Friday, May 1, 2009

the fear of losses meant that even countries with ample liquidity seem to have moved into the Treasury market, adding to the pressure elsewhere

From Follow The Money:

"The reserve manager panic of 2008 …

Yes, my headline is a bit overstated. Panic is too strong. A sudden stop might be a better term. or an (almost) orderly withdrawal. But there is more and more data suggesting that central bank reserve managers added to the stress in the credit markets during the crisis of the fall of 2008.

We have known for a long-time that some central banks shifted from buying huge quantities of US Agency bonds (Fannie, Freddie and the like) to selling fairly large quantities rather suddenly. Big buyers in the second quarter of 2008 were big sellers in the fourth quarter of 2008. And we now know that the world’s reserve managers pulled a fair amount of liquidity out of the international banking system in the fourth quarter as well.

The BIS data (table 5c) suggests that central banks pulled about $200 billion ($192.6 billion to be exact, summing “domestic” and “foreign” currency liabilities to monetary authorities) from the world’s big banks in the fourth quarter. Their euro deposits fell too, by almost $60 billion ($57.6 billion). That no doubt added to the pressure on the dollar liquidity of Europe’s banks: US money market funds and the world big central banks were pulling dollars out simultaneously.

The Fed and Europe’s central banks filled the breach, with their swap lines.

To be clear, when a country’s reserves fall, it has to run down its foreign assets — whether its holdings of Treasuries, its holdings of Agencies or its deposits with large banks. Emerging economies that ran down their reserves to — in effect — finance either capital outflows from their own country or to cover a current account deficit were helping to stabilize the system.

Think of it this way: some central banks ran down their deposits in the world’s banks to help their private banks repay the same international banks. That is stabilizing.

However, that wasn’t all that was going on. Global reserves were down by around $200 billion (my estimate, based on the COFER data) in q4, and dollar reserves were down something like $150 billion.

But central banks pulled close to $200 billion out of the big banks and another $150 billion or so out of the Agency market. That is a roughly $350 billion outflow …

So where was the money going? We know the answer: into short-term Treasuries. The Fed’s custodial holdings of Treasuries increased by $250 billion in q4.

I understand fully why reserve managers did this. Their core mandate is to make sure that their country has enough safe, liquid foreign assets to meet their country’s needs — and they over-estimated the safety and liquidity of some key assets. But the net effect of their actions was still destabilizing. They were pulling large amounts of dollar liquidity out of troubled financial institutions that were short of dollar liquidity.

Absent intervention by the Fed, the Treasury and a host of European central banks, a lot more illiquid financial institutions would have failed.

To be sure, emerging market central banks have at times played a stabilizing role in the market. They stepped up their purchases of dollars enormously when private investors’ lost their appetite for dollars in 2006, 2007 and early 2008. That big influx allowed the US to continue to run large current account deficits — and kept the dollar from falling further. Back then central banks were buying the assets private investors were selling. At a micro-level that was stabilizing, though I think a case can be made that at a macro-level it was destabilizing, as it blocked a needed adjustment in the US, and thus stored up future problems.

In the fall of 2008, though, emerging market reserve managers clearly added to the pressures in the credit markets. They moved money out of big banks at the same time private creditors moved money out of big banks. The overall result was destabilizing.

The conclusion that I have drawn is that reserve managers need to hold assets in good times that they are confident that they can continue to hold in bad times. When times were good — and when emerging market central banks were buying huge quantities of dollars to offset a fall in private demand for dollars (and large private inflows into the emerging world) — central banks reached for yield. At the end of the day, though, most reserve managers worry more about losses than returns, and the fear of losses meant that even countries with ample liquidity seem to have moved into the Treasury market, adding to the pressure elsewhere."


    May 1st, 2009 at 5:21 pm

  1. I believe that the Flight from Treasuries began after Fannie/Freddie in August. I’ve tried to find out if this is true, and, in the case of China, they did this, unless they perceived a real difference between implicit and explicit guarantees. Oddly, I thought that we were actually telling everyone that we explicitly guaranteed agencies with a wink and a nod. Apparently the Chinese didn’t believe this. Why?

    Geithner has recently been ridiculed for arguing for a complete govt guarantee. I would like to join the club of the ridiculed. We should have explicitly guaranteed Agency/Fannie/Freddie, and saved Lehman.

    The Flight from Risk is a serious issue because of Debt-Deflation. Here’s Martin Feldstein:

    “The resulting unusual economic environment of falling prices and wages can also have a damaging psychological impact on households and businesses. With deflation, we are heading into unknown territory. If prices fall at a rate of 1 percent, could they fall at a rate of 10 percent? If the central bank cannot lower interest rates further to stimulate the economy, what will stop a potential downward spiral of prices? Such worries undermine confidence and make it harder to boost economic activity.”

    A Debt-Deflationary Spiral is terrifying precisely because it has no natural stopping point. Theories which claim that there is one are way too optimistic. The Flight from Agencies was a signal that Debt-Deflation was a possibility. Unless you have a government guarantee behind this possibility, it becomes much more likely, because investors know that only governments have the resources to backstop such a guarantee.

    By the way, the point of the guarantee is not to spend the money, but stop the panic and allow an orderly process of losses.

    China has clearly stated that they believed that our govt had guaranteed these assets, and, since Lehman, have been getting more and more vocal about it. Why then, if that’s true, did they jump the gun in selling agencies in August?

    Finally, I want to reiterate what China has said about QE. According to the Chinese, in the Asian Crisis, they did not resort to QE. They claim that they were “responsible”. I do believe that China is making some headway in convincing the world that they are responsible, while we are not, even as they buy our bonds. To the extent that letting Lehman fail is seen around the world as the cause of this crisis, the US is seen as not being responsible.


    May 2nd, 2009 at 8:43 am

  1. there was a real debate inside the republican party about the logic of bailing out entities like the Agencies, and in the end Paulson offered a halfway house that fell short of complete backing. that apparently wasn’t enough for china. many countries concluded that the political cost of holding agencies (especially fannie and freddie) when the risk that they would need to be bailed out was in the news was also higher than the yield.

    for what it is worth, though, the fed’s custodial holdings of agencies have now stabilized.

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