Showing posts with label Setser. Show all posts
Showing posts with label Setser. Show all posts

Thursday, June 4, 2009

Until now, China’s policy has been dominated by concerns about the impact of any change in China’s exchange rate on China’s exports.

From Follow The Money:

"Change or more of the same?

Simon Johnson poses the core question facing the United States and China well:

If [China] doubles [its] holdings of US dollar assets over the next couple of years (let’s say, going towards $4trn), effectively financing our budget and current account deficit, will we all end up safer or more vulnerable?

China currently has a bit over $1.5 trillion in dollar assets, as not all of its $2 trillion in reserves (and more like $2.3 trillion to $2.4 trillion in government assets abroad) are in dollars. About ½ of the total is result of China’s purchases in just two years, 2007 and 2008. China’s trade surplus isn’t shrinking, at least not in dollar terms. Lex’s argument that China’s surplus is waning can be challenged.* And even if China’s trade surplus stabilizes in dollar terms and shrinks relative to China’s GDP, China is on track to double its foreign assets – and its US holdings – over the next four years. Think a $350-400 billion annual increase in China’s dollar assets, and a $500b plus increase in China’s foreign assets.**

That prospect should scare China’s leaders. China’s population thinks China has already invested too much in low-yielding dollar assets. Doubling down only makes the problem bigger. Bridgewater’s Ray Dalio noted in February:

But they [China] own too much in the way of dollar-denominated assets to get out, and it isn’t clear exactly where they would go if they did get out. But they don’t have to buy more. They are not going to continue to want to double down.

Nor should the US want China to double down. The past few months have made it clear that China’s dollar problem can quickly become America’s problem, as China’s doubts about the safety of its US portfolio reverberate through various US markets.

To be clear, the basic risk China is running hasn’t changed all that much recently. China’s government fundamentally is overpaying for dollars (and euros) to hold the RMB down to help China’s exporters. That policy always has carried with it a high risk of future financial losses.

The current crisis hasn’t fundamentally changed that basic reality.

Sure, the US fiscal deficit is up – and the Fed has cut policy rates in the midst of a severe downturn. But that is only half the picture. Household savings are up. Household borrowing is down. The private sector’s financial deficit is way down. The trade deficit is down too. Foreign inflows finance a trade deficit not the fiscal deficit and, in my book, financing a 6% of GDP trade deficit is more risky than financing a 3% of GDP trade deficit.

What has changed is China’s own perception of the risks. China’s population wasn’t focused on the cost of holding more dollar and euro reserves than China needs back in 2005 or 2006. Now it is.

And, or course, the over time the size of China’s portfolio grew, increasing the scale of China’s exposure. That is the nature of financing an ongoing deficit. The longer the current relationship continues, the more dollars (and euros) China will hold, and thus the greater the underlying risk.

Simon Johnson focused on Geithner’s non-confrontational tone in Beijing. But the basic message in Geithner’s Beijing speech was clear: the goal of both US and Chinese policy should be to move away from the current unbalanced relationship.

Our common challenge is to recognize that a more balanced and sustainable global recovery will require changes in the composition of growth in our two economies. Because of this, our policies have to be directed at very different outcomes.

In the United States, saving rates will have to increase, and the purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past. In China …. growth that is sustainable growth will require a very substantial shift from external to domestic demand, from an investment and export intensive driven growth, to growth led by consumption. Strengthening domestic demand will also strengthen China’s ability to weather fluctuations in global supply and demand.

If we are successful on these respective paths, public and private saving in the United States will increase as recovery strengthens, and as this happens, our current account deficit will come down. And in China, domestic demand will rise at a faster rate than overall GDP, led by a gradual shift to higher rates of consumption. Globally, recovery will have come more from a shift by high saving economies to stronger domestic demand and less from the American consumer.

Seems like a vote for change, not more of the same.

But what leverage does the US really have to change the basis of the relationship when it wants China to buy its bonds in the near term?

That question misses two key points. First, the trade deficit is down, so the US actually needs less financing from the rest of the world right now than it did in the past. It isn’t clear to me that the US relies more on China now than it did back in 2007 and early 2008, when China’s reserves were growing faster and the US external deficit was larger. Second, China’s own concerns about its dollar risk could generate a larger constituency for change inside China.

Until now, China’s policy has been dominated by concerns about the impact of any change in China’s exchange rate on China’s exports. Yet it is hard to see how China can realistically scale back even the pace of increase in its dollar exposure so long as it is running a large trade surplus and pegging to the dollar.

Chinese policy makers have been searching for a way to avoid adding to their dollar exposure without changing their dollar peg. Here though, I suspect that my colleague (boss, actually) Sebastian Mallaby is right: China’s efforts won’t get China very far so long as China’s capital account is closed and China pegs to the dollar. As China comes to the same realization, the pressure on it to adjust its policies will grow.

Of course, a world where China provides the US will less financing implies adjustment in the US as well. A China that imports fewer bonds will tend to buy more imported goods – which will help some parts of the US economy. But it won’t help sectors with large borrowing needs. Including the US government.

The troubles the dollar has faced recently suggest that the market wants the US to continue to adjust. It now seems as though there isn’t lots of demand for US asset at current interest rates in absence of an acute crisis. The external financing that would be needed for US demand to spur a global recovery may not be there. Market pressures then could spur a more balanced global recovery. A weaker dollar will help bring about a rebound in US exports just as stronger currencies abroad will push other countries to take steps to stimulate their own economies.

Change isn’t without its risks. One of the key factor pushing China to adjust – its concerns about the safety of its US portfolio (or, in my view, its China’s belated recognition that holding its exchange rate down has costs as well as benefits, as it requires continuously overpaying for dollar and euro denominated bonds) – also makes the market nervous. And a nervous bond market tends to make policy makers a bit nervous.

On the other hand, if China (and the US) double down, the underlying problem would in some sense only get worse. The basic issues won’t change. But the stakes will be even higher.

Over the past couple of days I discussed the Sino-American financial relationship with CNBC Europe, NPR’s All Things Considered and public radio’s On Point. I tried to argue that neither the US nor China should seek to maintain a world where China saves and lends and the US (households as well as the government) borrows and spends. The goal should be the creation of a more balanced relationship – one where the US doesn’t require so much Chinese financing and China doesn’t need so much US demand – not a return to the old unbalanced relationship.

The sources of pressure for change are increasingly obvious. Even in China. That’s good. But transitions aren’t easy. Deficits – even shrinking deficits – have to be financed. And financing an orderly (think gradual) adjustment poses particular challenges.*** For everyone.

