"Central banks that needed cash to cover large capital outflows from their own economies"

Brad Setser:

"A few quick words on the November TIC data

Posted on Friday, January 16th, 2009

By bsetser

China sold $9.2 billion of long-term Treasuries. But it also bought $38.2b of short-term Treasuries.( THE FLIGHT TO SAFETY CONTINUED ) China’s total Treasury holdings are up by $29.1b. By contrast it sold $3.1b of long-term Agencies( IMPLICITLY GUARANTEED ) and also reduced its short-term holdings by about $5 billion. China reallocated( TO EXPLICIT GUARANTEES ) its US portfolio, but it hasn’t cut back on its dollar purchases.( IT WANTS TO PRESERVE ITS CURRENT RELATIONSHIP WITH THE US AT ALL COSTS. )

The following graph, prepared with help from Arpana Pandey, plots the average increase in China’s reserves (defined broadly, to include hidden reserves) over the last 3 months v my best estimate (taking flows through London into account*) of China’s Treasury and Agency purchases. It speaks for itself.( THE FLIGHT TO SAFETY. PERIOD. FROM IMPLICIT TO EXPLICIT GUARANTEES. IN A CALLING RUN, THIS IS WHERE YOU WANT TO BE. )

The same story applies to the official sector as a whole. Central banks sold $26.2b of long-term Treasuries, but added $66.6b to their short-term Treasury holdings. Net central bank holdings of Treasuries — judging from the TIC data — rose by $40.4b. That is consistent with the $49.1b rise in the Fed’s custodial holdings of Treasuries. Central banks by contrast are reducing their holdings of short-term and long-term Agencies. They sold $14.3b of long-term Agencies, and their short-term holdings likely fell by a comparable amount.**

The countries that are really running down their Treasury portfolio — Korea and Brazil — are countries whose reserves are falling and need the cash( A CALLING RUN ). Russia is running down its Agency portfolio for a similar reason. It really needs the cash( A CALLING ). Its short-term Agency holdings are down to $13.7b. They were close to $100b — 496.8b — in December of 2007.

The big stories in the TIC data, it seems to me, are:

– The ongoing reallocation of central bank portfolios toward short-term Treasuries. That reallocation has been huge( THE FLIGHT TO SAFETY ). Central banks held $$276.8b of t-bills at the end of September. They hold $427.2b at the end of December. And judging from the Fed’s custodial data there is every reason to think that total rose in December. Foreign central bank demand for safe and liquid assets rose at the same time as private demand rose.( FOR THE SAME REASON. THE FLIGHT TO SAFETY. )

– The ongoing retreat of private capital from global markets, or what I previously called the reversal of financial globalization( SIMPLY A CALLING RUN OR DEBT-DEFLATIONARY SPIRAL. ). Foreign investors sold $56b of US long-term securities in November, and another $36.6b in October. Central banks that needed cash to cover large capital outflows from their own economies( A CALLING RUN ) or that simply wanted to shift to short-term t-bills accounted for the majority of those sales, but private investors were selling too. Americans have sold about $35 billion of foreign securities in each of the last three months as well.( A CALLING RUN )

As a result, the US trade deficit is now effectively financed by short-term inflows — including short-term inflows from central banks*** - and the fact that American investors are currently selling their foreign portfolio faster than (private) foreign investors are selling their existing US portfolio.( FOR THE SAME REASONS. A CALLING RUN. IN NOVEMBER, A PROACTIVITY RUN BEGAN. )

* London flows had no real impact on the recent data.
** The US reports data on short-term negotiable securities held by central banks and short-term Agencies held by all foreigners, but not short-term Agencies held by central banks. i have to extrapolate a bit.
*** Some of these short-term inflows may be a reallocation away from private custodians, and thus may not represent a true increase in demand for US assets.

This entry was posted on Friday, January 16th, 2009 at 11:21 am and is filed under U.S. trade deficit and external debt, central bank reserves. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site."

This is not hard to understand. In the comments, all sorts of technical reasons are put forth, but they are only symptoms, and of little or no explanatory power. Please read I. Fisher. What I call a Calling Run is a version of his Debt-Deflationary Spiral.

