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December 09, 2005

Whose Home Bias Are We Talking About Here?

Brad Setser gets a little cognitive dissonance from listening to Alan Greenspan:

RGE - Alan Greenspan, financial globalization, home bias and central bank reserves: I kind of liked the message of [the speech's last] paragraph.... Concerns about "the pernicious drift toward fiscal instability in the United States and elsewhere is not arrested" and warnings that "the adjustment process could be quite painful for the world economy" appeal to my inner bear.

Alas, I thought the warnings in the last paragraph were a bit at odds with the rather rosy tone of the rest of Greenspan's speech... arguing that deep fundamental forces in the global economy explained the widening of the US current account deficit, will allow relatively large deficits to be sustained, and will facilitate gradual adjustment.... Among those fundamental forces: a fall in home bias - the propensity of folks to use their savings to finance investment at home, not in the world at large.... Greenspan is tempted to conclude that since the US household deficit is small relative to the pool of global savings, there is little to worry about. But he is not quite willing to go that far....

I think Greenspan's core argument more or less goes like this:

["]Modern finance means that you do not have to save to spend. If households want to run a deficit, and firms a surplus, the financial system will intermediate between firms excess savings and households borrowing needs. Plus, a fall in home bias means that the borrowing needs of key US sectors can be financed globally, not locally. Those in need of financing can tap global markets. US household deficits can be financed by the surplus of Japanese, Chinese, or European firms. And a surge in US productivity (all those platform companies?) made the US an attractive place to invest. That is why a fall in "home bias" is leading to large net flows to the US. After all, if US investors lost their home bias and say European investors lost their home bias, US investment in Europe would be offset by European investment in the States, and there would be no net flow of capital. Everyone would just hold a more diverse portfolio....["]

What of the future? How well does Greenspan's story explain the current pattern of capital flows? Not very well, I would argue. Yes, productivity growth in the US is up. But the current world is not marked by large net flows from sclerotic Europe to the dynamic US, but rather by large net flows from the dynamic emerging world to the dynamic US. I am not sure productivity differentials explain why capital is flowing from China to the US, rather than from the US to China.

Private capital certainly is not fleeing China. Far from it. It is banging on the door trying to get in. Net private capital flows into China are quite large. Think close to $60 b plus of FDI, and $50 b, if not more, of "other" inflows.... [P]rivate investors have regained their appetite for financing high growth, high-risk emerging economies....

What explains the large (net) flow of funds from emerging economies to the US then? Not the decisions of private investors, but rather the decisions of foreign governments. There actually hasn't been a fall in home bias among private savers in China, one of the world's big net lenders right now.... Right now, private Chinese savers are running down their offshore accounts to increase their RMB holdings. They want RMB assets, not dollar assets. Hardly a reduction in home bias.

What explains the net flow of funds from China to the US then? Simple: the People's Bank of China is willing to transform Chinese demand for RMB assets (and foreign demand for RMB assets) into Chinese demand for dollar assets. It no longer holds domestic bonds (at least not many) against the money it issues; rather, backs the renminbi in circulation with dollars and euros - and... issues more and more sterilization bills.... Chinese savings is invested abroad, but the investment is not exactly done through the market....

OK, call me reserve obsessed. But I don't think you can explain the current global flow of capital - or the recent fall in home bias among savers in emerging economies - without talking about the actions of the world's central banks, or the actions of the governments of the world's oil exporters.

Posted by DeLong at December 9, 2005 11:05 AM