Brad Setser

Brad Setser: Follow the Money

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Iran, oil, dollar, euro

by Brad Setser
March 27, 2007

Iran indicated that it plans to reduce the dollar share of its portfolio to below 20%..  Something tells me it might not want to shift into pounds – a fairly popular alternative to the dollar – right about now either.  And for that matter, if it has euros on deposit in London …

It also indicated that China is now paying for its Iranian oil in euros.    Interesting.   

That brings up a question that Steve Kyle raised sometime ago over at Angry Bear – one that I have been meaning to address for sometime.   Does it matter that oil is priced in dollars?    

Steve’s answer is basically no.    And I don’t really disagree.   I certainly don’t think that the fact that most countries pay for their oil imports in dollars implies that either oil importers or oil exporters should keep their savings in dollars – and that is what really matters.  But I want to introduce one small nuance to his argument. 

First, though, does the fact that oil is settled in dollars imply that oil imports and oil exporters need to hold a lot more dollars than they otherwise would?    My answer is the same as Steve’s answer.  No.   Not really.     Sure oil importers probably need to keep some dollars on hand for transaction purposes.   But that fact alone doesn’t explain the huge dollar reserve holdings of many central banks.

Indeed, suppose an oil-importer wanted to set aside some funds back in 2002 to pay for its 2007 oil imports.   Should it have kept those funds in dollars?  Or in Euros?   The answer is pretty clear.  A euro buys less oil now than it did in 2002.   But a dollar buys far less oil now than in 2002.   Oil rose relative to both the dollar and euro, but it rose by more v. the dollar.  An oil importer would be better off holding its saving in euro, and then converting its euros into dollars when it needed to settle its 2007 oil import bill. 

By the same token, should an oil-importer hold its savings in dollars just because it gets paid in dollars?   The answer is not necessarily.    An oil exporter may want to hold assets that match the currency composition of its future imports (if you import a lot from Europe, you can limit your exposure to exchange rate moves by holding euro-denominated assets), not the currency of payment for its exports.   Or an oil-exporter may want to hold assets whose value is expected to appreciate not depreciate.   Clearly, in a backward looking sense, any oil exporter that set aside some money in 2002 would be a lot better off it held its savings in euros rather than dollars.    And as Steve Kyle notes, the currency that oil exporters opt to hold matters a lot more than the currency that they get in exchange for their oil.

“What really matters is what denomination they choose to HOLD their wealth in. After all, if an oil exporter accepts dollars and then converts them to euros 10 seconds later in order to hold them in that form it is the euro that ends up stronger and the dollar that gets weaker. So what really matters to the value of the dollar is whether the central banks of oil exporters like to have a portfolio heavy in dollar assets or heavy in other currencies.” 

So why do I think the fact that oil is still primarily settled in dollars may still matter?

Well, in part because a lot of oil exporters (still) peg to the dollar.   That means that they don’t want to drive the dollar’s value down, because it implies driving their own currencies down.   And with oil back above $60, the dollar flirting with 1.34 and inflation rising in a lot of oil-exporting economies, the last thing say the Gulf needs is an even weaker dollar.   Or to hold steadfastly to their current pegs as the dollar slides.  Kuwait and the UAE increasingly recognize this; the Saudis, not so much. 

That at least raises the possibility that oil exporters – especially those big enough to have an impact on global markets – might find it difficult to sell the dollars they receive in exchange for their oil without moving the market.   And specifically without moving the market in ways that push their own currency – which is tied to the dollar down.   

This is presumably a particular concern during periods of dollar weakness.  If my theory is right, some oil exporters who are paid in dollars may conclude that they have to hold the dollars they get, because selling the dollars would weaken their own currency. 

China incidentally is in a similar position.  It doesn’t export oil.   But it does intervene primarily in the dollar/ RMB market, so in the first instance, it accumulates more dollars than euros.  Keeping its portfolio balanced consequently requires ongoing dollar sales.  And when the dollar is under pressure, it may opt not to sell.

At least that is one theory.  I don’t really have a way of testing it.  China doesn’t reveal the currency composition of its portfolio.   The Gulf states don’t either.    China reveals the growth in its external portfolio – though it increasingly tries to conceal the pace of its growth.   So too does the Gulf.    Central bank reserve growth is pretty easy to track, but the growth in oil investment funds isn’t.    That makes it hard to know precisely how fast official assets are growing, let alone if Gulf states refrain from selling the dollars they get from their oil during periods of dollar weakness. 

There is another intriguing possibility.   Central banks may act a bit differently than oil investment funds, and specifically care a lot more about the impact of their reserve portfolio on the exchange rate than investment funds.  That implies that the Saudis – who keep most of their oil revenues on deposit at their central bank – end up holding a lot of dollars, while Kuwait, Qatar and Abu Dhabi – all of whom give most of their oil revenue to their investment funds – don’t. 

Or put differently, the Saudis work to stabilize the dollars’ value v. the euro even though some of the pressure on the dollar is coming from the sale of dollars by others in the Gulf.  

Call it free-riding by oil investment funds on central banks.

I am pretty sure that the various institutions that manage the GCC’s oil wealth don’t coordinate.  Yet several are big enough to move global markets.  

And as the management of China’s foreign assets gets split among different institutions, some of the same issues arise.   The PBoC might find it compelled to increase its dollar allocation – or at least to avoid selling dollars for euros – to offset pressure on the dollar that comes in part from the State investment company.

At this stage, though, this is all pure speculation.  I have some suspicions.  But my suspicions go far beyond what I can document …

45 Comments

  • Posted by AC

    China more-or-less pegs the yuan to the dollar (with slow appreciation). If it pays euro for its import oil, then it weakens somewhat the dollar and this the yuan vs. the euro. It is good for China because it wants to take away export markets in Europe. In January-Februar the Chinese goods export growth was more than 40%. The growth of export to the US was much less. Where did the rest go? I guess it went mostly to Europe (does anyone have data on this?).

  • Posted by Gheorghius

    I agree with you, and a little more.

    If Oil exporters hold their wealth in the currency of imports (say, Euros), they do hedge against a possible future appreciation of the Euro.

    On exports, however, your reasonment should be, if anything, reversed. “Hold not your wealth in $: if the dollar falls and drags down the real value of your export revenues, at least your wealth does not follow the same path”. But hold your foreign DEBT in dollars, so that if a dollar fall reduces your export revenues you also have a (real) debt (service) reduction.

    But this is all too simple. In real life, oil prices show a very strong negative correlation with exrates. So if the dollar falls against the Euro, oil prices tend to go up in $ and fall in EU: its a case where truly money is just a veil. Thus exrate movements have little influence, if any, on the real value of oil exports.