* China’s trade surplus in the 12ms through April reached $315b, v $255b in the 12ms to April 2008. The surplus in the last three months of data was $37b – v $39b at this time last year. That is encouraging – not growing isn’t the same as shrinking. Especially when China is stockpiling commodities, and thus somewhat artificially increasing imports and reducing its surplus. Let’s see what May tells us – if China really is going to lead the world out of the current slump, its surplus should shrink.
** I am assuming that China’s reserves resumed their upward March in the second quarter, as renewed confidence in China ended hot money outflows. Generally speaking, China amount of foreign exchange China has to buy to manage its exchange rate rises when the dollar is depreciating.
*** During an orderly adjustment, China’s dollar holdings – and thus its exposure to the US – would continue to rise. But the pace of increase would slow, until a new equilibrium was established, one that didn’t require ongoing Chinese purchases. The problem is that China’s exposure needs to rise even as China’s surplus with the US shrinks. Basically, China needs to bear the financial costs of supporting the dollar without getting the trade boost it got before. This shouldn’t be a surprise. I – and others – have long noted that the same folks who financed the expansion of the US trade deficit would likely need to finance its orderly contraction. But it isn’t clear that Chinese policy makers really ever thought out the end-game (i.e. their exit strategy from the dollar trap), despite their reputation for thinking about the long-term."

Me:


  1. “But it isn’t clear that Chinese policy makers really ever thought out the end-game (i.e. their exit strategy from the dollar trap), despite their reputation for thinking about the long-term.”

    It’s a well-deserved reputation. Comparatively. Here’s the answer:

    “The goal should be the creation of a more balanced relationship – one where the US doesn’t require so much Chinese financing and China doesn’t need so much US demand – not a return to the old unbalanced relationship.”

    It’s simply a matter of working out the details. China understands that it’s connected to us. And, just as we try and influence them through our statements ( On human rights, for example ), they try and influence us in the same way.I suppose they take the idea of a partnership more seriously.

    Whatever the press said, Geithner as the one person calling for a total guarantee. China surely knows this. That’s what they wanted and expected. As you say:

    “The sources of pressure for change are increasingly obvious. Even in China. That’s good. But transitions aren’t easy. Deficits – even shrinking deficits – have to be financed. And financing an orderly (think gradual) adjustment poses particular challenges.*** For everyone.”

    I believe that the US and China know where they want to go, it’s really a matter of the actions and compromises necessary to get there. In other words, China has a plan, but we have a say in how that plan works out.

    To me, what’s interesting is how they’re reacting to getting, more or less, what they want. I guess that they don’t trust democracy, while they’re pretty sure that they’re in control of their responses.

Tuesday, June 2, 2009

challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes

TO BE NOTED: From Follow The Money:

"More on the fall in private borrowing and the rise in the fiscal defict

The chart that supported my previous post attracted a fair bit of attention. But it was cobbled together at home and only looked at data over the past few years. With help from the CFR’s Paul Swartz, I looked at the quarterly data over a longer time period.

The story is clear. Government borrowing has increased dramatically. It topped 15% of GDP in the last two quarters of 2008. In 2007 and early 2008 it was more like 3% of GDP. But private borrowing has fallen equally sharply. Total borrowing by households and firms fell from over 15% of GDP in late 2007 to a negative 1% of GDP in q4 2008.

private-v-public-borrowing-thru-08-11

Negative borrowing by households and firms means, I think, that households paid down their debts in the fourth quarter.

It hardly needs to be noted that the fall in borrowing by households and firms in late 2008 was exceptionally rapid. A stronger economic cycle implied that the magnitude of counter-cyclical fiscal policy also needed to be ramped up.

The disaggregated data on borrowing by households and firms is also interesting. Household borrowing rose to record levels in 2003 and remained high through early 2006. Household borrowing fell in 2007, but for a time this fall was offset by a rise in borrowing by private firms. Borrowing by firms actually peaked in the middle of 2007 at a higher level than during the dot come investment boom. Chalk that up to a surge in leveraged buyouts and stock buybacks.

private-v-public-borrowing-thru-08-21

Both charts highlight the risk that worries me the most. In both the early 1980s and the first part of this decade, both the private sector and the government were large borrowers. And in both cases, borrowing rose faster than domestic savings, so the gap was filled by borrowing from the rest of the world. The trade and current account deficit rose. In the early 1980s, the US attracted inflows by offering high yields on its bonds. More recently, it did so by borrowing heavily from Asian central banks, together with the governments of the oil-exporting countries. But now yields are low (even after the recent rise in the yield on the ten year Treasury bond), and need to be low to support a still weak US economy. And China (and others) are visibly uncomfortable with their dollar exposure; banking on their continued willingness to finance a large external deficit seems like a stretch.

The challenge this time around consequently will be to bring down the government’s borrowing as private borrowing resumes.

Update: Household, household and government and total borrowing over time on a rolling four quarter basis:

private-v-public-borrowing-thru-08-3

And the quarterly data.

private-v-public-borrowing-thru-08-5

All data comes from table F1 of the flow of funds.

The downturn in total borrowing in the rolling four quarter sum reflects a low level of total borrowing in the second quarter (i.e. before government borrowing ramped up both to fund the fiscal deficit and to finance the financial sector). But even in the fourth quarter of 2008, total borrowing wasn’t up …"

Sunday, May 31, 2009

Treasuries are the only US financial asset that the rest of the world is still buying in large quantities

TO BE NOTED:

"Record demand, record angst

The bond market vigilantes are (supposedly) back. And this time, they aren’t just Wall Street traders. America’s foreign creditors are no longer willing to provide endless amounts of long-term credit to the US at low rates. So argues Mark MacQueen of Austin, Texas- based Sage Advisory Services (via Bloomberg):

“The vigilante group is different this time around … It’s major foreign creditors. This whole idea that we need to spend our way out of our problems is being questioned.”

From all this talk, you would never know that the world is actually still buying record amounts of US Treasuries. In fact, Treasuries are the only US financial asset that the rest of the world is still buying in large quantities. Demand for Agencies — and asset backed securities — has fallen off a cliff. Demand for equities has been anemic (though the last data point comes from March). By contrast, the 52 week increase in the New York Fed’s custodial holdings is way, way up.

fed-custodial-holdings-end-may-09

Over the last four weeks of data — basically the month of May — central bank Treasury purchases topped $70 billion even as their Agency holdings inched up. That is a big sum, almost a record sum. It implies that the rest of the world is currently shifting their US portfolio into Treasuries, not moving out of them.

fed-custodial-holdings-end-may-09-2

To be sure, not all is well.

Foreign central bank demand is still concentrated at the short-end of the curve,* and the US is issuing more long-dated bonds.

And key emerging market central banks (predictably) ares still reluctant to allow their currencies to appreciate. Tim Duy, in a superb Fed Watch:

The Fed’s ZIRP policy combined with stable financial markets once again makes the Dollar carry trade attractive. Since old habits die hard, this should “force” foreign central banks to accumulate Treasury assets - and it has. In this scenario, stable financial markets are now pushing for further reduction in the US external deficit … And, once again, it looks like much of the world, from the Fed to the Treasury to the emerging market central banks, are resisting the adjustment as it requires continued soft domestic demand in the US to limit imports.

