Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Where is China? The puzzling q1 COFER data on global reserve growth

by Brad Setser Friday, June 29, 2007

China reported a $135.7b increase in its reserves in q1.   

China doesn’t report the currency composition of its reserves to the IMF.  Its reserve total consequently usually appears in the “unallocated” line of the IMF’s data on foreign exchange reserves (The COFER data).

But unallocated reserves only increased by $107b in q1.  It is unusual — as the following graph shows — for the increase in unallocated reserves to be smaller than the increase in China's reserves.  It happened in q4 2005, but that is about the only case, at least the only recent case apart from q1 2007.



China is clearly the most important country that doesn't report data on the currency composition of its reserves to the IMF, but it isn't the only one — and the others generally have been adding to, not subtracting from, China's total.   One explanation for the q1 data is that some of these other countries reduced their reserve holdings, offsetting the very large increase in China’s reserves.  

But I track the reserve data released by a lot of countries, and I haven’t found many with falling reserves recently — so I certainly wasn't expecting a big offset to China's reserve growth.   Venezuela’s reserves did dip a bit in q1, but not enough to offset China’s $135b increase.  If any one knows of another country that reduced its reserves significantly in q1 2007, do tell —  the $30b fall in reserves needed to offset China's strong q1 is large enough that it should be relatively easy to find.

The increase in “allocated” reserve reported by emerging economies – that is emerging economies that report data on the currency composition of their reserves was $131.4b.  Another possible explanation for the smaller-than-expected increase in "unallocated reserves" is that some countries started to report the currency composition of their reserves, shifting from “allocated” to “unallocated.”   

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The Economist still isn’t convinced the RMB is undervalued …

by Brad Setser Thursday, June 28, 2007

Half a trillion dollars apparently doesn't get the respect it used to. Neither the author of last week’s Economics Focus column nor Morgan Stanley’s Stephen Jen think that the Chinese yuan (or RMB) is undervalued, despite annual reserve growth that would have been around $350b last year but for $100b or so of debt purchased by Chinese state institutions and that could approach $500b this year. 

The Economist, for all its free market barnstorming, apparently doesn’t mind massive government intervention in the foreign exchange market – intervention that necessarily means governments will be big players in a host of asset markets.

Indeed, it often seems that the larger China’s current account surplus (it looks set to rise above 12% of China’s 2006 GDP), the faster China’s reserve growth, the faster Chinese exports growth (30% y/y in the latest data) and the more net exports contribute to growth (2-3% of GDP in q1, about the same as in 2006), the more the Economist (and, to be fair, some economists) insists that China’s exchange rate isn’t truly undervalued. 

The Economist includes many different voices.   This week's leader on the lessons from the 1997 crisis includes a welcome call for China to let its exchange rate move more.  But I think it is fair to argue that its main editorial line consistently has emphasized that the RMB isn’t obviously undervalued even as China's trade surplus soars — while suggesting that other currencies (the Saudi riyal, the Japanese yen) are.  

The Economist tends to pick up on Stephen Jen's arguments, but not those of say Nick Lardy and Morris Goldstein.

And rather than encouraging China to mark the RMB to market, the last week's Economist argues we should all mark the RMB to a model, and specifically to a behavioral equilibrium exchange rate model.   Fair enough.  But marking-to-model poses its own risks, not the least the challenge of picking the right model.  

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Reserve diversification — what does the IMF data tell us?

by Brad Setser Wednesday, June 27, 2007

There is a lot of interest in reserve diversification.   

And most of those present at the May Euromoney fx conference in London—judging from the audience poll – believed that at least some central banks are diversifying.   

My comments back then emphasized the unprecedented pace of reserve growth rather than diversification.   Large-scale diversification seems hard to square with the record growth in central bank custodial holdings of Treasuries and Agencies reported by the New York Fed.  

My argument fell flat.   I sort of understand why.   

Flows drive markets and at the time the most visible flow in the currency market came from ongoing central bank sales of dollars for euros, pounds and a few other currencies.   G-10 currency traders care far more about the amount of dollars central banks sell than the amount they keep.  Presumably those trading US treasuries or agencies have a slightly different point of view.   

So I decided to step back and look at the data — and specifically the data from emerging economies countries that report to the IMF.  That doesn’t tell us what central banks are doing now.   But it provides the most detailed picture available of what central banks – or at least those central banks that report data on the currency composition of their reserves to the IMF – have done in the past.

Looking at the IMF data has another advantage.   I don’t need to make any assumptions to flesh this data out – it comes straight from the mouth (or spreadsheet) of reporting central banks.

The first chart shows the stock of reserves and the dollar share of those reserves on different axis. 

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Do foreign holdings of US debt put the US economy at risk?

by Brad Setser Tuesday, June 26, 2007

I am testifying later today (gulp) before the House budget committee — and the time that normally goes into writing blog posts has gone into preparing my written testimony.  

