Thursday, July 05, 2007

The Check was in the Mail

In a series of recent papers, Micheal Dooley, Peter Garber, and David Folkerts-Landau have been arguing against the textbook open economy macro model (and said model's dire predictions about the current set of global financial accounting imbalances). They argue that since Sovereign debt is not really collectible, poor countries must post effective collateral to get financial flows from rich countries. They further argue that past exports as represented by the US current account deficit are precisely this collateral.

In other words, China has given us a ton of stuff in exchange for t-bills. If they expropriate US or other rich country FDI, the US cancels their claim to the t-bills and we get the stuff for free. That is to say, China's huge reserve holding of dollars is just collateral against any appropriation of the FDI being done there.

Here is how they put it in their latest NBER working paper (gated, sorry):

The nature of the social collateral is so obvious it is hard to see. If the center cannot seize goods or services after a default, it has to import the goods and services before the default and create a net liability. If the periphery then defaults on its half of the implicit contract, the center can simply default on its gross liability and keep the collateral. The periphery's current account suplus provides the collateral to support the financial intermediation that is at the heart of development strategies. The interest paid on the net position is nothing more than the usual risk-free interest paid on collateral.

This is really cool.

Finally, a link to other Dooley et al papers on this topic along with criticisms of their approach is here.

UPDATE: Interesting comment over on Marginal Revolution, on this topic....

There's a practical problem with canceling China's dollar assets: The enormous secondary market in T-bills means that China can easily sell them to some third party who could redeem them at face value. I can't think of any way to close this loophole without effectively shutting down all trade in T-bills, which has enormous negative consequences for the U.S.

Sounds right, and raises an interesting problem. Even if sold at a discount, a quantity of t-bills that large might well drive prices down, and therefore raise interest rates a LOT at the next auction. Good point, Ammianus.

UPDATE II: A correction, from Belligerati. So, never mind on the secondary market way out. Angus was right all along.


Anonymous said...

"If they expropriate US or other rich country FDI, the US cancels their claim to the t-bills and we get the stuff for free."

I am not a member of the current account chicken little club, but, might not default of the sort they discuss have an impact (a rather dramatic impact) on interest rates in the U.S.? Wouldn't the higher cost of borrowing imply that all the stuff we got from China wasn't "free". Maybe a discount (maybe, depending on the interest rate response), but free?

You guys are economists--you tell me. If we can eat for free lunch, why wait for China to expropriate our FDI?

What am I missing?

Sameer said...

Hi there. I beleive that the distinction lies in the fact that a "default" wouldn't be a classical default, but a retaliation for expropriation. Thus, the credit of the United States would not suffer in the eyes of other holders of treasuries, because they are not planning on nationalizing the FDI in their countries. It will have some impact, as the demand from China for treasuries will disappear, so rates will go up, but not nearly as much as they would in the case of a generalized default.

Mungowitz said...

Sure, Sameer nailed the answer, IMHO.

Cancelling the debt held by *China* would border on an act of war.

But it would NOT affect the standing of debt held by (say) Japan or the U.A.E.

It would be an extreme measure, and it might well precipitate a run on China's currency. The resulting instability would cost the U.S. quite a bit.

But you are missing the point: most people are saying the *U.S.* is exposed, by having foreigners own debt. Angus's point is that China is even more exposed. He didn't mean to imply there are no costs to the U.S.

He just meant you shouldn't ignore the costs to China!

Anonymous said...

I find this line of reasoning fantastic in the strict sense for several reasons.

First, it supposes that China is somehow deliberately running trade surpluses with exactly those countries whose firms are planning to invest directly in China over the next N years. (Or is it targeting those firms?) Leaving aside the formidable knowledge problem, how is this feat executed on world markets? If China deliberately distorts the dollar/yuan exchange rate in order to generate the necessary surplus, doesn't this create arbitrage opportunities from three-way trades involving currencies that are not overvalued by the Chinese central bank? Will this not lead in short order to a decline in the value of the yuan in non-dollar currencies, not stopping until the 10:1 yuan/dollar exchange rate is an equlibrium? If, instead, the Chinese directly subsidized exports to the US, similar arbitrage opportunities would emerge in goods.

Second, it's not obvious that it's in the US government's interest follow through and default if the Chinese do in fact seize any "US" assets (however difficult those may be to define in a world of multinational firms) for reputational reasons. Sure, you can say that this is a particular response to a particular contingency, but in response I'll point out that the US Treasury has not announced a contingent response of any such kind--as far as we know this default threat exists only in minds of the authors of this NBER paper and (a few) of its readers. So now we're introducing an "implicit contract" rider to the purchase of US debt, which is that if somebody somewhere thinks up a plausible reason why it's OK to default then we just might do that. Well, maybe that would fly, but if I were Secretary of the Treasury I'd think more than twice before pulling the trigger on this strategy.

There's a much simpler and more direct alternative way for the Chinese to open themselves up to retaliatory default: The Chinese could buy the appropriate amount of the outstanding debt of the actual companies making the actual investments in China. None of the problems with the original proposal present themselves, but all the benefits remain.

Anonymous said...

edit: "10:1" should read "distorted." Or else change my name to "10 yuan bill."