Central banks that effectively peg to the dollar make for a strange kind of vigilante. Countries that do not want their currencies to appreciate have to intervene more when inflows pick up, and they have to invest that money abroad. And if central banks believe that the only acceptable, safe alternative to long-term Treasury notes is short-term Treasury bills, they will end up lending to the US at incredibly low rates so long as the Fed keeps rates low.( NB DON )

Key countries end up piling up short-term Treasury bills at a rate that has to make everyone nervous.

US policy makers have to worry about the weak foreign bid for long-term bonds, and the risk that the rise in mortgage rates will choke off the recovery. And at some point, foreign central banks will have to worry about the lack of interest income of their (now once again growing) foreign portfolio.

* Central banks bought a surprisingly large share of the 5 year auction, so this may be changing. We will have to see."

Thursday, May 21, 2009

At least those that are not guaranteed by the FDIC.

From Follow The Money:

"China’s new barbell portfolio: Treasuries and commodities?

Keith Bradsher’s New York Times story on the recent evolution of China’s foreign portfolio gets — at least in my view — the story right. Of course, that may be because I was — rather obviously — a source for the story. Check out the charts that accompany the article!

The basic story of China’s foreign portfolio is simple: it is trying to reduce the amount of (credit) risk in its fixed income portfolio while simultaneously taking on more commodity risk.

China’s purchases of Treasuries (especially short-term bills) have gone up even as China’s reserve growth has slowed, as China shifted money out of Agencies and — in all probability — out of money market funds that are taking credit risk and other privately managed accounts. The failure of Reserve Primary had a big impact on China. Bradsher:

“Financial statistics released by both countries in recent days show that China paradoxically stepped up its lending to the American government over the winter even as it virtually stopped putting fresh money into dollars. This combination is possible because China has been exchanging one dollar-denominated asset for another — selling the debt of government-sponsored enterprises like Fannie Mae and Freddie Mac in a hurry to buy Treasuries. ….

China was the world’s biggest buyer of [securities issued by government-sponsored enterprises] a year ago, splashing out more than $10 billion a month. But in the 12 months through March, it actually had net sales of $7 billion, and ramped up purchases of Treasuries instead. China has also changed which Treasuries it buys. It has done so in ways calculated to reduce its exposure to inflation or other problems in the United States. As recently as a year ago, China actively bought long-dated bonds, seeking the extra yield they could bring compared to Treasury securities with short maturities, of which China bought virtually none. But in each month since November, China has been buying more Treasury bills, with a maturity of a year or less, than Treasuries with longer maturities. This gives China the option of cashing out its positions in a hurry, by not rolling over its investments into new Treasury bills as they come due should inflation in the United States start rising and make Treasury securities less attractive.

At the same time, China has sought to ramp up its exposure to commodities. China’s government clearly is adding to its strategic stockpiles — and perhaps encouraging state firms to build up inventory as well. China’s government is encouraging Chinese state firms to invest more abroad, especially in the mining sector. And China’s government is providing financing to cash-strapped commodity exporters (Russia, Kazakhstan, Brazil and no doubt others) to help tide them through a rough patch and, China hopes, to secure future supplies. Bradsher:

“This spring China has also been stepping up its purchases of commodities, which are usually bought in dollars. Iron ore has been piling up on Chinese docks, government stockpiles of crude oil and grain are being expanded and stockpiles are being started for products like gasoline, diesel and sugar.”

China’s government presumably likes commodities in part because it believes in its own story — and, if you are bullish on China, conventional wisdom holds that you also should be bullish on commodities. China also hopes that its investments abroad will help to assure it a secure supply of the raw materials it needs. At the most basic level, the more investment in commodity production now, the lower the future price — and as a commodity importer, China would benefit from lower prices. And China could well view commodities as an inflation hedge.

That said, commodity price are volatile — so holding commodities is not devoid of risk. Buying the equity of commodity producers can be equally risky. And there is a long history that shows that investing in mineral production abroad is risky.

These though are risks that China seems to want to take right now.

Conversely, China doesn’t seem keen to take risk in the fixed income market. The old game of buying Agencies to get a bit more yield than Treasuries offer is over. And, I would guess — based on China’s comments about the importance of protecting the value of China’s investment in the US — that China also isn’t all that keen on the long-term bonds of large financial institutions. At least those that are not guaranteed by the FDIC.

China though doesn’t seem to have found a way to reduce its currency risk, despite all the recent talk. Probably because it is hard for a large country that pegs its currency tightly to the dollar to do so. China — per Bradsher — has found that it cannot buy gold without moving the market. That applies to currencies too.

Best that I can tell — see Figure 7 of the latest Setser/ Pandey paper on the management of China’s foreign portfolio — the United States’ share of China’s total portfolio has been fairly constant. The US data on its own suggests that China was moving out of dollars from mid-07 to mid-08,* and then moved back into dollars last fall. My best guess though is that the US data overstates both the move out of dollars from mid-07 to mid-08 and the move back into dollars in the fall. Rather than moving out of the dollar, China was moving out of Treasuries — and increasingly holding dollars in ways that the US data doesn’t pick up. Call it reaching for yield. After the crisis, China moved back into Treasuries — and started holding more of its dollars in ways captured by the US data. That at least is my best guess.

One thing to watch going forward: what China does if its reserve growth picks up again, and it has to put more money to work. For the past six months, China has essentially been reallocating its existing portfolio. Given China’s still large current account surplus, that was only possible because private money was leaving China. But if China ends up recovering faster than the rest of the world, capital inflows to China could easily resume … pushing China’s reserves back up.

* China’s recorded purchases of US assets from mid-07 to mid 08 are inferred primarily from the survey data. And the increase in China’s stock of Treasuries and Agencies was lower than I would have anticipated given the overall increase in China’s foreign assets. This period was also marked by large institutional changes in the way China manages its reserves - changes that potentially meant that the US data missed some of China’s holdings. For example, the CIC’s large holdings of dollar-denominated money market funds also did not appear in the survey data — likely because the CIC invested in “offshore” funds. Greater use of private managers and managed accounts will tend to lower recorded US holdings as well. There is also some uncertainty about the total scale of China’s foreign portfolio — which has an impact on the calculation of the United States share of the portfolio. I have compared China’s US holdings to its total foreign portfolio, not just to its reserves. That means that I am including the CIC and the PBoC’s other foreign assets and a (complicated) measure of the state banks foreign portfolio alongside China’s reserves."