    So one should look at more sophisticated hedging strategies to hedge the BoP, as in
    http://econpapers.repec.org/paper/oecdevaaa/23-en.htm

    As for the idea that CBs hold US$ to keep up the $ (not just against their own currency, but) against major world currencies, not only “this is all pure speculation”; but it is also inconsistent with the observation that “the various institutions that manage the GCC’s oil wealth don’t coordinate” (nor the Chinese with the Russians, the Saudi with the Venezuelans, the Iranians with the Kuwaitians, etc.).

    It’s funny. You don’t accept the idea – based on turnover data – that CBs are way too minuscule to keep the dollar up against FFSS, Yen, Euro, UK£, etc..; but you don’t provide alternative data to support your view that “several are big enough” not just “to move global markets” (this is obvious) but to keep the dollar up. And to my memory you never came up with even a anedoct about an oil fund manager etc. that told you (or others) s/he behaves in this way (“investing $ to keep the $ up against the Euro”). What is it?

    I have suggested many times that maybe CBs like $ because they think it’s a good currency to invest in. Facts since Jan 2005 have proven them right: the dollar has yielded more than most big curencies. But you cannot accept this idea. So I will try another. What about liquidity? CBs like liquidity: and the most liquid assets are $-denominated.

    Regards

  • Posted by Dave Chiang

    China not a Currency Manipulator
    http://www.atimes.com/atimes/China_Business/IB15Cb03.html

    ” The allegations are misplaced, not supported by either fact or theory. The distortions have been created by US trade and monetary policies and their effects on the exchange value of the dollar, rather than by China which has pegged its RMB yuan to the dollar at 8.28 yuan to a dollar within a narrow band of 0.03% for a decade, from 1995-2005, at times above and at other times below market trends.

    Manipulation involves willful, proactive volatile changes to profit from temporary technical market trends against market fundamentals. A stable exchange rate cannot be labeled as manipulative any more than a driver traveling at constant legal speed for long periods apace with the police car next to it can suddenly be accused of speeding merely because the police car slows down from loss of power.

    China alone, at substantial cost to its own economy, kept the yuan’s peg to the dollar all through the decade-long Asian financial crisis that began in July 1997, when all other Asian currencies devalued in quick order in a frenzied rush to the bottom. “

  • Posted by Dave Chiang

    The United States as the World’s Leading Currency Manipulator
    http://www.atimes.com/atimes/China_Business/IB15Cb03.html

    ” To restore global imbalance, the US needs to restore monetary and fiscal discipline and cease feeding its insatiable debt appetite with fiat currency under dollar hegemony. There is much noise from many quarters that the US must reduce its fiscal deficit. Yet the problem is not just the fiscal deficit per se, but that the deficit comes from spending on the wrong things, such as wars and tax cuts for the rich, that does not add to constructive economic expansion, instead of “on important national priorities, such as infrastructure, health care, schools, and targeted tax relief for threatened businesses and struggling working families.”

    Even a substantial increase in the exchange value of the Chinese currency will not reduce US-China trade imbalances if Chinese wages do not converge with US wages. China has recently let the RMB rise marginally against the dollar while the dollar has fallen against virtually all other currencies, particularly the Japanese yen and the euro. The US has been trying to compensate its structural loss of competitiveness in manufacturing by forcing the dollar to fall against all other currencies, but the Chinese yuan’s peg to the dollar stands in the way of this easy way out.

    In fact, the yuan/dollar peg has a supportive effect on the US strong dollar policy. US policy makers should realize that the yuan/dollar peg performs a positive function of forcing the US economy to restructure toward real productive revival, rather than the meaningless path of exchange rate manipulation. US loss of competitiveness is not caused by its currency being overvalued. It is the opposite: the loss of competitiveness is reflected in the fall of the dollar.

    The dollar’s fall is not caused by the yuan being pegged to it. It is caused by the US corporations seeking productivity gains by having low-wage workers overseas doing the producing. Thus increased US global corporate competitiveness is causing the loss of US domestic competitiveness in world trade. “

  • Posted by Guest

    Ex other factors, oil exporters and importers should be interested in hedging recurring currency exposure within their ongoing current account flows, due to patterns of net dollar denominated invoicing as a subset of gross current account flows. The net dollar current account may be quite different than the total net current account. Net dollar receivers and payers should be averse to risk of dollar appreciation or depreciation respectively, other things equal. And similar for other major currencies. Beyond this, they also must consider rebalancing their ‘stock’ (versus flow) portfolios on an ongoing basis, to account for special considerations such as dollar currency pegs or the dollar as a reserve currency.

  • Posted by Guest

    meant:

    ‘Net dollar receivers and payers should be averse to risk of dollar depreciation or appreciation respectively, other things equal.’

  • Posted by RebelEconomist

    This topic, and yesterday’s too, on China’s state investment company, raises the interesting issue of how official transactions affect the exchange rate.

    Or not! As I recall, academic opinion used to hold that invested – ie sterilised – intervention could not actually affect the exchange rate. If so, unless China is not really sterilising its intervention, all the controversy about its exchange rate policy is misplaced! Does anyone know what the latest scientific (ie rigorous whether academic or not) thinking is about how foreign exchange intervention works?

    My provisional view is that official transactions that affect the relative demand for anything priced in the two currencies concerned ought to have an effect. The argument that sterilised intervention does not work amounts to saying that the market entirely undoes its effect on prices (expressed in interest rates in the textbooks, on the assumption that sterilisation is done in bonds), which seems a bit extreme to me.

    If my view is correct, then it hardly matters (except for some minor holdings for transactions purposes) what currency commodities are priced in if the currency received does not affect what the revenue is spent on. But it does matter what assets a state investment company holds. In order to avoid undermining their own exchange rate regime, the Chinese must either invest in dollar assets, or invest in another currency pegged to the dollar, so that this inflow is redirected into dollar assets. On this basis, China’s state investment company can be a major buyer of US stock, property etc (and there is enough of this to absorb their demand), CFIUS permitting. Assets in GCC or Asian countries with informal links to the dollar might be OK, but investment in commodities or in Africa, which might prompt outflows into euros, sterling and even Swiss francs (!) would probably be unhelpful.

  • Posted by bsetser

    Rebel, I think your point that the assumptions required for sterilized intervention to have no impact are a bit extreme is right. most of the studies that show limited impacts from intervention look at what by current standards are small scale interventions in the euro/$ or dm/ $. I think the conventional wisdom now is that intervention on the scale of Japan’s intervention in 03/04 did have an impact. and intervention always has an impact in the context of pegs — by definition, intervention sets the nominal exchange rate. the usual argument is that setting the nominal exchange rate doesn’t determine the real exchange rate, b/c real adjustment will still occur via changes in domestic prices. there is evidence that such real appreciation is occuring in the oil exporters, but not in China.

    AC — I am not sure the impact on the euro/ $ is different if China buys euro to pay iran, or china pays iran in dollars and iran then buys euros to hold.

