travel and raises your risk of contracting an infectious disease, raises the risk that if you contract an infectious disease, you'll be far from home and have difficulties accessing medical care. So it's relatively obvious that tourism is going to face a much longer and more persistent shock. And that has some predictable effects. Net tourism exporters will face a shock, while net tourism importers will see an improvement in their balance of payments. And a lot of the net tourism importers already have substantial current account surpluses. I'm thinking of China, of course. Germany too. Germany tourists are well known throughout Southern Europe in the summer.
Setser: And then you have probably the biggest effect. We don't know how long it's going to last or how persistent it's going to be, but there's been an enormous fall in oil prices and a big reduction in demand for oil, which has, again, fairly predictable effects. Right now, a lot of oil exporting economies are on track to go into current account deficits, and the big oil importing economies, so that includes Europe, but almost all the north Asian countries too, will see an improvement in their commodity balance. So that should push up, in my view, the current account surplus over time of a country like China.
Setser: We don't know how persistent the dollar's strength is going to be. Right now the impact of the dollar's strength on trade is minimal, because trade is minimal. But if the dollar stays strong after the crisis, that would tend to raise the U.S. trade deficit. But I suspect that increase would conflict with the range of political and economic security imperatives, which will call for, and rightly, greater reshoring of the production of pharma critical, medical, and other equipment. And so I think that will introduce another set of pressures on the global system.
Setser: Right now, I think it's a little early to forecast how those pressures are going to play out. I think it's easier to forecast the impact of tourism and commodity shocks.
We don't know how persistent the dollar's strength is going to be. Right now the impact of the dollar's strength on trade is minimal, because trade is minimal. But if the dollar stays strong after the crisis, that would tend to raise the U.S. trade deficit. But I suspect that increase would conflict with the range of political and economic security imperatives, which will call for, and rightly, greater reshoring of the production of pharma critical, medical, and other equipment. And so I think that will introduce another set of pressures on the global system.
Beckworth: So you think there might be a small dialing back of globalization in short? Some onshoring of key industries in the U.S.? For example, you mentioned tourism might take a hit. But do you think globalization in general is going to be reconsidered? Or just on the margins?
Effects of the Crisis on Globalization
Setser: I honestly think it's too early to say. I think my base case is aspects of globalization will be reconsidered. There'll be reluctance to have full supply chain dependence on one country, like China. So that will create pressure for more regional supply chains. Whether that leads to something, even more fragmentation than falling back on existing economic regions, is an open question, in my view.
Setser: And then I think there are aspects of today's globalization that I hope will be challenged, and I'm not yet confident that there's enough political pressure to do so. And by that I'm thinking of the least savory, in my view, aspect of today's globalization, which is the ease with which multinational companies can shift the profits on their intellectual property to low tax jurisdictions, and in many cases, that leads to more trade. The U.S. exports pharmaceutical intellectual property to the Caribbean, the subsidiaries of U.S. pharma companies in the Caribbean license the right to produce their best, patent protected drugs to subsidiaries in Ireland, and then the U.S. imports the patent protected pharmaceuticals. Does that threaten our economic security? I don't know. Is that a sound basis for globalization and the growth of trade? In my view, absolutely not. And that should be reconsidered.
Beckworth: And that would take an act of Congress to change in tax law, to get us there?
Setser: It would require a fundamental change in U.S. tax law.
I think my base case is aspects of globalization will be reconsidered. There'll be reluctance to have full supply chain dependence on one country, like China. So that will create pressure for more regional supply chains. Whether that leads to something, even more fragmentation than falling back on existing economic regions, is an open question, in my view.
Beckworth: Okay. That will be interesting to see. One of the questions I have is, I agree there's probably going to be some onshoring or some change, at least in the margin. That'd be my sense. As you said, though, it's speculation at this point. I'm probably a little more optimistic about globalization than you, but I do wonder though, if this will lead, at a minimum, to greater diversification within globalization. So maybe we don't have all of our pharmaceuticals produced in the U.S., and not in India. Right now we've had this challenge if India was going to ... Withheld exports of generic pharmaceuticals to the U.S., and they finally reached an agreement with the White House. But I wonder if it might mean that in the future we rely on several countries, not just one country, for a vital product like pharmaceuticals. But we'll have to wait and see, I guess, for sure.