Me:


  1. “Conversely, China doesn’t seem keen to take risk in the fixed income market. The old game of buying Agencies to get a bit more yield than Treasuries offer is over. And, I would guess — based on China’s comments about the importance of protecting the value of China’s investment in the US — that China also isn’t all that keen on the long-term bonds of large financial institutions. At least those that are not guaranteed by the FDIC.”

    I’m still waiting for a good explanation of this. Even on the bonds of large financial institutions, it seems to me that the US didn’t like the idea of giving a big haircut to China.

    Unlike most people, I find the Chinese explanations for their actions, especially on their website, to make sense and appear forward looking, especially when you set them up against most other governments in this crisis.



  1. don — you are right. the us didn’t want to do anything dramatic that china would consider an affront. like default on agencies.

    but the us didn’t protect reserve primary (which china had invested in) from the fall out of LEH, and i would be quite surprised if SAFE didn’t hold some LEH and AIG bonds (LEH bonds weren’t made whole, obviously). The total amounts involved were small, but china in the crisis discovered that it is fundamentally loss adverse and the us gov didn’t protect it from all credit losses.

    and then there is a rumor (unconfirmed) that china (via SAFE) may have had some of the agencies preferred stock (or something in the capital structure between debt and equity) and was surprised when that wasn’t protected. just a rumor tho.

    as far as i know SAFE has never tried to explain in public why it shifted into agencies or why it shifted out … nor has it said anything in public about its little foray into equities. so i guess I am a bit less impressed by china’s public policy statements than you are!

Tuesday, May 19, 2009

But the dollar isn’t the dominant reserve currency along the periphery of the eurozone.

TO BE NOTED: From EconomPic Data:

"Russia Sheds Dollars for Euros

The Moscow Times (via Brad Setser)

The euro's share in Russia's forex reserves, the world's third-largest, overtook that of the dollar last year as the country pressed on with a gradual diversification, the Central Bank's annual report showed.

The euro's share increased to 47.5 percent as of Jan. 1 from 42.4 percent a year ago, according to the report, which was submitted to the State Duma on Monday.

The dollar's share fell to 41.5 percent from 47 percent at the start of 2008 and 49 percent at the start of 2007.


As Brad points out:
It is often asserted that the dollar is the global reserve currency. It would be more accurate to say the dollar is the globe’s leading reserve currency.* The dollar is the dominant reserve currency in Northeast Asia. And the two big economies of Northeast Asia both happen to both hold far more reserves than either really needs. The dollar is also the reserve currency of the Gulf. And Latin America.**

But the dollar isn’t the dominant reserve currency along the periphery of the eurozone. Most European countries that aren’t part of the euro area now keep most of their reserves in euros. That makes sense. Most trade far more with Europe than the US – and some, especially in Eastern Europe, ultimately want to join the eurozone.

* The rise in global reserves means that the world’s central banks hold more euros as part of their reserves now than they held dollars in 2000. If demand for dollars hadn’t risen any more, the rise in demand for euro-denominated reserves would be a big story …

** Best that I can tell, South and Southeast Asia generally hold a far lower share of their reserves in dollars than the big countries in Northeast Asia.
Go read his whole piece here

Reuters reports that Russia has “banned investment in bonds of agencies such as Fannie Mae and Freddie Mac

TO BE NOTED: From Follow The Money:

"Russia’s waning appetite for dollars

If Russia were China — or if Russia’s reserves were growing at the same pace as in late 2007 or early 2008 – today’s revelation that Russia cut the dollar share of its reserves over the course of 2008 would be big news.

The dollar share of Russia’s reserves is now (or at least was in January) a lot closer to 40% than 50%. Reuters (via the Moscow Times, and other sources):

The euro’s share in Russia’s forex reserves, the world’s third-largest, overtook that of the dollar last year as the country pressed on with a gradual diversification, the Central Bank’s annual report showed. The euro’s share increased to 47.5 percent as of Jan. 1 from 42.4 percent a year ago, according to the report, which was submitted to the State Duma on Monday. The dollar’s share fell to 41.5 percent from 47 percent at the start of 2008 and 49 percent at the start of 2007.

It is often asserted that the dollar is the global reserve currency. It would be more accurate to say the dollar is the globe’s leading reserve currency.* The dollar is the dominant reserve currency in Northeast Asia. And the two big economies of Northeast Asia both happen to both hold far more reserves than either really needs. The dollar is also the reserve currency of the Gulf. And Latin America.**

But the dollar isn’t the dominant reserve currency along the periphery of the eurozone. Most European countries that aren’t part of the euro area now keep most of their reserves in euros. That makes sense. Most trade far more with Europe than the US – and some, especially in Eastern Europe, ultimately want to join the eurozone.

Russia has long traded far more with Europe than with the United States. By increasing the euro share of its reserves, Russia is in some sense just converging with the norm among other countries on the periphery of the eurozone.

Russia’s announcement also settles one mystery — or at least one little thing that I have spent a bit of time pondering. The following chart shows the Setser/ Pandey estimates of Russia’s dollar holdings relative to Russia’s foreign exchange reserves.

Interpreting the chart requires one additional bit of information. The quality of the data improves around the middle of the year, as the best US data comes from the (June) surrey of foreign portfolio investment in the US. The further from June, the larger the potential error.

Dollar assets for Russia (and China, but that is a more complicated story) were a bit lower than I would have expected in the June 2008 survey. I worried, though, that the survey was just missing a portion of Russia (and China’s) portfolio. Now though I would guess that the survey was more or less right about Russia. The US data then implies that Russia reduced the dollar share of its portfolio in early 2008 …

What of the apparent rise in Russia’s dollar share — at least based on our simple model — over the past few months?

Chalk that up to the limits of the US data.

We know from the US data that Russia has sold its short-term Agency portfolio. It literally took its holdings of short-term Agencies down from close to $100 billion to $1 billion. Almost of all of Russia’s remaining Agency portfolio in the Setser/ Pandey estimates consequently consists of longer-term Agencies.

And I would guess that Russia has actually sold off that portfolio at a faster pace than the Setser/ Pander estimates imply. If Russia sold a long-term Agency bond to a US investor, that would register in the data. But if Russia sold a long-term Agency bond to an investor outside the US, the TIC data wouldn’t pick up a thing. And our estimates are ultimately based off the TIC data …

Reuters reports that Russia has “banned investment in bonds of agencies such as Fannie Mae and Freddie Mac, saying it needed more liquid assets to meet the needs of its own budget” and here I suspect the Russians really have backed their words with actions.

An aside: Greg White’s reporting on Russia is always worth reading. The close to 10% y/y fall in Russia’s q1 GDP is a reminder of just how brutal the adjustment in Eastern Europe has been. The fall in output in a host of countries is now larger than back in the emerging market crises of the 1990s.