    Gheoghius — I don’t think the turnover data is meaningful at least not in the sense of the small official share of turnover implies that official intervention doesn’t matter. we can debate this. but that isn’t what I am using to judge who is big enough to matter. My metric is a bit different — while central banks and oil funds account for a small share of turnover (for reasons explained in the deal flow literature), they account for a large share of the net increase in $ exposure. And in equilibrium existing foreign $ creditors have to stay put (in aggegrate) and someone has to add $850b to their dollar exposure. So my definition of big enough to matter, roughly speaking, is anyone adding over $50b to their reserves in a year — or anyone making a comparable shift between their existing stock of euros/ $ to matter. right now, an awful large fraction of the global current account surplus is found in EMs, and a large share of the growth in EM foreign asset is coming from oil funds and CBs. that is why i think they matter.

    Of course, I could be wrong. it is just a theory. But the folks I know in the markets seem quite interested in what the big official players are doing (but then again, I may know a very self-selected group in the markets)

  • Posted by Macro Man

    The long run relationship between oil and the euro (DEM) is zero, or close enough to zero not to matter. The rsq is 0 for the last 10 yrs and 0 for the previous ten years.

    Claiming that CBs have little no impact on FX because of turnover data ignores the fact that it is net, rather than gross, flows that matter, and these guys introduce an enormous net flow into the market. They are in every day, and they have an enormous impact.

    I am shocked, shocked that Mr. Chiang links Chinese editorials claiming that China (home of the $20 billion a month intervention and daily appearance in EUR/USD) is not a currency manipulator and that the US (no intervention for its own account in 9 years) is somehow the world’s biggest manipulator. What’s next? China actually has no c/a surplus, or US subprime loans amount to 120% of world GDP?

  • Posted by RebelEconomist

    As I say from time to time, not maintaining the effective size of its reserves arguably makes the US a currency manipulator by neglect, and the Chinese editorials’ point that RMB is being fixed not depreciated is not unreasonable, given that we accept fixed currencies within countries. China’s position is not as untenable as you imply.

  • Posted by Guest

    one measure of a currency is as a unit of account (in addition to a store of value & means of exchange) so to the extent that the dollar is no longer being used as much as an accounting convention when pricing commodities, i think that matters, altho i think you’re also right that the ‘store of value’ component probably matters more (psychologically); one thing the dollar has going for it is that it’s convenient and the institutional inertia behind it is enormous — hence its reservability — but i don’t think there’s any question that it is losing momentum and the pricing aspect is just more evidence of this! (along with the fundamental instability of BWII of course :)

  • Posted by Guest

    btw corporate credits next year could be the equivalent of subprime this year and CB intervention in ????

    “Borrowers and lenders both agree the market for corporate credit is looking like a house of cards. So here’s a question. If borrowers and lenders alike agree the corporate debt boom can’t last, why isn’t anyone stopping it? … The long-term consequences of their actions are, conveniently, someone else’s problem… [and] they don’t want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead…” http://online.wsj.com/article/SB117495177692049687.html

  • Posted by Guest

    oh and paul kasriel appears to be on the verge of joining nouriel’s camp…

  • Posted by Macro Man

    Rebel, I was referring to the EUR/USD exchange rate as much, if not more, than the RMB. But even with the RMB..it is pegged to a basket of currencies, not the USD..but good luck trying to regress the RMB’s fortune against any basket you like. It doesn’t work. Why? Because the RMB is manipulated against its basket.

    Moreover, one could argue that any country that has an international trade profile like China’s but chooses to adopt a pegged exchange rate regime is guilty of manipulation to one degree or another.

  • Posted by Dave Chiang

    China shifts to euros for Iran oil. Russia and Venezuela have also shifted to the euro earning the animosity from the Bush Administration. If we could only obtain the cooperation of Saudi Arabia and the Gulf Arab states to adopt the euro for energy exports, that would trigger a global flight to dump the dollar. Oil importers China and Japan would no longer be forced to retain US dollars for the purchase of strategic commodities especially oil, but would instead stockpile euros. Oh, but I forgot that was the primary reason for the US military protection racket in the Persian Gulf and war in Iraq which ensures US Dollar hegemony is maintained. The US Dollar is no longer backed by Gold since Richard Nixon, and not worth its weight in paper with the rapidly deindustrialized “monetary service” economy based on subprime mortgages. It is however “de facto” backed by the Gulf Arab Oil reserves in secret agreement with the US Treasury Department and IMF.

  • Posted by Doubter

    The best thing for the US in the longrun would be to have Mr. Chiang oversee the decline in the dollar – so we could get our industrial base back, and make our own bluejeans. We’d also soon find alternatives to oil for transporation, too, under pressure. Americans don’t seem to respond to anything but crisis.

  • Posted by gillies

    ” It is however “de facto” backed by the Gulf Arab Oil reserves in secret agreement with the US Treasury Department and IMF.” (dave chiang.)

    if it is a secret – how do you know ? and if you know that, maybe you can answer this one – is afghan opium/heroin traded in dollars ? and if it is, is that another secret arrangement or something done for convenience ? i am interested in that part of the global economy which is ‘off the books.’

  • Posted by LC

    DC:

    Brad and Steve Kyle just made a pretty good case that there won’t be much a difference if people paid Euros instead of dollars for oil. What matters is in which currency they hold their wealth and reserve. As long as they’re pegged to the dollar, dollar dominance (or hegemony as you call it) will continue. I think BWII still has legs and could be more stable than many critics contend. I don’t see another currency that can take place of dollar in the next decade or two. I also think it’s a good thing, because US power, when applied properly, extends global market and the relatively liberal world order. My concern is the backlash against US power at home and the turn toward isolationism. I fear that as long as Iraq remains a mess, isolationist sentiment will remain fairly high.
    Also, I am shocked, really shocked (in the spirit of Captain Renault and Macro Man) that the Chinese don’t consider themselves currecny manipulators.

  • Posted by carmelus

    Although you could know the reserves composition of China and oil gulf states , these do not have to sell their dollars thanks to the currency swaps or any other derivative instrument. Maybe they have the dollars and at the same time they are shorting dollars.Currency swaps volume is I think 6 times larger than the spot market and you could disguise it in that way.

  • Posted by jeeves

    Indeed, suppose an oil-importer wanted to set aside some funds back in 2002 to pay for its 2007 oil imports. Should it have kept those funds in dollars? Or in Euros?

    How much of oil is traded on the spot market anyway?

    Isn’t most of oil traded on long term contract basis for many years ahead? If those contracts are priced in USD, then there would be a benefit to USD.

    If long term oil agreements are priced in USD, then it oil importers will try to accumulate USD or hedge USD.

    An oil importer would be better off holding its saving in euro, and then converting its euros into dollars when it needed to settle its 2007 oil import bill.

    Well, for long term contracts, that’s a risk that needs to be hedged – who knows what the Euro-USD will do in future? And whoever is the bag holder for that risk will create a demand for USD.

