I have boiled two years of experience with the (frustrating) TIC data into six easy lessons –and thrown in a chart showing the large gap between the official flows that showed up in the last survey and the official flows that showed up in the TIC data over the same time frame just to spice things up. 

1/ Always look at the data on short-term flows.   In February, the increase in short-term official holdings accounted for about $20b of the $33b in total recorded official inflows. Total flows were stronger than long-term flows.

2/ If the data on official holdings on Treasuries doesn’t make sense, look at the data from Norway for an explanation.  The activities of Norway’s government pension fund appear in the “official data.”   They seem to trade actively.  In February, they sold $8.2b of long-term Treasuries and added $8.3b to their cash holdings.   They also were big sellers of Treasuries in January ($11.7b).   Sometimes this seems to reflect Norway’s willingness to sell options and the like to get a bit more yield.  Sometimes it seems like the Norwegians are betting on the shape of the Treasury curve. 

Right now, though, the Norway’s government fund is probably raising cash to buy more equities.  By increasing their equity portfolio they are effectively diversifying away from the dollar.  The US has a slightly lower share in their equity portfolio than their debt portfolio.  Above all, though, raising the equity share increases Asia's weight in their portfolio (largely at expense of Europe).  Selling high?  Front-running the People's Investment Company? 

3/  The TIC data usually provides very little useful information about what the other oil exporting economies are doing.  The Asian oil exporters bought $1.2b of long-term debt and equity while reducing their short-term claims by $5.1b in February.   Does that mean anything?   Probably not.  There hasn’t been a good correlation between the Gulf’s rising assets and the TIC inflows for a long-time.    Russia increased its short-term holdings by $3.5b in February, after cutting its short-term holdings by $5.3b in January.   That is probably just noise.   We already know that Russia has diversified away from the dollar, and increasingly seems to be sifting from short-term to longer-term Agencies.  But Russia’s purchases of longer-term Agencies don’t seem to consistently show up in the TIC long-term data (January is something of an exception). I think Russia buys in London rather than in New York.

4/  The TIC data systematically understates Chinese purchases.    The last two surveys showed about $90b more in Chinese purchases than showed up in the TIC data.   The most recent survey showed $193b of Chinese purchases of long-term debt between June 2005 and June 2006, v $105b in the TIC over the comparable period (the previous survey showed $165b in purchases, v $76b in the TIC).    Recorded Chinese flows remained strong in February ($17.1 total inflows, $16.1b long-term debt, with $9.9b in long-term treasuries, $2.3b in long-term agencies and $3.9b of long-term corporate debt).   However the TIC data almost certainly still understates actual Chinese purchases – Chinese reserve grew by almost $53b in February.  

Some of that reserve growth likely came from shuffling pre-existing Chinese foreign assets between the state banks and the central bank.   Stephen Green of Standard Chartered writes the "explosive increase [in Fx reserves] is likely explained by funds that has already entered China moving around, rather than new hot money inflows."  Basically, some of China's hidden reserves stopped hiding (see Richard McGregor of the FT for more).  But I would still guess China bought more than $17b.

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Macro Man asked the IMF to sort out a world where the US current account deficit is increasingly financed by the growth in emerging market reserves (and the expansion of a few investment funds).     After all, the last few months have seen a marked fall off in the private sector’s willingness to finance the US current account deficit, with the slack taken up by the official sector.  

The Federal Reserve Bank of New York’s custodial holdings are an imperfect measure of official inflows.   They leave a lot out.    But they are currently rising at a $10b a week pace.  The q1 increase, annualized, is close to $510b.    And that just scratches the surface.    Personally I suspect that the dollar holdings of the world’s central banks are growing at a roughly $800b annual pace. 

What happened this weekend?    Best I can tell, not much.  Lots of talk about Paul Wolfowitz, to be sure.  But little else.   

As Stephen Roach highlighted on Friday, the official sector is now inclined to stop fretting about risks associated with the US external deficit and instead to celebrate strong global growth that has accompanied the rise in the US deficit.   

Their timing may prove off.  