* The rise in global reserves means that the world’s central banks hold more euros as part of their reserves now than they held dollars in 2000. If demand for dollars hadn’t risen any more, the rise in demand for euro-denominated reserves would be a big story …
** Best that I can tell, South and Southeast Asia generally hold a far lower share of their reserves in dollars than the big countries in Northeast Asia."

And:

"
Euro's Share In Reserves Overtakes U.S. Dollar 19 May 2009Reuters
The euro's share in Russia's forex reserves, the world's third-largest, overtook that of the dollar last year as the country pressed on with a gradual diversification, the Central Bank's annual report showed.

The euro's share increased to 47.5 percent as of Jan. 1 from 42.4 percent a year ago, according to the report, which was submitted to the State Duma on Monday.

The dollar's share fell to 41.5 percent from 47 percent at the start of 2008 and 49 percent at the start of 2007.

Concern about countries allocating a greater share of their reserves in currencies other than the dollar has been one of the factors weighing on the greenback in recent years.

Sterling's allocation in Russia's reserves was broadly steady at 9.7 percent of the cash pile, while yen holdings rose to 1.3 percent from 0.8 percent, the report showed.

Russia's gold and forex reserves stood at $427 billion at the start of 2009, having been depleted by roughly a third in five months by interventions in the currency market in a bid to keep ruble depreciation under control.

In line with other global reserve managers, Russia has taken a more cautious approach with its investments in the face of the global financial crisis.

"In the second half of 2008, due to the global financial and economic crisis and against the backdrop of liquidity problems on external financial markets, the credit risks linked to the Bank of Russia's activity in managing forex reserves have increased," the Central Bank said in its report.

The regulator said it had reduced the maximum length of deposits on which reserves are placed, giving no more details. It has also reduced credit limits for counterparties on the external market and limited the list of counterparties for deposits on the external market.

Russia has also been gradually increasing holdings in gold and has banned investment in bonds of agencies such as Fannie Mae and Freddie Mac, saying it needed more liquid assets to meet the needs of its own budget.

The report showed that 10.8 trillion rubles ($336.8 billion) of Central Bank investments were in foreign bonds.

Of that, the debt of European issuers accounted for 6.5 trillion rubles, U.S. issuers made up 4.06 trillion rubles, yen-denominated Japanese bonds 150 billion rubles and bonds of international organizations 120 billion rubles.

The Central Bank has previously said it keeps more than 30 percent of its reserves in U.S. Treasuries."

The United States is making policy decisions purely according to domestic considerations and is giving little thought to the outside world

TO BE NOTED: From Reuters:

"
Wary of U.S. debt, China shifts gears on investment
Tue May 19, 2009 8:23am EDT

By Simon Rabinovitch - Analysis

BEIJING (Reuters) - China has engineered a subtle yet significant shift in the investment of its foreign exchange reserves, a sign of how it is willing to act on concerns about financing an explosion of U.S. debt.

Beijing has been far and away the single biggest foreign buyer of Treasuries over the past year, but this apparent vote of confidence belies how it has turned its back on long-term U.S. debt in favor of shorter maturities.

China's move to the shorter end of the U.S. debt spectrum is a defensive tactic adopted by the wider market as well on the view that the United States will have to raise interest rates down the road to control inflationary pressures when the economy recovers from the financial crisis.

But the shift also comes after pointed comments from Beijing expressing worries over the security of its U.S. investments and calls from Chinese government economists for a tough line with Washington in return for continued access to loans.

"The United States is making policy decisions purely according to domestic considerations and is giving little thought to the outside world," said Zhang Ming, an economist at the Chinese Academy of Social Sciences (CASS), a leading think-tank.

"This being so, the Chinese government should prepare its defenses," he said. "We can keep buying U.S. debt but we have to attach some conditions."

But China's leverage may be limited, despite sitting on the world's largest stockpile of foreign exchange reserves at $2 trillion.

The very surge in U.S. debt -- the Treasury plans gross issuance this fiscal year of $8 trillion -- means China's heavy buying is increasingly looking like a drop, albeit a very big one, in the ocean.

PLAY IT SHORT

Beijing has also taken pains to stress that, while uneasy about the U.S. economic outlook, it views Treasuries as a safe investment. And it knows that it would lose a lot from a plunging dollar with so much invested in the U.S. already.

So rather than cut off financing for the U.S.'s record budget deficit for this fiscal year, China has instead, little by little, shifted its buying out of longer-term bonds.

Between August 2008 and March 2009, China bought $171.3 billion of bills, debt that carries a maturity of up to a year, compared with just $22.9 billion of longer-term notes and bonds with a maturity of two years or more. It also sold $23.5 billion of long-term agency debt, U.S. data shows.

That followed purchases of just $9.6 billion of bills against $47.8 billion of bonds and $45.6 billion of agency debt in the first half of 2008.

For a chart showing China's short-term buying, click on:

here

The shift illustrates how it was more than cheap talk when Premier Wen Jiabao said in March that he was "a little bit worried" about China's investments in the United States.

The Chinese central bank was also unusually direct this month in expressing unease with U.S. economic policy, saying the dollar could come under serious pressure because the Federal Reserve was printing money to fend off the financial crisis.

The most recent data shows China bought more long-term notes than bills in March, but a single month does not reverse the marked change over the past year.

"Demand is weakening and it is being kept mainly at the short end," said Andy Xie, an independent analyst and formerly Morgan Stanley's chief China economist.

"This is an adjustment," he said of China's shift into Treasury bills. "This is not a collapse of confidence yet."

Indeed, with its economy expected to speed up, China might soon have to contend with more speculative capital inflows, which would add to its forex reserves and force it to recycle yet more dollars into U.S. investments to cap yuan appreciation pressure.

"The most probable scenario is one where Chinese demand for Treasuries re-emerges on the back of renewed Chinese reserve growth," said Brad Setser, an economist at the New York-based Council of Foreign Relations who tracks China's forex flows into the United States.

For a chart showing China's FX reserves and Treasuries, see:

here

China has long pledged to diversify its reserves away from the dollar. The composition of its reserves is a state secret but analysts estimate the proportion in Treasuries has increased. They say about two-thirds are held in dollar-denominated assets with at least $1.2 trillion in Treasuries or U.S. government agency debt.

DIMINISHING CLOUT

With the United States needing to fund a huge deficit to support its recession-hit economy, Chinese government advisers have made bolder calls for Beijing to lock in better terms as its chief foreign financial backer.

CASS economist Zhang said China should, for starters, mainly buy Treasury inflation-protected securities. Second, Beijing should ask Washington to issue foreign currency debt and even bonds convertible into U.S. bank stakes, he said.

Although not official policy, Zhang's views offer a window onto how Beijing is giving more thought to how to flex its muscles in the U.S. debt market.

Yet China's ability to pressure the United States may be about to diminish, and quickly.