    I agree on one point – that it is the oil exporters who finally make the decision. They make the call to price contracts in USD, which makes the importers accumulate USD.

    So yeah, terms of settlement, as denominated in long term agreements, does matter. If the terms are in USD, it benefits USD. If they are in euro, it benefits euro. Even if the importers turn around and sell the settlement currency for some other. The hedge against long term contracts require that importers have that buffer. In fact, if importers have their demand increasing, the size of the buffer they need increases, requiring more of the settlement currency.

    Say oil was priced in euros, and the importer had a enough reserves for 2 yrs worth of oil. Lets say that the exporter, after getting it, dumped those euros and got USD. Does not matter. The importer will have to accumulate that much Euros (and more, if the importers demand is rising) for the next two years contracts. The dumped Euros and some more, again end up with the importer.

    So more and more of the settlement currency end up as reserves, the more the demand for oil rises.

    Currently lot of countries have too large reserves. Thats a different point. That does not in any way prove that quoting oil prices in USD does not matter.

  • Posted by Dave Chiang

    LC

    Under the tutelage of Henry Kissinger, the Saudi Royal family is provided with US military protection for the physical survival of the regime in exchange for supporting US geo-political and economic objectives. Moreover, the recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. The phenomenon known as US dollar hegemony was created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. And US Dollars and only US dollars are accepted for the purchase of strategic Gulf Arab oil. It is hypocritical and intellectually dishonest for Paulson and Bernanke travel to Beijing to insult the intelligence of the Chinese when the US remains the biggest currency manipulator with US Dollar hegemony enforced by the direct military control of Gulf Arab energy reserves. Not surprisingly, Chinese Oil development contracts in Iraq were torn up by the Bush Administration.

  • Posted by bsetser

    Most oil contracts guarantee delivery but not price, at least as i understand it. so the spot price matters. certainly the price series in the US import data for oil matches moves in the oil price with a very short lag. the one month forward is the reference price as i understand it.

    carmelus — agree that it is possible. the question is to what extent various key players have lowered their de facto $ exposure via swaps, and who is on the other side of the trade. i heard a rumor that the koreans had reduced their $ exposure via swaps, but when i tried to find evidence of it (larger than expected valuation gains/ losses in the monthly data series) i didn’t see it.

    gillies — good see you on the site. i was afraid the registration requirement was gonna deter you.

    gillies and DC. the saudis used to have a very close financial relationship with the US. but that was back in the 70s. it really isn’t what it once was. the Saudis are pegging to the $ for their own reasons, not b/c of any secret deal that i am aware of. the US/ Saudi joint economic commission was a big deal once, but it isn’t now.

    does anyone disagree with two parts of my argument:

    1/ Some folks who get paid in $ end up holding the dollars rather than selling when the $ is under pressure

    2/ oil central banks (i.e. SAMA) have a higher $ share of their portoflio than oil investment funds (i.e. ADIA)

  • Posted by Dave Chiang

    Under former Iraqi president Saddam Hussein, Iraq oil was priced in euros in protest to US foreign policy. Immediately after the US invasion, Iraqi oil was repriced for export in US Dollars and only US Dollars. Iraqi energy development contracts with Russia and China were terminated by the Bush Administration. By the way, Iraqi oil should belong to the Iraqi people. Why can’t the Iraqi people even be permitted to sell their oil in the currency of their choice?

  • Posted by LC

    DC:

    1. I don’t know much about Kissinger’s supposed deal with Saudi Royal family. I can’t confirm or deny that such a deal exists. However, supporting US geopolitical and economic objective is a good thing for the world. China has been doing it for nearly 4 decades now and China has benefited from it greatly.
    2. I thought Paulson and Bernanke were well mannered and delivered good economic advice. I didn’t think they were insulting the Chinese. I am sorry if you or the Chinese feel this way, but I think the visit was very cordial and the message was right on.
    3. I think a lot of current politcal talk from both capitals are hypocrisy. The Chinese are just as guilty as Americans. After all, they are particpating in this system, they know their interests are aligned with Americans but they won’t publicly admit it.
    4. The current administration has done a lot of dumb things. I don’t think it’s just Chinese contracts in Iraq that were torn up. I would advise the Chinese to be patient and this adminstration too shall pass.

  • Posted by Guest

    supposedly the (underground) cash market is switching to euros because the EUR500 bill is more convenient than lugging around USD100s.

  • Posted by Emmanuel

    Dr. Setser, my 2c worth:

    (1) For the same reason that some are content to hold cash or to leave money in their current accounts and not place these funds in CDs or something better yielding, others keep their money in $ even when it is under pressure. They are indifferent for some reason;

    (2) Following this line of reasoning (inertia, path dependency, etc.) CBs tend to keep their reserves in the currency they were originally accumulated in. OTOH, it is well-documented how the US is allergic to certain foreigners (namely the Chinese and Middle Easterners) buying American assets. So, these investment funds have little choice but to invest in other countries and thus change the denomination of their holdings. Little mystery here.

  • Posted by Dave Chiang

    What wasn’t reported in the US mainstream news media was what the Chinese told Paulson and Bernanke on their recent visit to Beijing. Vice Premier of the State Council, Wu Yi, told Paulson and Bernanke that, “the Chinese nation state should not be compared to a Gulf Arab Oil states that can be bribed or bought off”.

  • Posted by bsetser

    bonds are assets, and if the US is allergic to Chinese bond purchases i haven’t seen the evidence … but i know what you mean (the opposition is to equity purchases)

  • Posted by LC

    DC:

    I don’t know what was the context around Wu Yi’s outburst, but she’s mistaken if she viewed Paulson and Bernanke’s visit as an attempt to buy off the Chinese state. The more important fact is China chose to enter the global system herself, so in a sense she was bought off the minute the Chinese people realized the obscene economic system known as Communism didn’t work.
    As China becomes more integrated into the global economy and becomes more important, I hope the Chinese leadership doesn’t make the same mistake Americans made at beginning of the 20th Century. In a similar mistaken belief that America doesn’t need Europe, the Congress and the Fed chose a series of policies which wrecked the global trading system. The result was a fragemented world, death of millions and allowed Communism to be established as a credible ideology.

  • Posted by koteli

    Sorry for the subject change, but, because of the Keyword and oil/inflation relationship, here goes a good article:

    British pawns in an Iranian game

    By Pepe Escobar

    The 15 British sailors and marines who were patrolling the Shatt-al-Arab – or Arvand Roud, as it is known in Iran – were not exactly indulging in a little bit of Rod Stewart (“I am sailing/stormy waters/to be with you/to be free”). They had their guns loaded. These would certainly have been fired against Iraqi smugglers – or, better yet, the Iraqi resistance, Sunni or Shi’ite. But suddenly the British were confronted not by Iraqi but by Iranian gunboats.

