The Goldman takeover of W's second term (Bolton, Paulson) continues …

I'll leave it to you all to figure out.

My timing isn't great, but I am taking a few days off – and won't have sustained internet access.  I'll be back full time on Monday.

Chinese stock markets have not been as frothy as the Chinese economy – though the Chinese market is doing better in 2006 than it has for a long time.  But what doesn’t go up as fast also doesn’t necessarily go down as fast. India, Turkey, Brazil, Russia and other emerging economies with (formerly) frothy stock markets have pushed China off the front pages of the financial press.

The US decision not to brand China a manipulator helped too.  Though I would note that China has yet to reciprocate by allowing the RMB to appreciate a bit.    China presumably wants to wait til markets are a bit calmer.   It always finds a reason to wait.

But there has been a lot of good work on China recently — work that is worth just a bit of attention.

John Makin has nicely pointed out that the combination of rapid reserve and rapid deposit growth and strict lending controls have led to an absolutely enormous build up of liquidity inside the Chinese banking system.

He doesn’t think that is a stable situation.   I tend to agree.

The World Bank’s Beijing office continues to do a great job of providing real time analysis of China’s economy.   The latest quarterly dissects the surge in bank lending, investment and exports in the first quarter.  It notes that Chinese investment continues to be biased toward the tradables sector …

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Or, rather, it almost certainly held at least 70% of its reserves in in June 2005.   At the end of June 2005, China’s reserves – counting reserves transferred to the state banks – were around $770b.   China’s holdings of US securities totaled $527b (68% of the total) at the time, according to the latest US survey data.  

And the survey only covers China’s holdings of US securities.  It leaves out China’s dollar bank accounts – so presumably China had slightly higher dollar holdings at the time.   Consequently, it represents a lower limit on China’s dollar holdings.  So I would say that China held at least 68% of its reserves in dollars – and probably more — in the middle of 2005.

More importantly, the survey data tells a very different story about the scale of Chines financing of the US than the story than emerges just from the TIC data.   Since 2004, the TIC  "flow" data has consistently suggested that a very low fraction of China’s reserve increase – maybe 40% — was going into US securities.   

For example, between June 2004 and June 2005, according to work that Casson Rosenblatt of RGE has done, China’s reserves increased by around $240b.   During that period, Chinese purchases in the TIC data totaled $97b (exactly 40% of the increase in US reserves).   But if you look at the change in Chinese holdings between the End-June 2004 survey and the End-June 2005 survey, a very different story emerges.  China’s holdings of US securities – according to the survey data – increased by $186b (78% of the increase in China’s reserves).

The TIC data tells one story.  The survey data quite another.  

That isn’t atypical.  The data are collected in different ways.  And both data sets have problems The TIC data comes from data on transactions, and thus is a good measure of flows.  But it sometimes gets the buyer wrong.  The survey data is a measure of the stock of US debt held abroad.  It sometimes does a better job of tracking the ultimate owner of US debt than the TIC data.   The TIC wouldn’t, for example pick up the People’s Bank of China’s purchase of a US treasury bond held by a German pension fund, while the survey data, in theory, would.  But, as Daniel Gros has noted, the survey data also seems to miss some foreign holdings of US debt – not everyone seems to want to report everything. 

In this case, though, the story in the survey data makes a bit more sense.  China is big and it pegs to the dollar, so if it really shifted away from dollar reserves, it presumably would put quite a bit of pressure on the euro/ dollar – and thus on the RMB/ euro.

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Is the lesson of the most recent bout of turmoil in the emerging world “emerging market economies have changed, but the markets have not”?

How have emerging economies changed since 1997, the last time money flowed their way in a big way?   Fundamentally, by saving rather than spending the commodity windfall, and by saving rather than spending the huge wave of capital that flooded emerging economies the past few years?   Obviously, there are exceptions – Eastern Europe, Turkey, India (now) and with oil prices high, Thailand and Korea – all run current account deficits.   But in aggregate, the emerging world has a big current account surplus despite attracting (til the last two weeks) big capital inflows.

Some countries in my view have taken prudence to such excess that their prudence has become a risk.  China won’t use long-term capital inflows from FDI, let alone short-term flows to finance a current account deficit.  As a result, its burgeoning reserves are contributing to a domestic credit bubble, barely restrained by administrative controls.  Too many oil exporters still budget for oil at $25 and, since they peg to the dollar, often have weaker real exchange rates now than in 1998, when oil was $15.  

But there also have been real changes in places that needed real change.   Brazil has eliminated two of its three major vulnerabilities.   Its external debt is way down, its exports are way up.   It has basically eliminated its domestic dollar-linked debt (good move).   Alas, the combination of high domestic rates, lots of short-term debt and a relatively large fiscal deficit has proven a bit more intractable.   Turkey addressed one major vulnerability – its fiscal deficit is basically gone.   Of course, it also has a big housing and consumption driven current account deficit.   That too is a real vulnerability.  But with something like 70% of the Istanbul stock market in foreign hands, big falls in the lira and Turkish stocks now hurt London and New York more than the Turkish banks … at least one hopes.   