China owns nearly a quarter of the U.S. debt held by foreigners, calculations based on Treasury data show.

But its share of debt held by the public -- in the United States and abroad -- has leveled off at 11 percent and is likely to drop, as Washington is on course to issue about $2 trillion of net new debt this year to finance its mushrooming deficit.

The bulk will be absorbed by Americans themselves, as the recession has driven U.S. households and firms to save far more.

For a chart on China's weight in the Treasuries market, see:

here

"Conditions in the Treasury market will be increasingly determined by American demand for Treasuries and less determined by the scale of foreign demand," Setser said.

This is very good news for both countries in at least one respect; it will help dismantle the "balance of financial terror" that has been said to define their relationship.

The United States is now less reliant on China for financing, and China in turn can diversify away from Treasuries without destroying the value of its existing holdings.

In theory, at least. Global markets' fixation with China's every move in managing its reserves will not fade away so easily.

"There is still the emotional impact of the idea of China diversifying," said Stephen Green, chief China economist at Standard Chartered Bank in Shanghai. "If news of that leaked when the dollar was already weakening, the impact would be amplified."

(Reporting by Simon Rabinovitch; Graphics by Catherine Trevethan; Editing by Neil Fullick)"

Thursday, May 14, 2009

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

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. “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.

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."

Me:

    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.

And:

    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.

Sunday, April 26, 2009

the party kept going long after private investors ceased to be willing to finance it

TO BE NOTED: From Follow The Money:

"How much “capital flow reversal” insurance should the world offer?

That isn’t a question that is usually asked in the debate about the “right” size of the IMF. But it strikes me as a question worth asking.

Back in 2006, US growth slowed relative to growth in the world. Private demand for US assets fell.* But the US didn’t have to “adjust” — that is to say bring its trade deficit down to reflect the reduced availability of private financing. Why not? Emerging economies, who received most of the influx of private money not going to the US, generally used this influx to build up their reserves. A rise in financing from central banks and sovereign funds offset the fall in (net) private demand for US assets.** The US trade deficit fell a bit relative to US GDP, but not by all that much.

Thanks to a generous supply of credit from the emerging world’s central banks, the party kept going long after private investors ceased to be willing to finance it.

Suffice to say that when emerging economies running comparable deficits to the US encounter a comparable fall off in private financial flows, the amount of financing that gets recycled back their way by the US and EU (though institutions like the IMF) is far smaller. Between 1997 and 1999, “volatile” private capital flows (bank loans and portfolio flows, I left FDI out) swung from a $100 billion inflow to a $100 billion outflow. The net increase in IMF’s lending over this time by contrast was only around $30b — not all that much relative to the $200 billion swing.

The current crisis isn’t all that different. Between 2007 and 2009, volatile capital flows are expected to fall from a positive $250 billion to a negative $400 billion — a swing over over $650 billion. IMF lending — based on all existing programs — will increase by close to $120 billion (see this chart by my colleague Paul Swartz). That is more than in the past, but not enough to offset the fall in capital flows, and certainly not enough to offset the combined impact of lower capital flows and lower commodity prices on the commodity exporting region.

Scaled to world GDP, the current swing in private capital flows and the (projected) rise in official lending looks roughly similar to the swing back in 97-98.

I don’t know what the right balance between financing and adjustment is. No one probably does. And it clearly varies from country to country. Some countries are in worse shape than others.

But it is still striking that the emerging world did more to help the US avoid adjustment from say early 2006 to mid 2008 than the US, EU and Japan seem likely to do (through the IMF and World Bank as well as bilaterally) to help the emerging world avoid adjustment now, even with the recent expansion of the IMF.***

Call it part of the United States exorbitant privilege. So long as key emerging economies peg to the dollar and allow their reserves to rise when private demand for their financial assets rises, the US gets more protection from a sudden reversal in capital flows than other countries with large deficits.

But also call it part of a broad system that has resulted in a persistent uphill flow of capital — and thus part of a broad system that led the US to run larger external deficits over the past few years than really were healthy.

* US investors started buying more non-American long-term assets while (private) foreign investors lost interest in US assets. The fall in private demand though wasn’t immediately apparent because a lot of official flows initially registered as private flows through the UK and other financial centers.
** $100 billion in “private” outflows from China in 2006 lowered the global total. Those private outflows though were clearly the product of an effort to hand some of China’s reserves over to the state banks to manage. They weren’t really private.
*** It also interesting that the $200 billion or so in financing Russia got from the sale of its reserves far exceeds the IMF’s total commitments to date; that helps put the IMF’s actions in context."

Monday, April 20, 2009

They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in

TO BE NOTED: From Follow The Money:

"The central bank panic of 2008

Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion.

Central bank sales of Agencies in 2008: close to $100 billion.

That is a one-year swing was close to $400 billion.

It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market.

Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

The comparison though should give pause to those arguing that sovereign investors are always a stabilizing force in the market because of their long investment horizons. If a few very large actors loses confidence in a certain type of debt, they can have a big impact.

There is a second reason why central banks’ sales of Agencies wasn’t quite as disruptive as it might have been: The US central bank – moved to offset the outflow of foreign central banks from the Agency market. Foreign central banks sold Agencies to buy Treasuries, and the US government sold Treasuries to buy Agencies. And American money market funds never lost confidence in the Agencies. When they stopped holding the financial sector’s paper, they bought both short-term Agencies and short-term Treasuries.

The willingness of the official inflows (from places like the IMF) to offset the swings in cross-border private capital flows has, historically, been smaller. With the benefit of hindsight, a strong case can be made that the IMF’s financial response to the Asian crisis was too timid, with the IMF asking for too much adjustment and providing too little financing. Loans from the IMF and World Bank were clearly far too small to offset the swing in private capital flows.

This isn’t just a historic debate either.

Eastern Europe has attracted large net capital inflows over the past few years. Bigger inflows, relative to its GDP, than Developing Asia in the 1990s.

And by all indications Eastern Europe is now experiencing a comparable stop in private inflows, and in all likelihood, those large private inflows will turn into large private outflows. But there also now seems to be a greater willingness to use the IMF to provide more financial support than in the past …

* The swing would be larger if I added data for the Asian NIEs (including Korea, a crisis country) to the total. Alas, the IMF WEO data set doesn’t have BoP data for the NIEs. Help, please! I am a heavy user of the IMF data, and this is something that they should be able to add …"

Friday, April 17, 2009

At some point, though, central bank and flight-to-safety demand for Treasuries will fade

TO BE NOTED: From Follow The Money:

"Reserve managers keep buying Treasuries …

Chinese reserve growth has slowed. Russia’s reserves are down in the first quarter (though most of the fall was in January). Saudi foreign assets fell in January and February.