    This correspondent has been to the Shatt-al-Arab. It’s a busy and tricky waterway, to say the least. Iraqi fishing boats share the waters with Iranian patrol boats. From the Iraqi shore one can see the Iranian shore, flags aflutter. These remain extremely disputed waters. In 1975, a treaty was signed in Algiers between the shah of Iran and Saddam Hussein. The center of the river was supposed to be the border. Then Saddam invaded Iran in 1980. After the Iran-Iraq War that this sparked ended in 1988, and even after both Gulf wars, things remain perilously inconclusive: a new treaty still has not been signed.

    The British are adamant that the sailors were in Iraqi waters checking for cars, not weapons, being smuggled. It’s almost laughable that the Royal Navy should be reduced to finding dangerous Toyotas in the Persian Gulf. Some reports from Tehran claim the British were actually checking Iranian military preparations ahead of a possible confrontation with the US.

    Western corporate media overwhelmingly take for granted that the British were in Iraqi or “international” waters (wrong: these are disputed Iran/Iraq waters). Tehran has accused the British of “blatant aggression” and reminded world public opinion “this is not the first time that Britain commits such illegal acts” (which is true). Tehran diplomats later suggested that the British might be charged with espionage (which is actually the case in Khuzestan province in Iran, conducted by US Special Forces).

    Chess matters

    The coverage of the sensitive Shatt-al-Arab incident in the Iranian press was quite a smash: initially there was none. Everything was closed for Nowrouz – the one-week Iranian New Year holiday. But this has not prevented radicalization.

    Hardliners like the Republican Guards and the Basiji – Iran’s volunteer Islamist militia – asked the government of President Mahmud Ahmadinejad not to release the sailors until the five Iranian diplomats arrested by the US in Iraq were freed. They also demanded that the new United Nations sanctions imposed on Iran over its nuclear program be scrapped. And all this was under the watchful eyes (and ears) of the US Navy’s 5th Fleet in Bahrain.

    Much of the Western press assumed Iran wanted Western hostages to exchange for the five Iranian diplomats, without ever questioning the Pentagon’s illegal capture of the Iranians in the first place. Then the plot was amplified as an Ahmadinejad diversion tactic as the UN Security Council worked out a new resolution for more sanctions on Iran and as Russia told Tehran to come up with the outstanding money or the Bushehr nuclear plant it is building in Iran would not be finished.

    The Shatt-al-Arab incident has been linked to an Iranian response to Washington’s accusations that Tehran is helping Shi’ite militias with funds, weapons and training in Iraq. For the record, Iran’s ambassador in Iraq, Hassan Kazemi Qomi, said there is absolutely no connection: “They entered Iranian territorial waters and were arrested. It has nothing to do with other issues.” Not surprisingly, Iraqi Foreign Minister Hoshyar Zebari had to take the side of the occupiers who installed him in his post: he said the British were in Iraq invited by the Iraqi government and were operating in Iraqi waters.

    This doesn’t stop people, especially in the Islamic world, questioning what business the British, as an occupation force, had in the Shatt-al-Arab to start with.

    From the depths of their abysmal, recent historical experience, even the Arab world – which is not so fond of Persians – sees the US-orchestrated UN sanctions on Iran for what they are: the West, once again, trying to smash an independent nation daring to have its shot at more influence in the Middle East. More sanctions will be useless as China and India will continue to do serious business with Iran.

    Tactically, as a backgammon or, better yet, chess move – in which Iranians excel – the Shatt-al-Arab incident may be much more clever than it appears. Oil is establishing itself well above US$60 a barrel as a result of the incident, and that’s good for Iran. It’s true that from London’s point of view, the incident could have been arranged as a provocation, part of a mischievous plan to escalate the conflict with Iran and turn Western and possibly world public opinion against the regime.

    But from Tehran’s point of view, for all purposes British Prime Minister Tony Blair is a soft target. The episode has the potential to paralyze both President George W Bush and Blair. Neither can use the incident to start a war with Iran, although Blair has warned that his government is prepared to move to “a different phase” if Iran does not quickly release the sailors.

    If the Tehran leadership decides to drag out the proceedings, the Shi’ites in southern Iraq, already exasperated by the British (as they were in the 1920s), may take the hint and accelerate a confrontation. Strands of the Shi’ite resistance may start merging with strands of the Sunni resistance (that’s what Shi’ite cleric Muqtada al-Sadr has wanted all along). And this would prove once again that you don’t need nuclear weapons when you excel at playing chess.

  • Posted by Gheorghius

    BS and macroman, your view is: “I don’t think the turnover data is meaningful …” I say fine, would you provide “meaningful” alternatives? If “it is net, rather than gross, flows that matter”, I say come forth with your data: then we can discuss. I know turnover is a biased (against CBs) indicator, but if you have an idea of the dimension of the bias, then it is still an acceptable proxy to determine who is big – Or find better data and you use them in context (not “$ bn.” but ratios!!), so as to show how big is public vs. private “intervention” on the US$.

    To illustrate my point, take BS: “my definition of big enough to matter, roughly speaking, is anyone adding over $50b to their reserves in a year”: Well, I think I know many big & medium private institutions who buy US$: as you do with CBs, we could add them together to form many small (or large) groups of investors that add each 50bn$ a year to their portfolio. (You don’t believe me? Then believe a friend of mine who knows: see his blog: http://www.rgemonitor.com/blog/setser/183512/). They too finance the US CuA as much as CBs.

    The moral of the story is: any regrouping of US$ buyers (including CBs) can be easily shown to be “saving the $”: but it does not prove that other groups of $-buyers are less relevant. Put CBs in context, and whatever “net flows” data you use, you’ll find that CBs intervention does not weight much, at least not more than many private $ buyers without whom the dollar would long have gone to hell. Or maybe not?!! For … there are also other private wealthy groups who don’t buy $ now, but hold it and don’t sell it, or are ready to buy it at (slightly?) lower levels.

    On the other hand, I would not take the argument so far as to deny that “the folks I know in the markets seem quite interested in what the big official players are doing”. I take it: CBs are indeed powerful actors when intervention is added to other policies, and they are getting bigger. Also, their intervention in forex mkts may influence exrates in the short term (that’s what your folks are interested in). And they can influence their own currency. But we are debating the medium – longterm overall value of the $. And you further say: CBs deliberately buy $ to keep it up against Euro!. So my challenge is : find a central banker (not the folks in the mkt) who confirms this and I’ll be most surprised.

    I beg you some bibliography on the “deal flow literature” just to know what you’re referring to.

    —————————

    CBs’ LIQUIDITY PREFERENCE AND ITS IMPACT ON EX-RATES

    Now putting aside debates, I suggested that CBs like dollars because of liquidity. No one has taken up this argument. But it bears some consequences!