Important changes, all.  The emerging world looks very different today than it did in say 1997, at the peak of the previous wave of capital inflows from New York, London and Tokyo.

What of the markets?   Have they changed since the last emerging market crisis? Gotten better at differentiating the good from the bad? 

In some sense, the answer to the question "Have the markets changed?" is obviously yes.   Just look at the growth in hedge fund assets under management (and hedge fund fees – see Edward Chancellor of breaking views) and credit derivatives.  

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If oil producers intend to cut production to keep prices above $50, why are so many oil producers budgeting for oil at $30?

And in the process creating a government savings glut?   The growing deposits of the government of the oil producers at their own central banks are absolutely stunning.

The Saudis will add over $100b to their reserves this way this year.   That is enough to write a check of $20,000 to each of Saudi Arabia’s roughly 5 million households.

Just saying.

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One common argument about China that I never have fully understood is that China’s banks are OK because China has tons of dollar reserves.

It is implicit in this statement by the (very good) Richard McGregor in his FT report on the (retracted) Ernst and Young report on China’s bad loans.

China's total liabilities for non-performing loans may be as high as $900bn, dwarfing official estimates and outstripping the country's massive foreign exchange reserves, according to a study of Beijing's bad debt problem.

I don’t get it.  

Foreign exchange reserves are useful if depositors want to take their money out of the country.   But when it somes to making up a gap between Chinese banks RMB deposits and their RMB deposits, they need an RMB asset – not dollars.    Typically that asset is a government bond.  So what matters – far more than China’s dollar reserves –is the capacity of China’s government to issue and pay a bunch of RMB debt. 

I am assuming, of course, that China’s banks are not totally sound now.  No doubt, a lot of bad loans have been bought by the PBoC and shifted to the asset management companies (which will need to be bailed out) or otherwise moved off the banks' books to prepare three of the big four state commercial banks for stock market listings.  But a certain fraction of their new loans are also likely to go bad.

But the quality of the banks balance sheets is a seperate issue from how you bailout bad banks. 

When the US bailed out its savings and loans, it didn’t use its euro and yen reserves.

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Incidentally, I am not the only one who thinks that the US current account deficit is heading toward a trillion.   The OECD now forecasts $965b current account deficit in 2006 (7.2% of GDP), and $1070b in 2007 (7.6% of GDP) — rather than link to the full report, with the actual numbers, I’ll just link to the summary.   Justin Lahart of the Wall Street Journal reports that the April ports data suggests strong imports and not-so-strong exports, which supports this forecast. And, given the pending surge in net US interest payments as the interest rate on US external debt rises from 3.4% (2005) to something closer to 5.5%, it seems likely to me that the US current account deficit will be above $1 trillion for a long time.  Barring a very hard landing.

Still, David Altig notes that the US remains a safe haven in times of stress.  David Altig asks “where else would you go?”    Actually, he puts it in a slightly more colorful way.

To anyone waiting for the greenback slaughter, I have one question: If, heaven forbid, the global economy goes south, who ya gonna call?

He asks, I answer.

If the global economy goes south because of an oil supply shock, I would run into the Canadian dollar and the Norwegian krone.  I would even rather hold the Russian ruble than the US dollar.  Putin isn’t the nicest guy, but Russia is now a substantial net creditor – and with oil at $70 Russia is adding about $150b to its reserves a year.  I kid not — Russia's reserves have been rising by $5b a week recently. Its external fundamentals are solid.  And I doubt the central bank will be able to resist nominal ruble appreciation forever.

I would also prefer the euro and even the yen to the dollar.  Both Japan and Europe have more energy efficient economies than the US (yep, energy intensity is a structural problem).   Oil exporters want to spend their windfall on European goods, not American goods.   And if oil gets higher, Americans will want to import more Japanese energy-saving technology (hybrids).   But I realize that the euro/ yen over dollar call is a bit more conversial – Peter Garber of Deutsche Bank thinks the dollar would rally in the event of a big oil supply interruption.   Lots of petrodollars would need a home.  My botton line though is simple: in the face of a shock that increases the current account deficits of all oil importers, I wouldn’t want to hold the currency of the oil importer with the biggest deficit.

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… against market downturns. 

Wasn’t a key selling point of hedge funds that they could make money even when the (US) stock market was falling, unlike mutual funds?

Well, hedge funds may be hedged against a fall in the US stock markets, but it sure doesn’t seem like hedge funds were (fully) hedged against falls in the stock markets of many emerging economies.   Or jitters in commodity prices.

I fully realize hedge funds do a whole lot of different things these days, and that in many ways the name "hedge fund" doesn't tell you much about what a fund really does.  Hedge funds can do things mutual funds cann't do, but that doesn't mean that they all do the same thing.  Or are all fully hedged.  Directional macro bets aren't "hedged,"  and long-short funds are only hedged v. certain risks, not others.  Those betting on credit spreads are long credit risk, even if they have hedged their interest risk and so on.