Most emerging economies — including some that thought they had ample reserves a year ago — want more foreign currency liquidity. They are looking to borrow foreign exchange pretty much any place they can. Russia, Korea and Abu Dhabi are all poised to issue international sovereign bonds. Other cash-constrained countries (and companies) are turning to China for help, especially if they have a bit of oil or iron ore to offer in exchange. Still others are turning to the IMF.

The amazing thing is that central banks are buying more Treasuries now, when their reserves are shrinking, than they ever did when their reserves were growing.

After several years when plain vanilla Treasuries were out of favor as a reserve asset, demand for Treasuries surged late last year. It fell off a bit in January, but picked up again in February. Moreover, we know that little has changed since then. The Fed’s custodial of Treasuries are up by a stunning $76 billion since the end of February. Central banks were particularly active in the past week. Custodial holdings of Agencies are down by a little more than $8 billion since February.

Foreign demand for Agencies has truly disappeared. Look at the following chart, which shows rolling 12m purchases of all Treasuries and Agencies, includes short-term T-bills and short-term Agencies:

Indeed, the fall off in demand for long-term Agencies has been sharper than the fall off in demand for long-term US corporate bonds or equities.

Chalk that sudden stop to the reserve managers at a few large central banks. For a while, Agencies backed by prime mortgages and an implicit government guarantee were almost as toxic to central banks as subprime debt was to commercial banks. The Fed is buying Agencies, but almost no other central bank is.

Treasuries are the only US asset foreign investors still want, despite their low yields. Over the past 12 months, the US — rather amazingly — could have financed its trade deficit by just selling Treasuries. And nothing else. At least so long as Americans didn’t move large sums out of the US.

It still could for that matter. The $85.1 billion in Treasuries foreign investors bought in the first two months of 09 (mostly in February) easily exceeds the $62.2 billion January-February trade deficit.*

At some point, though, central bank and flight-to-safety demand for Treasuries will fade. That won’t necessarily signal a loss of confidence in US government bonds. It could equally signal renewed confidence in the Agencies — or at least an and to the reallocation of existing reserves toward Treasuries.

The fact that the US is financing its external deficit entirely by selling Treasuries understandably makes people a bit nervous. After so much has gone wrong over the past year it is natural to focus on the remaining risks. The sudden loss of foreign confidence in the Agencies is a cautionary tale.

But there are also three sources of comfort:

One, it is far easier for central banks to shift out of Agencies (and large uninsured deposits) and into Treasuries than it is for central banks to shift out of Treasuries. Especially when most countries are looking to increase their holdings of truly liquid assets. China now seems worried about the safety of its reserves, but far more countries worry that they don’t have enough reserves to be safe.

Two, American demand for foreign assets has fallen alongside foreign demand for US assets. That reduces the total amount the US need to borrow from the world.

Three, the big fall in the US trade deficit means that the US has to sell far fewer foreign assets of all kinds. A $30 billion monthly trade deficit doesn’t worry me quite as much as a $60 billion monthly trade deficit.

Ongoing demand for Treasuries and faster US sales of foreign “risk” assets than foreign sales of US “risk” assets have provided sufficient financing to cover the United States’ much reduced trade deficit. But I wouldn’t want to count on the current mix of financing to cover a growing deficit. That, in view, is still where the real risks lie.

*We don’t have data on the March trade deficit, and April isn’t over. But the $135.5 billion rise in the Fed’s custodial holdings of Treasuries so far this year seems to be roughly in line with the likely deficit. On the other hand, some of the inflow must be coming out of dollar assets, though less seems to be coming out of the Agency market than in the last half of 2008."

Thursday, April 16, 2009

foreign demand for US assets other than short-term Treasury bills — has dried up

TO BE NOTED: From EconomPic Data:

"No Foreign Demand for US "Risk" Assets

Brad Setser reports:

It is a good thing the US trade deficit has come down, because foreign demand for US financial assets — actually foreign demand for US assets other than short-term Treasury bills — has dried up.

Foreign investors bought $68 billion of T-bills in February. Russia alone (likely Russia’s central bank) bought close to $14 billion. Private investors — seemingly Japanese private investors — also bought $23.5b of longer-term Treasury notes. Otherwise, though, foreign investors didn’t buy much of anything. And Americans also didn’t buy many foreign assets.


It will be interesting to see if March's rally in risk assets corresponded to an increase in demand by foreigners.

Source: Treasury

Sunday, April 5, 2009

China is, according to Krugman, hoping for a magical solution that will “rescue China from the consequences of its own investment mistakes.” I agree.

From Follow The Money:

"Sign of strength or evidence of weakness? China’s dollar reserves

On Friday, Paul Krugman interpreted China’s call for a new reserve currency as a sign of weakness:

“But Mr. Zhou’s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”

China is, according to Krugman, hoping for a magical solution that will “rescue China from the consequences of its own investment mistakes.” I agree.

Krugman rather provocatively argues that “China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind.”

I agree, at least in part.

I would be surprised if the State Council received a memo from the PBoC back in 2004 saying “$500 billion in reserves isn’t enough for a country with a closed capital account; let’s aim for $2 trillion by the middle of 2008.”

At the same time, China’s leaders made a series of choices that resulted in the accumulation of huge quantities of reserves. Even if China’s leaders didn’t plan to hold so many dollars, they weren’t willing to make the policy changes needed to avoid accumulating their current stash.

No doubt the Asian crisis led most Asian countries to conclude that they wanted more not fewer reserves. At the same time, it is hard to attribute the buildup of China’s reserves simply to the Asian crisis. China — like other emerging Asian economies — actually didn’t build up its reserves immediately after the Asian crisis. If China’s only priority was building up its reserves, it should have devalued the RMB in 1998 – not maintained its peg to an appreciating dollar.

The growth in China’s reserves started in 2002, and then really started to accelerate in late 2004. It consequently can be attributed in large part to China’s decision to maintain its dollar peg even after the dollar started to depreciate from 2002 on.

China could have moved decisively away from the dollar at various points from 2002 on; if it had, it would have ended up exporting a bit less, running a smaller current account surplus and building up far fewer reserves.

In late 2003 it was clear that the reversal of hot money flows, a lending boom and the export boom had combined to push up China’s inflation rate. China faced a choice. It could have allowed the credit boom to continue, knowing that the resulting rise in inflation would lead to a real appreciation that would offset that real depreciation created by China’s link to the depreciating dollar. Or it could have allowed the RMB to appreciate, reducing hot money inflows and inflationary pressure. It opted, instead, to limit loan growth and to tighten fiscal policy while keeping the peg to the dollar. That policy worked in a sense: lending growth slowed, inflation came down and imports fell. But it also created China’s large current account surplus.