"At least a crisis marked by a run out of risky US assets and into safe US assets. "

Brad Setser looks at Balance Of Payment Data:

At least a crisis marked by a run out of risky US assets and into safe US assets (THE FLIGHT TO SAFETY ). Right now Agency bonds — think Freddie and Fannie — are considered risky assets while Treasuries are not ( WHY ? BECAUSE THEY ARE EXPLICITLY GUARANTEED BY THE GOVERNMENT I PRESUME, WHILE THE AGENCY BONDS ARE IMPLICITLY GUARANTEED. TO ME, THIS UNCERTAINTY SPRINGS MAINLY FROM LEHMAN. I AM ALONE IN BELIEVING THIS APPARENTLY )

A run out of all US assets and the dollar would look very different.

The October TIC data tells a striking story — one marked by a massive surge in demand by both private and official investors for “safe” assets. Foreign investors bought $182 billion of Treasuries — including $147.4 billion of short-term Treasury bills. There is no real mystery why bill yields dropped so low even as the supply of bills surged. And foreigners added $207 billion to dollar bank accounts.

Sum that up and it works out to close to $400 billion in demand for safe dollar denominated assets. If that kind of monthly inflow is annualized it is a shockingly large number. ( THAT'S A MEASURE OF THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY )

It isn’t hard to figure out why the dollar rallied.

$400 billion in a month is far more than the US needs to cover its trade deficit. It allowed foreigners to reduce their holdings of Agencies by close to $75 billion (including a $25 billion fall in short-term Agencies), their holdings of long-term corporate bonds by $13 billion and their holdings of US equities by $6 billion without causing any strain on the dollar.

Indeed, the fall in foreign holdings of US corporate bonds and US equities (though not the outflow from the Agencies) could have been financed by the sale of $36 billion of foreign assets by US residents …

Usually I argue that the TIC data understates official flows. And this month’s data may well do so.

Some of the $35 billion in long-term Treasury bonds bought by UK investors were probably bought by central banks, and selling by central banks could have contributed to the $13.8b in net sales of long-term Agencies. But in broad terms I don’t doubt that private demand for “safe” US assets soared as a result of the crisis — and much of the inflow came from private investors seeking to increase their holdings of the most liquid dollar assets ( LIQUIDITY IS ALSO IMPORTANT AS A RESULT OF THIS CRISIS ).

In October, China was about the only central bank adding to its reserves (I suspect, it hasn’t formally released its reserves data). Most central banks were selling. That shows up in the US TIC data. South Korea, Brazil, Mexico, Russia and Ukraine were all net sellers of long-term US Treasury bonds …

The big central bank flow was a reallocation away from Agencies toward Treasuries. And specifically toward short-term Treasury bills.

China increased its holdings of short-term Treasury bills by a stunning $56 billion while also buying $10 billion of long-term Treasuries. That flow alone would have been enough to cover the trade deficit in the absence of any offsetting outflows. Russia cut its holdings of short-term Agencies by a little over $22 billion while increasing its holdings of short-term Treasuries by almost $12 billion.

So much for talk that central banks are always a stabilizing presence the market. They clearly have destabilized the Agency market. The fall in demand for Agencies over the past three months — and most Agency demand has come from central banks until recently — has been sharper than than the fall in demand for US corporate bonds (think securitized subprime mortgages, the category “corporate bonds” in the BoP data includes asset-backed securities) after the crisis of last August.

The fall in demand for corporate bonds (the redline) is what generated a rather scary graph after the initial crisis last August. Things haven’t gotten any better since …

The Agency market is a rather important market. Increased lending by the Agencies offset the fall in demand for “private” mortgage-backed securities after the crisis last August. More recently, the absence of a “central bank bid” has kept Agency spreads wide even after the US Treasury bailout of Freddie and Fannie. And that in turn has pushed the US to adopt other measures to bring down long-term mortgage rates. The Fed and the Treasury are literally now buying the Agencies that foreign central banks are selling. Action, reaction …"