    CBs use reserves primarily to intervene in forex mkts. They also want an interest, so they want to invest them, but only in financial instruments that they can sell easily, quickly, massively, and without causing disruptions (price declines) that would cause losses to them. On these grounds, there’s nothing better than US T-Bills & T-Bonds. Also, CBs want to hold reserves in the currency of intervention: it’s the $, for two reasons. 1) many peg to the $. 2) In any case, the $ is involved in 80$ of all forex transactions (you cannot go directly from, say, real to euros, you have to go from real to dollars to euros, etc if you want liquid mkts.)

    Consequences.
    (a) When reserves become very large, CBs don’t need to keep all of them ready at hand for intervention and
    (b) CBs organise fund managing institutions outside CBs, that have a different approach (more profit-oriented)?
    (c) as a result, you get diversification of reserves out of the dollar.

    It would be incorrect in my opinion to use this argument to explain why the $ is falling right now (the true explanation is: changing US interest rates outlook). Still, I think this is the trend in official portfolios, and these are the primary reasons.

  • Posted by koteli

    An analisys by an american journalist and professor:

    Iran: We will know soon…
    by Richard Heinberg

    For the past two years or so informed commentators (including Seymour Hersh and Scott Ritter, among others) have been predicting a US air attack on Iran. MuseLetter for March 2005, titled “Onward to Iran,” summarized relevant information available at that time. In recent months concern over America’s intentions has grown even more intense, to the point that it has become the fulcrum of nearly every discussion about the future of world affairs.

    As many have pointed out, an attack could have cataclysmic implications for the region, for the world economy, and not least for the oil import-dependent and nearly bankrupt US. Recently Rolling Stone magazine convened a panel of experts to assess the situation in Iraq (“Leaving Iraq: The Grim Truth,” by Tom Dickinson, March 7, ). The panel, which included such policy luminaries as Zbigniew Brzezinski (Jimmy Carter’s national security advisor) and Richard Clarke (counter-terrorism advisor to four presidents), concluded that the war in Iraq is lost. In the course of the discussion, Bob Graham, former chair of the Senate Intelligence Committee, made the following comment: “This administration seems to be getting ready to make—at a much more significant, escalated level—the same mistake we made in Iran that we made in Iraq. If Iraq has been a disaster, this would be multiple times Iraq. The extent to which this could be the horror of the twenty-first century is hard to exaggerate.”

    Recent crucial events include the passing of the UN-imposed deadline for Iran to halt uranium enrichment, the stationing by the US of two aircraft carrier battle groups—the Eisenhower and the Stennis—in the Persian Gulf, a meeting in Baghdad attended by delegations from both Iran and the US, and the imposition of toughened economic sanctions by the UN Security Council.

    …The arguments against such an attack are overwhelming. It would solve nothing strategically: it would not end Iran’s nuclear program and would not result in regime change. While arguably it would be of short-term political benefit to the administration (which could use the event to rally the public, crack down on dissent, and lash out at the political opposition in Congress), in order to actually mount an attack it would be necessary to persuade many outside the president’s and vice president’s offices of the need for such action. Cheney can’t fly the planes himself; indeed, several branches of government would have to participate in—or at least refrain from sabotaging—the attack plans. And to sell those plans to senior officers in the armed forces, as well as high officials in the CIA and the State Department, there would need to be some perceived benefit or threat sufficiently compelling so as to override the general war-weariness and Cheney-wariness that has gripped Washington.

    Meanwhile, however, it appears that the preparations for such an attack continue. On this score, Seymour Hersh’s ongoing reportage in The New Yorker is essential reading.

    …Perhaps the most ominous bits of recent news concern Russia: for the past few weeks that nation has been delaying delivery of nuclear fuel to Iran, and is now withdrawing all 2000 of its technicians at the Bushehr nuclear plant.

    …So, we are faced with three questions: whether a US air attack on Iran will occur; and, if that is now inevitable, how it will be justified and how it will unfold.

    …In order for the attack to proceed, a pretext will be necessary, and the nature and strength of the pretext will reveal a great deal about the behind-the-scenes strengths and weaknesses of the various players, and give clues to how events might proceed. Here are the main possibilities: …

    Currently events are unfolding very quickly. Things to watch over the days ahead include the resolution of the matter of the seized British sailors; Iran’s response to the new UN sanctions; and the fate of the second round of official discussions, scheduled for early April in Turkey, which is expected to include Secretary of State Condoleezza Rice and her Iranian and Syrian counterparts.

    If an attack does ensue, the immediate consequences could be moderate to catastrophic—with the moderate effects being more likely, since everyone has had time to think through the various scenarios and is likely to follow through on scripted actions and responses. The longer-term prognosis is not as favorable, as those scripted responses go only so far. The US, Europe, Russia, China, and India all have vital interests in the region, and a general explosion of Sunni-Shia violence could draw these interested parties into conflict. At the very least, we are likely to see an expansion of the chronic violence in Iraq spreading outward throughout the Middle East and perhaps Central Asia as well, with an arc of chaos extending from Pakistan to Saudi Arabia. The worst case is painful to contemplate. If the US and/or Israel follow through on their implied threats to deal militarily with Iran, this may constitute the most dangerous and fateful international gamble in decades.

    Some late-breaking stories that give credence to Heinberg’s fears:

    Russian intelligence sees U.S. military buildup on Iran border
    RIA Novosti (Russia)
    Russian military intelligence services are reporting a flurry of activity by U.S. Armed Forces near Iran’s borders, a high-ranking security source said Tuesday.

    “The latest military intelligence data point to heightened U.S. military preparations for both an air and ground operation against Iran,” the official said, adding that the Pentagon has probably not yet made a final decision as to when an attack will be launched.

    He said the Pentagon is looking for a way to deliver a strike against Iran “that would enable the Americans to bring the country to its knees at minimal cost.”

    He also said the U.S. Naval presence in the Persian Gulf has for the first time in the past four years reached the level that existed shortly before the invasion of Iraq in March 2003.

    Col.-Gen. Leonid Ivashov, vice president of the Academy of Geopolitical Sciences, said last week that the Pentagon is planning to deliver a massive air strike on Iran’s military infrastructure in the near future.
    (27 March 2007)

  • Posted by koteli

    I’ll finish with tonight news:

    Saudi king slams ‘illegitimate occupation’ of Iraq
    Lydia Georgi, AFP
    Saudi King Abdullah, whose country is a close US ally, on Wednesday slammed the “illegitimate foreign occupation” of
    Iraq in an opening speech to the annual Arab summit in Riyadh.

    “In beloved Iraq, blood is being shed among brothers in the shadow of an illegitimate foreign occupation, and ugly sectarianism threatens civil war,” Abdullah said.