The concerns I expressed – along with Dr. Roubini — about the rising US external deficit back in 2004 were clearly premature.   But after a period when the risks seemed (even to me) to be falling, they look (at least to me) to be rising once again.   US export growth looks to be slowing. Menzie Chinn has all the details.   In 2006, strong export growth helped to offset a rising oil import bill.   I would not count on strong export growth to offset a potentially large rise in the US interest bill during the course of 2007.  

I consequently am less convinced than the G-7 Ministers and Governors (and Iceland's central bank governor) that the US current account deficit has peaked.   And I am quite sure that the share of the US current account deficit financed by the official sector has risen substantially over the past couple of quarters. 

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Please allow me a bit of latitude.  China won’t add $500b to its reserves in 2007 for the simple reason that the central bank will sell some of its reserves to the state investment company.  Moreover, China might opt to ship some of its spare dollars over to the state banks.    But rather than spell those qualifications out, I am going to talk of “reserves.”

There is just no way to get around the fact that China bought a ton of foreign exchange in the first quarter.   Its reserves went up $135b in the quarter – topping its previous record quarter ($85 or so in q4 04).    Only about $5b of the increase came from valuation gains v. $20b or so in late 2004, so China actually bought a lot more fx in the market now than then — $130b v $75b (by my estimates).    $130b in a quarter works out to $520b for a year.

To paraphrase Macro Man – who is almost as reserve-obsessed as I am – China accrues foreign exchange reserve faster than Britney Spears accrues tabloid headlines. 

Jon Anderson of UBS is more measured, but he still wrote: 

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On the surface, the February trade data doesn't seem to tell us much.  The $58.4b February trade deficit is a tad smaller than the $58.9b January deficit, but the overall story is the same:  the trade deficit seems to have stabilized at around $60b a month, $720b for the year.    A $720b trade deficit still implies – if I am right about the income balance — a $850b plus current account deficit.

Scratch the surface, though, and I think three stories emerge from the data:

1.  US export growth looks to be slowing

2.  The improvement on the import side from oil isn't going to last.  Non-oil imports are still growing — albeit a rather modest pace.

3.  Europe is doing its part to support global rebalancing, Asia isn't. 

Exports.    On a y/y basis, exports were up 8.9% in February.   But by recent standards that is a slow pace.    February exports were actually $2.6b lower than in January.    If March exports bounce back to their January level, the q/q growth in exports (annualized) would be around 4%.     Nothing great.    My biggest concern is that the export boom of 2004-06 is about to fizzle.   Exports are now back at around 11% of GDP – about where they were in 2000.   

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OK, I probably should strike “world” and insert “the world’s governments” instead.  It is pretty clear that central banks and oil investment funds provided the bulk of the financing the US needed in 2006 (see Table 1.2 on pp. 8-9 of Chapter One of the WEO).  

However, at least one important government doesn’t think that it makes sense to add to its existing dollar holdings.  Xia Bin (an economist with China's Development Research Center), a few days ago:

'Everyone knows that they should try to cut their US dollar assets. But, of course, if China wanted to make such a move, a big cut, our losses would be large as well. That would be very difficult to do,' he said

True.  But adding to your reserves doesn’t reduce the ultimate loss.  It defers the realization of the loss, but it also increases the size of the ultimate loss.   But the key point Xia Bin raises is the first sentence – the idea that “everyone” knows that they want to hold fewer, not more, dollars.

Bin's statement is also hard to square with the fact that China's reserves increased by $135.7b in the first quarter alone.   Only about $5b of that likely came from the rising dollar value of China's existing euros and pounds.   A a $130b quarterly increase (ona  flow basis) is a $520b annual pace of increase — a truly stunning sum.    China almost certainly added about $100b, if not more, to its dollar holdings in the first quarter alone.

Two trends seem to be to be in tension.

Trend one: The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves.    China’s central bank has made it known that it thinks it has enough reserves.  Some in China think the PBoC already has far more reserves than it needs. Korea’s central bank has indicated — at various points in time — that it has more than enough salted away.  The ADB agrees.   So does the World Bank, the IMF, and for that matter, the US Treasury.   With good reason.    Read Olivier Jeanne and Romain Rancierre.   