In the summer of 2005 China had another opportunity to reverse course. But it opted for a mini-revaluation against the dollar – a change that had no real economic impact. China maintained a very subdued pace of appreciation against the dollar for another two years even as its current account surplus soared. That predictably pushed up China’s reserves

And in early 2007, China made another choice: when it opted to create the CIC and allow SAFE to take more risks, it implicitly recognized that it had more reserves than it needed. Rather than letting SAFE buy equities, it could have allowed the RMB to appreciate to a market clearing level.

At key points then, China shied away from the decisions that would have allowed it to avoid accumulating so many reserves. China’s leaders probably didn’t intend to accumulate $2 trillion in reserves, but they weren’t willing to make the policy choices needed to change China’s growth trajectory either.

And now China has a problem. Its dependence on exports meant that it ended up importing unemployment from the rest of the world just when China’s own property boom soured. And it so happened that the costs of relying on exports for growth became obvious at the same time that the costs of accumulating more reserves than China needs also became very visible.

China’s leaders likely hoped big investment gains would help offset their currency losses. Now, though, they realize that they bought equities and other risk assets at the top of the market, and thus added to their losses. China’s leaders have noted the criticism that has been directed at the CIC. They now that fessing up to additional losses won’t be popular –

China’s 2007-2008 bet on global equities and riskier bonds likely cost it north of $50 billion — it all depends on exactly how much of its portfolio it put into risk assets. To be sure, it is in far better shape than Ontario Teacher’s Pension Plan, which lost a staggering 40% on its fixed income portfolio. Most of China’s reserves were in safe government bonds, and those bonds increased in value over the course of the crisis. But as Arvind Subramanian notes, China’s currency losses will eventually dwarf its equity market losses.

Those losses shouldn’t be a surprise. Currency losses on unneeded reserves are the price a country pays for subsidizing its exports with an undervalued exchange rate. But that doesn’t make it any easier to accept the losses – or to handle the inevitable argument that China’s leaders squandered China’s reserves.

China’s leaders are setting the stage to argue that these losses are the fault of bad US policies. They aren’t. They are the result of China’s own policy choices. Subramanian correctly observes “[China] is seeing itself as the victim of the dollar standard when it has been, for a long time, a beneficiary and promoter of this standard.” China’s leaders, though, have no incentive to recognize this.

But even if China didn’t explicitly plan to build up to many reserves, it now has them — and China’s leaders are no doubt interested in using them to increase China’s influence.

It isn’t hard to think of creative ways China could use its reserves to increase its global position. China alone could provide all the extra $500 billion the IMF now needs if it wanted to do so. Or it could set up a Chinese monetary fund to compete with the IMF.

To date, China has been fairly cautious, generally turning down countries that trekked to Beijing to appeal for emergency loans – though the recent expansion of RMB swap lines suggests that China may now be willing to take more risks. One potential problem: China would need to explain to its own citizens why it is using its reserves to help other countries rather than doing more at home.*

And then there is the elephant in the room: Will China’s large dollar holdings — and the fact that is is now the United States largest creditor — give it any influence over US policy?

I have thought about this question for some time now.

China’s leverage comes not from the fact that it has a lot of dollars, but rather from the possibility that it might stop adding to its dollar portfolio (when its reserves are growing) or sell its dollar portfolio (when its reserves are stagnant). China is now big enough to have an impact on the market. SAFE holds around 15% of the outstanding stock of marketable Treasuries, for example. The $400 billion of US financial assets China bought in 2008 constitute a meaningful share of both net and gross inflows to the US.

But China can only exercise leverage if it is willing to accept the consequences of scaling back its dollar bet – a fall in its exports, and an upfront financial loss on its existing reserve portfolio. If China isn’t willing to accept those costs, it is – as Dr. Krugman puts it – stuck.

In some sense, it makes financial sense for China to take its financial lumps sooner rater than later. Buying dollars to keep the dollar from falling (against the RMB) allows China to avoid taking losses now, but that implies that China is effectively taking on the risk of a much larger loss in the future. So far, though, China’s leaders have always preferred to risk a bigger loss in the future than take a certain loss today – and to defer shifting the basis of China’s growth away from exports rather than to force adjustment immediately. Unless those preferences change, China doesn’t have much leverage.

Especially as the US isn’t going to start selling China special SDR denominated bonds to help China out – let alone start selling China RMB bonds.

At the same time, China’s leaders – and the United States leaders – should be thinking through the consequences of letting current trends continue.

China added $1500 billion to its reserves (counting the PBoC’s other foreign assets, but excluding the funds shifted to the state banks and the CIC) from the end of 2004 to the end of 2008, and probably added close to a trillion dollars to its portfolio.

China cannot easily shed its existing dollar exposure. But it also doesn’t have to maintain a set of policies that imply large current account surplus, and ongoing pressure to add to its dollar portfolio.

Andrew Batson’s Wall Street Journal story on Governor Zhou’s call to create a new global currency was the most emailed story on the WSJ’s website for a while. The FT’s stories on this have also gotten a lot of attention.

China’s $1.5 trillion or so in US portfolio** increasingly makes both sides of the Pacific nervous. Letting that portfolio grow to $2 trillion, or $2.5 trillion, won’t make the underlying issues go away. It isn’t healthy for China to rely so heavily on exports for its growth, or for the US to rely so heavily on the government of a country that now seems ambivalent about the dollar for financing.

Let’s hope that China’s stimulus proves strong enough for China to lead the rebound in the global economy – and for Chinese demand to emerge as a true engine for global growth.

* Foreign assets can only be used to meet balance of payments needs – whether to cover a trade deficit or finance capital outflows. China cannot use its reserves domestically. At least not directly. It could though use its reserves to finance a trade deficit that stems from a huge fiscal stimulus.
** The Setser/ Pander estimate of $1.7 trillion looks a bit high, given the latest survey data. $1.6 trillion seems more realistic, if one assumes that China has around $120 billion in US corporate bonds (The TIC data shows that China has been a significant buyer of corporate bonds, but those bonds don’t show up in the survey). The latest survey data suggests the dollar share of China’s portfolio is probably closer to 65% than 70%, though I am not totally confident of this."

Me:

    April 5th, 2009 at 6:39 pm
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    I’m probably the only person who finds the speeches of Chinese officials interesting. Take this one:

    http://www.pbc.gov.cn/english//detail.asp?col=6500&ID=138

    Remarks of Deputy Governor Wu Xiaoling on the International Seminar on the Tenth Anniversary of Asian Financial Crisis

    June 21, 2007

    “(3) China promised that the RMB would not depreciate. Being a highly responsible country, the Chinese government made the decision of no depreciation of the RMB with an aim of safeguarding regional stability and promoting development, which played a pivotal role in maintaining economic and financial stability of the Asian countries and the world at large, as well as Asian countries’ economic recovery and regaining of rapid growth in later years. ”

    To me, this explains their current views.