But it sure seems like everyone in the 2 and 20 world was piling into to emerging market equities a while ago.   It was an easy way to make money.  Hedge funds following different strategies all seemed to be taking the same long position.  So I am not totally surprised a lot of funds have losses.

Hedging a long emerging economies position with a short on the S&P sort of works, but not entirely.  Sometimes emerging market fall more than other markets.   And I don't think many folks were long say Turkish banks and short the broader Turkish market, or long Brazilian mining companies and short the broader market.  Most bets were simply long Turkey or long Brazil.

Among my current worries: the temptation to make money (lots of it) by selling insurance against a more volatile world when volatility was falling may have been too great for some folks to resist.   Paul McCulley:

With policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums – the market compensation for underwriting volatility – lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall.

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Felstein has argued that more “competitive” dollar would contribute to reducing the US trade deficit, and at least help to slow the rise in the US current account deficit.  I agree – though I would think the case for Asian and Gulf appreciation is stronger than the case for Euro appreciation.   Dollar depreciation alone isn't enough to bring the US trade deficit down (and slow the increase in the US current account deficit, which is set to rise because of growing net interest payments even if the trade deficit stabilizes), but it is a part of the process.

But that is not what this post is about.  Feldstein also has argued that the US data understate central bank financing of the United States.   Throw in financing from the oil states' investment authorities as well.   And the more I look at the data, the stronger Feldstein’s argument that the US data understate official inflows looks. 

For one, recorded inflows of around $220b seem low relative to global reserve accumulation (after adjusting for valuation changes, and including all Saudi foreign assets) of around $660-670b.     There is no doubt that central banks bought more euros and pounds and yen in 2005 than they did in 2004.   Recorded purchases of euros, yen, pounds and the like in the IMF’s COFER data totalled $150 billion, and since the IMF does not have data on the current composition of China and others who added, by my estimates, $300b to their reserves (on a valuation adjusted basis), that total is no doubt low.    Add in another $80b in non-dollar purchases from that set of countries.   That makes $230b, out of around $580b in (valuation-adjusted) reserve  growth — leaving $350b for the dollar.   I won't go through all the details for how I calculated this, but it is based on a fairly detailed analysis — and includes an implicit guess about changes in the portfolio of those countries who don't report their currency composition of their reserves to the IMF.

However, the IMF COFER data exlude reserves China shifted to its state banks (and a smaller currency swap), Taiwan's reserves and the increase in the Saudi-Monetary authorities non-reserve foreign assets.  Add those in and global reserves grew by about $660-70b by my estimates.  So even if the world’s central banks bought $250b of euros, pounds and yen in 2005 – that still leaves a bit over $400b for the dollar.   

$220b shows up in the US data, maybe $90b will show up in the BIS data showing central bank dollar deposits …  and so on.   But there is still a gap of around $100b.    Maybe more.  

And the $660-70b total leaves out the Norwegian oil funds, and the oil money parked in the Kuwait investment authority, Abu Dhabi’s investment authority and so on.    Add in at least another $50b there.    A good chuck of that went into dollars.    So I strongly suspect the US data understates official financing by at least $100b, maybe more.    And that sets aside the question of what the world’s banks are doing with all the dollars that central banks have placed on deposit – some no doubt are lent out to folks who lend to the US (though some are lent out to folks who buy Brazil’s dollar bonds as well). 

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At least if you have borrowed dollars to buy stocks in emerging economies that are tanking.

The series of crisis that rocked emerging economies in the 1990s were a formative experience for me.   So Monday’s big sell-offs has a rather familiar feel.  It sure seems like investors are running from all emerging economies, no matter what their vulnerabilities.     

I can understand running out of Turkey’s 2008 lira bond.  Those who bought it were betting the lira would be stable and Turkish inflation would continue to converge toward European levels.    Neither assumption panned out so far this year.   Turkey’s fiscal and current account deficits also look to be bigger than expected.  But Indonesia isn’t Turkey, and it too sold off.

And for a country like Brazil, the swing in sentiment was swift.   Brazil’s central bank was adding to reserves big-time in the first half of May (reserves grew by $7 billion between the end of April and May 15.  A few days ago real was close to 2.05; today it came close to 2.30 – what flowed in, flowed out.   Talk about sudden stops

Tuesday has been a bit different.  With oil prices still high, investors moved back into Russia. 

Those who argued that in the new post-crisis world, emerging markets were no longer correlated but rather traded on their individual merits may need to reevaluate just a bit.   The money sort of flowed in everywhere earlier in the year, and right now it seems to be flowing out everywhere.  It sure feels like a large set of creditors is reevaluating emerging market risk in mass – as the one factor that links the country’s that have sold off is that they attracted flows from the same set of people.   The FT on Monday's moves:

The MSCI emerging markets index was on track for a 10th consecutive decline, its worst run since August 1998, when the Russian default triggered worldwide market turmoil.

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