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The conventional wisdom among financial journalists seems to be that exchange rates don’t matter.   At least when it comes to China.     Lex – in an otherwise good column on China’s March trade data – writes:

“To be fair, even if it [The RMB] had moved more [Since July 2005] it would have done little to subdue the trade surplus, given the high level of imported parts in Chinese-made goods and low land and labour costs.

In the short-term Lex is right.  A move in the exchange rate would change prices more than volumes.   But I still don’t quite see how the argument that the RMB/ $ has essentially no impact on trade flows can be asserted with such confidence.

For one, a growing body of evidence indicates that China doesn’t need to import as many components as it once did.   That cheap RMB.  It encouraged parts production – not just final assembly – to shift to China.    

The rising Chinese content of Chinese exports helps explain the recent rise in China's trade surplus (see the World Bank's latest report).  It also should make China’s trade more responsive to changes in the exchange rate. 

For another, a fair amount of evidence suggests that changes in broad trade weighted RMB do have an impact on trade flows (as do most real exchange rate moves).    

From 1995 to 2002, the dollar generally appreciated, so the RMB generally appreciated as well. During that period China’s global trade was roughly balanced.   China’s annual export growth was very volatile.  But on average, the pace of growth was good, but not great.  Something like 15% y/y.  I would need to dig a bit to get the precise number.

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I suspect I am one of a very small number of people who eagerly awaits the publication of the Treasury’s annual survey for foreign portfolio investment.     Wall Street doesn’t find it particularly useful: it looks backwards, and come out with a long lag.   The most recent survey tells us what happened between July 2005 and June 2006 – ancient history.     Academic economists don’t particularly like it either.    The survey data doesn’t form a nice time series that can be easily downloaded and analyzed.   It wasn’t even an annual publication until 2002.    

To the uninitiated, the survey’s results look like one page of numbers after another.  But those numbers tell stories.  If a country’s reported portfolio has lots of Treasuries and Agencies and no corporate bonds or stocks, it screams “central bank.”      Little quirks jump out.   Russia and India both hold a lot of short-term securities.    But not quite the same short-term securities.  The Bank of Russia holds Agencies and won’t touch Treasuries or short-term corporate paper, the Reserve Bank of India holds Treasuries and corporate paper, but won’t touch Agencies.   China’s state administration of foreign exchange has been a big buyer of “Agency ABS” – basically, mortgage backed securities with an agency guarantee.   “Official” buyers bought $54.5b of “Agency ABS’ between the end of June 2005 and the end of June 2006.   China bought $51.5b.   The Bank of Russia, by contrast, won’t touch Agency ABS, but it snaps up an awful lot of the debt the Agencies issue directly.  It bought about $30b of short and long-term Agency paper between the end-June 2005 and end-June 2006.   

And so on.   If you spend enough time with the data, you can learn a lot about “he who cannot be named.” 

Here are the five big stories that emerge – in my view – from the data.  

1.   China has not diversified its reserves.   Let me shout that: “CHINA HAS NOT DIVERSIFIED ITS RESERVES.”      According to the survey, China bought $193b of US long-term debt between the end of June 2005 and the end of June 2006.   To state the obvious, $200b (rounding up) is a lot.   Someone should write a story about how China influences the US economy that emphasizes the export of debt – not the export of goods.  

The US “exported” $87b of long-term Treasuries, $83b of long-term Agencies, $23 of long-term corporate debt to China between the end of June 2005 and the end of June 2006.   During that period, the US exported $48b of goods to China.    No wonder many on Wall Street like an unbalanced world … 

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1. The spread (over Treasuries) on Brazil’s dollar bonds is now 120 bp.     I remember when …

2. Brazil added close to $25b to its reserves in a single quarter ($23.7b if you want to be precise).    Reserves rose from a tad over $85b to just under $110b.    Back during Brazil's most recent crisis, it often had — after netting out IMF borrowing — less than $20b in the bank.  At the end of 2004, a little more than than two years ago, Brazil only had $27.5b or so net of its IMF loan.   

The IMF’s total commitment to Brazil back in 2002 chalked in at a bit over $30b.   It was considered huge at the time.   And it wasn’t all disbursed in a quarter either.    The biggest quarterly disbursement was “only” $6.3b.  

