It reflects what seems to be a widespread sense inside China that US treasuries aren’t a good investment

TO BE NOTED: From Follow The Money:

“We hate you guys … but there is nothing much we can do”

Posted on Sunday, May 17th, 2009

By bsetser

That – now famous — quote by Luo Peng isn’t really true. China’s government choose to peg its currency to the dollar. More importantly, China’s government choose to peg to the dollar at a rate that can only be sustained – in most states of the world – only if China’s government intervenes heavily in the foreign exchange market. If China didn’t peg to the dollar at the current rate, it wouldn’t need to intervene as heavily in the market — and thus wouldn’t need to accumulate quite so many dollars.

To be sure, the pace of China’s dollar reserve accumulation slowed when “hot money” moved out of China in q4 2008 and q1 2009 (see this graph). But there are some (tentative) signs that reserve growth is starting to pick back up – we will know when China releases its reserves data for q2.

And there certainly is no shortage of evidence that China’s public complaints about the safety of US financial assets haven’t kept it from buying US Treasuries.

The TIC data for March was quite extraordinary. Foreign investors bought — gulp – over $100 billion of Treasuries in March: $55.3 billion in longer-term notes and another $47.9b in short-term bills. Indeed, over the 12ms of data – a period framed on one end by Bear’s collapse and at the other end by the stress tests, with Lehman’s failure punctuating the middle – foreign investors have bought a stunning $800 billion of Treasuries. $300 billion of longer-term bonds and $500 billion of short-term bills.

In March, China – according to the TIC data — bought $14.85b of longer-term bonds and $14.5 billion of bills. Talk about not putting your money where your mouth is. As a result, China’s Treasury portfolio – shown here disaggregated between bills and bonds – continues to rise.

Over the last 12ms, China has bought around $270 billion in Treasuries — $173b of bills and $98b of longer-term notes. That surge came even as Chinese reserve growth slowed. China, in effect, stopped buying all US assets other than Treasuries. Agencies especially.

The shift in China’s portfolio during the crisis – described in more detail in an updated paper that I have done with Arpana Pandey of the Council on Foreign Relations — mirror the global data almost perfectly. China wasn’t the only foreign investor that shifted out of Agencies and into Treasuries – or, for that matter, the only investor who stopped buying US equities and corporate bonds.

Russia sold its Agencies to buy short-term Treasury bills. Its holdings of non-Treasury short-term securities have gone from $97 billion at the end of 1997 to $1 billion at the end of March 09 while its holdings of Treasury bills rose from next to nothing to $73 billion. A host of smaller central banks did something similar. And private investors abroad – including, I suspect, European banks – wanted more bills too.

A plot of total foreign demand for Treasuries (short-term and long-term) against total foreign demand for Agencies (short-term and long-term) makes this shift brutally clear:

The fact that key foreign investors didn’t lose faith in Treasuries when they lost confidence in the debt of the Agencies, private US financial institutions and issuers of asset-backed securities helps to explain the dollar’s resilience during this crisis.

There frankly isn’t much more to say about the TIC data these days. Foreigners are consistently buying only one type of US asset. Ok, there was a bit more foreign interest in US equities in March too. But the scale of the inflow into equities was dwarfed by the inflow into Treasuries.

I understand the logic of this flow.

The crisis reminded central bank reserve managers that they cannot take much credit risk. They cannot – politically – afford to take visible losses. And as long as they report their reserves in dollars, holding Treasuries is the one safe choice. Some central banks and sovereign funds also underestimated their needs for liquidity. Kuwait and Abu Dhabi, for example, have had to draw heavily on their foreign assets to finance domestic bailouts.

At the same time, China’s increasingly rhetoric isn’t an accident. It reflects what seems to be a widespread sense inside China that US treasuries aren’t a good investment.** Private Chinese savers presumably wouldn’t want to buy Treasuries at current rates. But China’s current exchange rate regime compels China to buy dollars when private Chinese investors don’t want them.*** The result: a strange world where China’s government ends up buying an asset that China’s people currently do not want …

That is one of many ironies of the Bretton Woods 2 system. Its stability hinges on the willingness of central banks in the key surplus countries to buy dollars when private investors in their countries won’t.

*The methodology that Arpana Pandey and I use to estimate China’s purchases actually suggests a somewhat smaller number for China’s March purchases, as we attribute some purchases through London to China. In March the UK was a net seller of Treasures, which mechanically reduces our estimate of China’s total holdings a bit. The different though is truly trivial.
** These arguments tend to put more emphasis on the (growing) US fiscal deficit and less emphasis on the (shrinking) US trade deficit than I would. And they ignore the fact that dollars never were a good investment for China, as China was buying dollars precisely because there was market pressure for the dollar to fall and the renminbi to rise. For the sake of simplicity, I am ignoring those periods when private money was moving out of China, as I suspect the current bout of optimism about China’s growth prospects has reduced those flows.
*** China could then sell those dollars for other foreign currencies. But if those sales drove the dollar down, they would also drive China’s currency down so long China pegs tightly to the dollar. That would not please many of China’s trading partners."