That means I haven't had time to fully explore a range of interesting topics:

  • The Economist's (continued) insistence that a 10% of GDP (and rising) current account surplus, 30% y/y export growth and $500b in intervention in the fx market is not a sign that a currency is (just perhaps) a wee bit undervalued. 
  • Larry Summers' argument that the preeminent economic policy challenge right now is to find ways to address the unequal distribution of the gains from recent growth.  No doubt his new paper with Jason Furman and Jason Bordoff is worth reading.
  • Bear Stearns' decision to back — i.e. to provide a loan that, best I can tell, allows the fund's existing creditors off the hook — the least troubled of its two troubled hedge funds but not to back the other, more leveraged and thus more troubled, fund.   Like Naked Capitalism, I wonder if that is viable — from the outside, Bear seems to be threatening to turn over the keys of its more troubled fund to that funds' creditors and daring them to liquidate the more leveraged funds assets and set a market price that would make it hard to mark-to-model, no matter what the consequences are for Bear's reputation.  If I am reading this wrong, do tell …

The Budget Committee's hearing is structured around the question of whether large foreign holdings of US debt put the US economy at risk?  My answer is pretty simple: the United States' ongoing need for a large increase in foreigners' willingness to hold US assets in order to fund large ongoing deficits remains a potential economic vulnerability. 

I try to lay out two different risks.  One is that foreign investors fail to provide the US with enough financing, forcing too rapid adjustment.   The other is that foreign investors provide the US with so much financing — at least in the short-term — that they prevent a necessary adjustment from happening, allowing the underlying disequilibrium to build.  

I know my comparative advantage — I'll be focusing on the US debt that foreign central banks hold as part of their reserves.   The actions of central banks — and sovereign wealth funds — are central to both stories. 

As Ted Truman and Fred Bergsten have argued, what matters most for the US — as for any country with a large deficit — is the total amount of financing that foreign investors are willing to provide, not the precise financial instruments that foreign investors want to hold.   If total inflows are less than the current account deficit, something has to change — the dollar has to fall and interest rates have to rise to the point where foreigners are willing to lend and invest more, or the US would need to borrow and invest less.   

But so long as central banks offset any fall off in private financing, this specific risk won't materialize.   That seems — at least to me — what has happened over the past few quarters. 

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Putting the BRICs cash to work ….

by Brad Setser Saturday, June 23, 2007

Foreign central banks custodial holdings at the New York Fed rose by close to $12b last week, with over $4b in Treasury purchases.   Combine that data point with the fall in Treasury yields, and it seems reasonable to conclude that foreign central banks found Treasuries more attractive at 5.2% than at $4.8 or 4.9%.   Anecdotes suggesting that central banks jumped back into the market early this week seem true.   

The trouble over at two Bear Stearns hedge funds (well chronicled by Naked Capitalism) also may have contributed to the fall in Treasury yields this week.

One thing seems clear: central banks still have a lot of cash to play with, cash that has to go somewhere.  Brazil has resumed releasing its reserves data in a timely way, so we now know Brazil's reserves increased by about $15b ($14.6b) in May.

If China added $38b to its reserves in May — $38b is my estimate for the valuation-adjusted increase in China's April reserves — then the BRICs added a record $95b to their reserves in May.  That is up from around $70b in March and a bit less than $80b in April (all data has been adjusted for valuation effects).

The BRICs are not the only emerging markets adding to their reserves at a rapid clip either.   Some small Latin countries are doing their part –as, for that matter, are many smaller Asian economies.  Thailand and Malaysia, I am thinking of you …  

Global reserve growth likely far exceeded $100b in May.   Central banks have to be buying a lot of something.

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Yes, Virginia, exchange rates do matter (JPY edition)

by Brad Setser Thursday, June 21, 2007

The yen depreciates.   Against the dollar, bien sur.   But especially against the euro and other European currencies.    Guess what happens?

Japanese exports to Europe rose by nearly 18% (y/y) in May

No doubt some will argue that the ongoing rise in Japan's trade surplus (at a time when oil is expensive and the US economy has slowed) has no more to do with the weakness of the yen than the ongoing rise in China's trade surplus has to do with the RMB's weakness.   

I don't buy it.    A forthcoming Marquez/ Schindler study (hat tip, Menzie Chinn)  suggests that a 10% appreciation in the RMB (in real terms) would reduce China's trade surplus by between $65-70b (around 2% of China's GDP).   

And yesterday's Wall Street Journal illustrated just the yen/ dollar influences trade flows.

Toyota sells a lot of cars in the US.  It has to decide whether or not to make those cars in the US, in Japan or somewhere else.   Over the past few years, the ratio between Toyota's US sales and its US production has fallen, as Toyota's US production hasn't increased as rapidly as its US sales.   

Toyota has plants in the US as a hedge against yen strength — to be sure.   But also as a hedge against a return of the Japan-bashing of the 1980s.   The more plants Toyota has in the US, the more votes Toyota has in Congress.  But at some point, the financial cost of "political" hedging gets to be too high.  Toyota seems to have reached that point.  