    He also said that Arab nations, which are planning to revive a five-year-old Middle East peace plan at the summit, would not allow any foreign force to decide the future of the region.
    (28 March 2007)

    Bush’s Royal Trouble
    Why Is King Abdullah Saying No to Dinner?
    Jim Hoagland, Washington Post
    President Bush enjoys hosting formal state dinners about as much as having a root canal. Or proposing tax increases. So his decision to schedule a mid-April White House gala for Saudi Arabia’s King Abdullah signified the president’s high regard for an Arab monarch who is also a Bush family friend.

    Now the White House ponders what Abdullah’s sudden and sparsely explained cancellation of the dinner signifies. Nothing good — especially for Condoleezza Rice’s most important Middle East initiatives — is the clearest available answer.

    Abdullah’s bowing out of the April 17 event is, in fact, one more warning sign that the Bush administration’s downward spiral at home is undermining its ability to achieve its policy objectives abroad. Friends as well as foes see the need, or the chance, to distance themselves from the politically besieged Bush.

    Goodnight you all.

  • Posted by koteli

    Sorry, Gheorghius, for my interference in your post (much more interesting for the blog crowd, probably!).

    Anyway, you’ll receive several answers, I hope and I expect.

    A very intersting post!

    I’m waiting to Brad’s answer!

    Good night again.

  • Posted by bsetser

    Gheorghius — the deal flow reference is that hard one; there was a professor of finance from I think USC who gave a presentation at the treasury in 2001, but i cannot remember his name.

    For the net flows, here are some ballpark estimates –

    Net growth in official assets (CBs $750 + oil funds $150b). Estimated increase in $ holdings. $500 and up .. I would estimate closer to $600. If you want the details, use the RGE free trial subscription that comes with registration and look in the section of the site under RGE content that is called reserve watches and petrodollar watches. the oil fund estimate is in the most recent petro$ watch, the reserve estimate is in the latest global reserve watch. I also explain my methodology.

    US CAD = $850-$860.

    Net increase in private exposure: $260-$360b. It depends on the size of the estimated growth in official dollar assets.

    there are a couple of qualifications — some $ assets are claims on other EMs so don’t finance the US, but this is likely small v the $900b total (i would estimate it at around $20b). the other big one is that there are ways of blurring private and official flows. An investment hires a private manager to manage its assets, but tells the private manager it wants dollar exposure. Official or private? I count it as official. A central bank deposits $ in london where they are borrowed by a hedge fund or a private equity firm? A harder case — but i still say official. the official sector is taking the $ exposuire. but the private sector has the credit or equity market risk, so in truth it is blurred.

    why do I think CBs have bought more $ when the $ is falling? B/c that is what the IMF data says — again, see my reserve watch.

    as for the liquidity argument, i think that as CBs increase their holdings, a) they intrinsically become less liquid (Japan cannot realistically sell its huge treasury holdings) b) they start dabbling in less liquid markets (China and MBS) and less liquid curencies (China and korean won) c) they start to care more about investment returns and less about “liquidity” as in access to cash in a crisis. China doesn’t need $1.2 trillion on hand at a moment’s notice. $100-200b will do.

  • Posted by Gheorghius

    Brad,

    I think we agree on CBs liquidity preference: it declines as reserves grow; I just pointed out that this trend is negative for the US$.

    On the grow of official Reserves, I know the data (thanks mostly to your blogs). To estimate their relative importance, we need to put these data in context. You offer for this purpose some data on the private sector which I’m not sure I understand:

    “Net increase in private exposure: $260-$360b. It depends on the size of the estimated growth in official dollar assets.”

    Are they the result of: Total US CuA deficit – Reserve growth? Then how do they add up?

    Moreover, I’m afraid that these data won’t solve our difference, I’m afraid that you didn’t get my point. Which is, again, the following.

    If you take the “total official net flows” and you contrast them with the “total private net flows”, of course you’ll get more or less that CBs cover between 60% and 100% of the UD CuA deficit (let’s assume 100%, for the sake of the argument): I AGREE on this! Plane macro accounting.

    But my point is that this partition between CBs and Private is arbitrary, and you draw some conclusions that are in my opinion arbitrary and wrong. The truth is that ALL those (institutions and individuals, private and public) who have positive net US$ flows do “support the dollar”‘s overall value. All of them. Take on the right side those who are “$ buyers” and on the left side those who are “$ sellers”, you’ll find on the right side many many people, and central bankers will be a very small fraction. So if you want to say that CBs net finance US CuA, and private sector overall doesn’t, I say Ok. But if you want to say that CBs are decisive in supporting the US$ against the private sector, and that without CBs the $ would be 20% lower, I say: wrong (look at the yen); and “ad hoc” to boost the “irrationality” of current global trends which you dislike. No, private players determine the dollar’s overall value much more decisively than CBs. And they are not irrational. Their rationality is bounded, as is ours, but no worse than ours.

    Regards

  • Posted by bsetser

    Gheorghius — on this we will need to agree to disagree. gross private inflows and outflows are quite big, but in aggregate, the accounting, as you note requires someone outside the US to build up their claims on the US. recently most of that buildup has come from central banks. ergo, my logic for thinking central banks matter.

    the argument against this that i find most compelling is that the buildup of central bank claims can only finance a US deficit if private creditors outside the US are willing to hold on to their existing claims (in aggregate — they can sell them among themselves, but they cannot sell them back to the US — that doesn’t work from a bop standpoint). so one of the conditions that allows $500b plus in official asset accumulation to finance a $850b deficit is that all existing private creditors (and the stock of private claimso n the US is large) have to hold onto their claims. otherwise, the official inflows would finance private outflows (a la turkey in 2001, or Argentina in 01, or other cases). that obviously hasn’t been the case.
    but even in stock terms, the offiical sector’s share of total extenral claims on the US economy is rising.

  • Posted by Gheorghius

    Agreed! All of it!

    Note, further, that you keep aggregating all “private”: this approach hides that many privates are piling up $s. And they do it willingly.

    But if you want to limit yourself to considering the private sector in aggregate “not selling $”, I think this will enough to recognise the decisive role of mkts in setting major exrates, and avoid describing a world where CBs set ex-rates, and set them at arbitrary, irrational levels, causing globalimbalances for pure political (policy) reasons.

    So this may finally open up the discussion on global adjustment and the adequacy of current exrates! Are mkts irrational? Or if they aren’t, why do they keep the US$ spot rate at levels where it is not clear that the US CuA deficit is sustainable?

    See next!

    Regards

  • Posted by Gheorghius

    So in conclusion:

    1) we agreed that – by not selling $ net , even buying a little – the private sector supports the current US$ level.

    2) it follows that major exrates are not determined by CBs intervention (except when CBs want to keep their currency low, as JP did in the past)

    3) so if exrates are inconsistent with what they should be, it requires that private participants are irrational – but this is a strong hp, as they bet money and we don’t.

    4) so there must be an alternative possibility. That is, exrates are not irrational, if one looks as he should to the forward structure.

    I took our common agreement a bit further, maybe we can agree on bits of it?