Setser: Look, I mean I think within the broader tragedy associated with the pandemic and its economic fallout, there has been one source of optimism, and that source of optimism has been the force with which central banks globally have acted, and the skill and speed of the Fed's reaction. So I really do think that in one sense, central banks did learn some of the lessons of 2008, that the debate about monetary policy, which you've been at the center of, the debate about crisis facilities, and a lot of long, tedious seminars ...
Setser: …Organized by central banks around the world with academics and others, have in some sense yielded a payout. Which is that that has laid the intellectual groundwork for a much more creative and aggressive central bank response, and likely wouldn’t have been the case without that groundwork. And I think the absence of that ... A similar, vibrant discussion on the health side, has conversely made all of us less prepared than we should have been in the face of the COVID-19 shock.
I think within the broader tragedy associated with the pandemic and its economic fallout, there has been one source of optimism, and that source of optimism has been the force with which central banks globally have acted, and the skill and speed of the Fed's reaction.
Beckworth: Absolutely. And I agree with your point about the central banks, Federal Reserve in particular, responding so quickly. And we've discussed this before on the show, it's interesting to compare their response this time around to 2008. It took a little more effort, a whole lot more debate, there's a lot more discussion at the FOMC about when to respond, how to respond. Where now, it’s been a very concerted effort. Only one regional president voted against, for example, the rate cut they did that took them to zero. But the response has been very rapid and very aggressive, surprisingly so. And it's great to see that in something so serious as the pandemic.
Beckworth: And I think you're right, they've learned lessons. So this past decade hasn't been completely for naught. They've definitely taken to heart the lessons and the challenges they've experienced in the past.
Beckworth: One last question, Brad, and then I'll let you go here. But China, what are the long term prospects for China? What do you see happening there?
Long-Term Prospects for China
Setser: Well, I mean China's always complicated. There's the international dimension, which is on one level China is the biggest beneficiary, right now, of some of the COVID-19 shocks. China benefits more than anyone else as the world's largest oil importer from lower oil prices.
Setser: And as the world's largest producer of personal protective equipment, China may see, over the next several months, and I would certainly hope, China sees an increase in its exports. Now, to be clear, that's not going to affect overall exports. Overall trade is going to remain depressed, but China is in a position, if COVID-19 stays relatively well contained within the manufacturing heartlands of China, to potentially help the rest of the world meet its need for personal protective equipment.
Setser: In the long run, more diverse supply chains, which I agree are part of the likely response, likely implies less Chinese-centric supply chains, that implies an additional challenge for China. And then China never has completely solved the core question about how to rebalance it's economy away from investment. It's still very dependent on domestic investment stimulus to maintain internal demand.
Setser: I would hope that China moves much, much more aggressively to put in place the policies needed to support a more consumer based economy. I think they've talked a lot about it, but when I look at actual policy changes, those actual policy changes have lagged. I don't think many people know that China has an incredibly regressive tax system, that China has a very high minimum contribution on its social security system, which leads to a very regressive tax scale.
I would hope that China moves much, much more aggressively to put in place the policies needed to support a more consumer based economy. I think they've talked a lot about it, but when I look at actual policy changes, those actual policy changes have lagged.
Setser: And China collects very little in personal income tax, around 1.3% of its GDP. U.S. collects 10. So there's enormous scope there for China to change how it taxes, and to tax more progressively, which would help support consumption. And use the higher tax revenues to invest in public health, to expand the availability of medical care, to expand a range of social benefits.
Setser: So if China responds constructively, to what I think are some very real challenges, challenges that would have led its growth to slow even without the COVID-19 shock. I think China can rebuild its economy in a way that doesn't rely as heavily on either exports or investment. But it does take a profound rethinking of China's economic system. And I think the central reforms are reforms that China needs to put in place internally.
Beckworth: Okay. Well, let's hope that COVID-19 is ultimately a catalyst for these reforms you've talked about, and even more. Maybe it will be the tipping point that turns China in a direction that has better institutions, better balanced economy, and better relations with the rest of the world.
Beckworth: Well with that our time is up. Our guest today has been Brad Setser. Brad, thank you so much for coming on the show again.
Setser: It’s been a great pleasure, thanks for giving me a soap box.
Photo by John Guccione