Reserve managers stopped buying Agencies rather suddenly; there wasn’t much advance warning.

From Follow The Money:

"Not putting your money where your mouth is

Posted on Wednesday, May 13th, 2009

By bsetser

In March, China’s premier expressed concern about the safety of China’s (large) investment in the US, including China’s investment in Treasuries. China’s citizens have realized — rather belatedly — the risks associated with holding more reserves than China really needs.*

And some in Japan are also now starting to worry about the safety of Japan’s dollar-denominated Treasuries.

You might think — based on all this chatter — that central bank demand for US Treasuries has waned.

It hasn’t.

Central bank holdings of Treasuries at the New York Fed have increased by over $500 billion over the last 12 months. Central bank purchases in the 12ms through March set an all-time record - and purchases in the 12ms through April are only a bit lower.

Central bank holdings of Treasuries at the New York Fed rose by close to $100 billion in the first quarter of 2009. That is down from the $250 billion increase in the fourth quarter of 2008, but it had to fall from that pace: $ 1 trillion in annualized Treasury purchases is rather hard to sustain when central bank reserves are falling. The $100 billion central bank added to their Treasury portfolio at the Federal Reserve over the last three months of data is still more than central banks bought in late 2003 and early 2004 - a time when Japan was buying what then seemed like huge quantities of Treasuries.

Indeed, the rise in central banks’ Treasury holdings over the last 6 months is far larger than can be explained by the (non-existent) growth in central bank reserves. It reflects a shift out of Agencies — and (less discussed) a shift out of large deposits in the major international banks. Treasuries aren’t free of all risk, but central bank reserve managers have concluded that they are less risky than other dollar-denominated reserve assets.

The pace of outflows from the Agency market is a warning against too much complacency on the United States part. If central bank reserve managers do lose confidence in an asset, they can go from buying large sums to selling large sums quite rapidly. Confidence is a mysterious thing. Reserve managers stopped buying Agencies rather suddenly; there wasn’t much advance warning. The fact that most most recent central bank inflows have gone into short-term bills is also a signal of sorts. Central banks either are desperate for the most liquid asset of all — or they haven’t been comfortable buying lots of ten-year dollar-denominated notes at yields under 3% and risking mark-to-market losses if Treasury yields eventually rise.

At the same time, most reserve managers worry far more the risk of visible losses, especially credit losses, than about returns. They also need to make sure that they hold enough truly liquid assets to cover their countries immediate needs in a crisis. Right now most central banks seem to be more worried about the risk that they will find themselves with too few liquid US Treasuries rather than the risk that they will hold too many.

Indeed, it isn’t inconceivable that if the gap between the yield on short-term bills and longer-term notes gets large enough, credit-risk adverse reserve managers who want a bit more yield will shift out of bills and into longer-term notes. Central banks do need some income. And they are more comfortable taking interest rate risk than credit risk. Optics.

All the talk about the risks of holding Treasuries, central bank demand for Treasuries also has held up far better than central bank demand for almost any other asset. Central bank demand for Treasuries hasn’t grown as fast as new issuance. Indeed, for the first time in years, central bank reserve managers aren’t absorbing the majority of the Treasury’s new paper. But that is entirely a function of the huge size of the US Treasury’s borrowing need, not a function of any fall in central bank demand.

And in some sense it is strange that the major central banks haven’t publicly talked about the risks of the assets that they are selling, while the national leaders of a few key countries with big reserve portfolios have publicly discussed the risks of the assets that they are buying …

* The usual argument is that the US will inflate away the value of China’s Treasuries. That argument clearly puts blame for any fall in the value of China’s Treasury holdings on US policy makers. The bigger risk though is that the dollar will fall against China’s currency, reducing the CNY value of China’s external portfolio. That fall could happen even if inflation in the US never picks up, as there are strong fundamental reasons to think that renminbi should rise over time against the dollar — and, for that matter, the euro. However, it is far harder to attribute losses from currency moves to bad US policy — as China’s leaders opted to build up their dollar reserves in order to keep China’s currency from rising. That policy helped China’s exporters, but it also exposed China’s taxpayers to the risk of future losses — as they were effectively “over-paying” for dollar reserves that China didn’t need for its own financial stability."

Me:

1. Don the libertarian Democrat responds:
   

   “Indeed, it isn’t inconceivable that if the gap between the yield on short-term bills and longer-term notes gets large enough, credit-risk adverse reserve managers who want a bit more yield will shift out of bills and into longer-term notes. Central banks do need some income. And they are more comfortable taking interest rate risk than credit risk. Optics.”

   This is indeed the plan of QE. The point is to keep short term interest rates low,in order to give an incentive for higher yield, and have longer term interest rates rise, attacking deflation and showing a recovering economy. Both are aimed at the Fear and Aversion to Risk.

   Eventually, there should be a move to longer term bonds with higher yields. In my mind, this would be a good thing.