  • Posted by Macro Man

    Gheorgius, CBs do not support the dollar against third country currencies like the euro and sterling…quite the contrary! They are large sellers of dollars, in aggregate, against these currencies, with net amounts running into the tens if not hundreds of billion dollars per year. This has a very real effect.

    This, in turn, inspires dollar selling against more undervalued currencies- RMB, RUB, etc., which leads to ever-more dollar buying (against these pegged currencies), which in turn leads to more dollar selling (against euros, sterling, etc.)

    The data you ask for doesn’t exist in official form; it has to be calculated. Basic caluclations suggest a rather impressive net flow:

    http://macro-man.blogspot.com/2006/11/harry-potter-and-fx-reserve-manager-why.html

    A 1% trade (fairly modest by international bond/currency manager standards) for SAFE is now $10 billion. That sort of size definitely has an impact!

  • Posted by Guest

    ” One of the conditions that allows $500b plus in official asset accumulation to finance a $850b deficit is that all existing private creditors (and the stock of private claims n the US is large) have to hold onto their claims ”

    Of course, the liquidation of foreign private claims could be funded to a degree by the liquidation of U.S. foreign claims – i.e. foreign private claims could be liquidated partially without affecting the current account, and therefore without affecting the potential for official asset accumulation to fund the deficit. This could happen through the liquidation of interbank claims on both sides of the U.S. external balance sheet, thereby shrinking its overall size.

  • Posted by Guest

    ” This partition between CBs and Private is arbitrary ”

    One might view the association of CB purchases of U.S. dollars with current account surpluses rather than gross capital account inflows (meaning accounting period additions of liabilities to the external balance sheet position, not flow ‘turnover’) as arbitrary as well, other things equal. It is a similar mode of associating certain assets with certain liabilities within a larger balance sheet operation – an association of convenience rather than logical necessity (an error of ‘mental accounting’).

    E.g. suppose one views CB reserve increases as offsets to gross capital inflows of U.S. dollars of equal size. Then no net long position is created in U.S. dollars by the central bank – there is a chain of intermediation consisting of U.S. dollar reserves // monetary base/domestic debt // foreign U.S. dollar debt. The net currency position for this chain is flat – U.S. dollar assets offset U.S. dollar liabilities. The net long U.S. dollar position by default must then be associated with private sector investment of the current account surplus.

    But the profile of the partition can be forced, at least partially, by constraints on the relative size of the various funding channels. E.g. if both the current account surplus and CB reserve accumulation are large relative to gross capital inflows, then one really must associate the investment of the net long position and influence on the currency with the central bank to some considerable degree. Perhaps such a constraint is operational/binding in the case of the major reserve accumulators.

    This all assumes that the settlement of the profile of the U.S. external balance sheet is a primary driver of exchange rates. In addition to this is the velocity of turnover through nostro account settlement of foreign exchange transactions. However, such turnover doesn’t affect the aggregate external balance sheet profile per se – it merely shifts the ownership composition of the overall profile, albeit at very high velocity.

  • Posted by RebelEconomist

    Gheorghius

    May I try to develop the debate between you and Brad?….I think it may be related to the point I made above, about the academic argument that sterilised intervention does not work (and maybe also my doubts about the ability of central banks to control interest rates).

    If I understand correctly, you are arguing that private sector investors are supporting the dollar as much as the central banks, because they are willing holders at the present exchange rate. Maybe you would also say that central banks cannot affect the exchange rate, because any appreciation they achieve raises the probability of capital loss and prompts selling to the restore the balance of risk and return to its previous state – which (assuming that the central bank intervention has not affected returns and other sources of risk) is at the initial exchange rate. If so, the only lasting effect of intervention is to switch dollar assets from the private to the public sector. Am I right, or do I misrepresent your view? I assume that exchange rate risk is what you have in mind when you mention the sustainability of the US CAD.

    The flaw in such an analysis is that its characterisation of the cost-benefit analysis of dollar asset holdings is too simple. There are other reasons to hold dollar assets besides risk and return. You mention liquidity yourself. Also, private sector investors may also have a certain amount of wealth to invest somewhere. Both of these reasons mean that private sector investors also care about the size of their dollar holdings to some degree. They may reduce their holdings of dollar assets in response to the increase in exchange rate risk generated by the intervention-driven appreciation, but not enough to entirely undo the appreciation. I believe this is what international economics textbooks call the portfolio balance channel.

    My conclusion is that you are both right. The private sector is supporting the dollar as much as the central banks, but only with a smaller stock of dollar assets than would be the case without intervention. If central bank holdings of assets are small in relation to the private sector, intervention does not work. How big a proportion of the stock central banks have to account for to affect the exchange rate depends on the utility of those assets beyond risk and return. I would imagine that the utility of dollar assets is relatively large, and also that central bank holdings of dollars are relatively large, so I can believe that intervention is holding the dollar up.

  • Posted by bsetser

    Gheorghius — i do play the fx market in a really boring conservative way (distribution of my pension fund across asset classes), but on a scale that is tiny v. our friend macroman! I basically agree with your argument vis a vis the $, tho with proviso that macroman introduces — the CBs are big net sellers of $/ net buyers of euros in pounds right now, and that flow has an impact on the market. prices are set at the margins. but the broad equilibrium is one where US holdings of Eiuropean assets (mostly private) balance European holdings of US assets (mostly private) and while foreign central banks shape the market (as do the fed and ECB via their interest rate policies), it basically is an equilibrium shaped only indirectly by central banks.

    I disagree with you on the yen $. there are three big long $/ short yen positions out there — call it real Japanese private money (pension funds and insurance funds holding $/ buying more $), real Japanese public money (the MOF’s $900b of reserves) and leveraged private money (borrow yen to buy $ bonds or $ equities). the two private stocks — the real money one and the levered one — are big, no doubt. tho perhaps not as big as the public money stock. but the MoF shapes expectations — japanese real money is more comfortable being long $ (unhedged) if they expect the MoF won’t allow a huge yen appreciation.

    and Macroman’s point also applies here — all data suggests that central banks haven’t been big buyers of yen (i.e. sellers of $), so there hasn’t been a big central bank inflow into japan (unlike europe). that has helped to shape prices.

  • Posted by gillies

    “Why can’t the Iraqi people even be permitted to sell their oil in the currency of their choice? ” (dave chiang)

    so what currency do those iraqis stealing oil for the black market demand ? if it were dollars, that would undermine your argument. if currencies are manipulated by the authorities – i think it is legitimate to enquire what goes on outside the control of the authorities.

    – and those convenient 500 euro notes mentioned by ‘guest’ above. some people even allege that they were deliberately designed to corner the black market and attract the cash-only operators to support the euro. five helicopter loads of 100 dollar bills were sent from the u s to support the kurds. in 500 euro bills that would have been one helicopter. . . .