Yet without the IMF loan, Brazil would have almost certainly defaulted on its external debt.    The big “China” surge in commodity prices wouldn’t have come along quickly enough to save Brazil from default.    

A country that needed a huge credit line from the IMF to avoid default five years ago now borrows in US dollars for only a bit more than the US Treasury.   Talk about multiple equilibria.

The foreign currency balance sheet of Brazil’s government has been completely transformed over the past five years.   Brazil used to have far more dollar debt than dollar reserves, and, to top it off, Brazil’s central bank sold a lot of insurance against further falls in the real when the real was under pressure.    The government was effectively short dollars and long real – its balance sheet deteriorated when the real fell.  Now Brazil's government is long dollars.   It borrows from the world in real to buy dollar reserves …  

The carry trade, you know.  It hasn’t gone away.  Who doesn’t want to borrow yen to buy real?   And if the central bank is going to step up its intervention to keep the real from appreciating further (the real is back to where it was in 2001, before the 2002 crisis), well, volatility in the real/ dollar should fall – making it easier to lever the size of the trade up. 

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Dated perceptions of China: 

• Chinese banks are filled with NPLs.  
• China runs a surplus with the US but a deficit with the rest of the world, so its trade is in rough balance.
• China just assembles imported components with little value-added.

New realities:

Chinese banks are stuffed with sterilization bills.   The asset management companies are now stuffed with the bad loans formerly held by 3 of the 4 big state banks (ABC is still a mess).   Most of the loans extended in the recent boom are performing – with nominal GDP growing so much faster than bank’s lending rate, it is hard not to come up with the funds to pay the banks interest.   That – plus a juicy lending to deposit spread — is the underlying reason why the former state commercial banks are now worth quite a lot, even if they may not be worth quite as much as the markets now think they are worth. The risk facing the banks is that a large share of the current crop of loans will go bad … 

China runs a big surplus with the world, not just the US.  The World Bank estimates that China’s 2006 current account surplus will reach $230b, or 8.7% of China’s GDP.   Net exports – incidentally – contributed an estimated 3.3% to China’s GDP growth in the second half of 2006, up from 2% in the first half of 06.   So much for rebalancing.  Export growth accelerated even more in the first couple of months of 2007.  Citi now expects China to run a $30b monthly trade surplus in the second half of the year.

And China is rapidly developing the capacity to manufacture high-value added components, not just to do the final assembly.  You don’t need to trust me on this.    JP Morgan and the World Bank have reached a similar conclusion.

Grace Ng and Qian Wang of JP Morgan note: 

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Many analysts believe – extrapolating from the q4 data and the stabilization of the non-oil trade deficit – that the US current account deficit has peaked.  Stephen Jen is the most prominent example, but far from the only one.   Reuters reported a while back:

"We believe the current account has peaked" and will decline to $809 billion in 2007, said Nigel Gault, U.S. economist for Global Insight. "The trends are becoming more favorable. Robust export growth, and some cooling in import growth, should keep the deficit down this year."

I disagree — at least if the US avoids a housing-induced recession and US growth re-accelerates over the second half of the year.    

Why?  Like Dr. Chinn, I expect the income balance will deteriorate significantly in 2007.  The US looks set to grow more slowly than the rest of the world, but I doubt that will generate a improvement in the trade balance sufficient to offset the deterioration in the income balance.   The deterioration in the income balance has taken longer to materialize than Dr. Roubini and I anticipated back in 2004, but I am fairly confident the deterioration will emerge in 2007.  

The US trade deficit – the non-oil trade deficit at least – did stabilize in 2006.    World growth was strong, pushing up US exports.  The lagged effect of the dollar’s 2003 and 2004 depreciation also helped – in most econometric models there is a 2-3 year lag before the full impact of a currency move is found in the export data.   

US non-oil import growth slowed along with the US economy.   I was a bit skeptical on this front – largely I wasn’t seeing a slowdown in the trade data with East Asia.  But it turns out I wasn’t looking in the right place.  US imports from Canada (non-energy imports) fell quite sharply.  Think autos.  Think timber.   The category “non-oil industrial supplies” includes a lot of things that go into building houses.

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