So long as Toyota makes a lot more money building cars in Japan and shipping them to the US than it makes building cars in the US, it has a strong financial incentive to invest in more Japanese capacity — not more American capacity. Norihiko Shirouzu in yesterday's Wall Street Journal:

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Does Bretton Woods 2 end with a bang or with a wimper — a dialogue

by Brad Setser Wednesday, June 20, 2007

What follows is a bit of an experiment.   I am posting — with permission — a lightly edited version of an email exchange that I had with a global equity portfolio manager a few days ago.  

Like all good conversations, it evolved.  What started out as a conversation about China's economic cycle — or more precisely, the absence of much recent macroeconomic volatility in China — developed into a  broader discussion of US competitiveness, global capital flows and the conditions that might bring today's relatively stable equilibrium to an end.    Enjoy.

Global equity portfolio manager: 

The growth rate of China's exports and construction & mfg in general raises another question. US history suggests that high growth regions have greater economic volatility since so much of their economy  represents growth industries. A slowdown in growth rate creates powerful "feedbacks" (not the right word), since getting to a  steady-state economy requires substantial restructuring.

Might this be true of China, even as a short-term effect? If US export  growth goes to zero, what about all their internal business devoted to generating increased growth? This is not clearly stated in most articles discussing global rebalancing. 

Brad Setser:

Your point on China is a good one. In the 90s Chinese growth (overall  and in exports) was high but very volatile. Some of that was external  — Asian crisis/ tech bust (and impact on demand for computer assembly). Some was internal (inflation & over investment in early 90s  restructuring of state-owned enterprises in late 90s). From 02 on though Chinese growth has been high and lacked volatility.  The same is true of exports. You could argue this is just storing up future volatility in both… 

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The T-Bill conundrum

by Brad Setser Tuesday, June 19, 2007

10 year Treasuries — and other long-dated Treasury notes — usually yield more than short-term instruments.   One widely cited explanation for the fact that until recently longer-term rates were well below the Fed Funds rate: "Non-market" demand from central banks.

As 10 year yields rose over the past couple of weeks, Asian central banks generally stood on the sidelines.   They do not seem to have been big sellers –though the last two weeks custodial data from the New York Fed do suggest some sales of Treasuries and some purchases of Agencies — but they also weren't big (net) buyers.  Those betting on a strong central bank bid were burned.

But all the cash that is flowing into the coffers of central banks had to go somewhere …

Societe General has noted that the gap between the interest rate on 3m T-bills and the Fed Funds rate – close to 75 bp at the end of last week — is exceptionally large. Indeed, the gap is now as wide as it has been during major market disruptions in the past.   The interest rate on 3m T-bills usually is close to the Fed Funds rate.

I strongly suspect that central bank funds that previously were flowing into long-dated Treasuries and Agencies are now flowing into the T-bill market.   At the right rate, I also suspect central banks will once again be willing to snap up longer-term bonds once again.

True, the April TIC data is at odds with a story built around a surge in central bank demand for short-term bills.  But the April data is by now rather dated.  Right now, it sure seems like the central bank bid for longer-term Treasury notes and Agency bonds — which contributed to the "conundrum" — has become a central bank bid for short-term T-bills.

Like most, I am drawn to stories that confirm my own suspicions.  But do take a look at the work of Steven Gallager and Aneta Markowska of Societe General.

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Sovereign Wealth Funds are sexy, but the real story right now comes from plain old central bank reserves …

by Brad Setser Tuesday, June 19, 2007

Everyone now wants to talk about sovereign wealth funds, both how big they will become and how they will (or will not) impact a range of markets. 

I tend to agree with Tony Tassel and Joanna Chung of the FT.  If sovereigns shift from buying bonds to buying equities, the impact on equities is rather more ambiguous than many think.  More demand is good, but private equity has already been pretty effective at transforming central bank demand for debt (counting private demand for debt that yields more than the debt that central banks buy as a knock-on effect from central bank demand) into demand for equities.  And if shifting from bonds to equities drives down bond prices and drives up rates, well, that isn’t obviously good for equities.  

If central banks want to shift from “safe” – at least in the sense of lacking credit risk — Treasuries and Agencies to various spread products, they risk buying in at the peak.  After all, in recent years (and especially 2006) central bank demand for safe assets topped the creation of safe assets, so private investors who sold their treasuries and agencies to central banks bought risky assets.   Add in the impact of the CDO put, and, well, it is hard to imagine how sovereign wealth fund demand for “spread” products could drive spreads down further ….

The only strong conclusion that I have been able to draw from looking at the asset allocation of existing sovereign wealth funds is that they, unlike central banks, don’t shy away from emerging markets.  But then again most emerging markets don’t need any more inflows.  The last thing Brazil – and a host of other countries –want is for China’s new investment fund to start to play the carry trade and add to the pressure on Brazil’s currency.    The oil funds would love to invest in Asia, but what Asian country currently needs the money?  Almost all can finance their existing level of investment out of domestic savings.  India invests more than it saves, but it already is attracting more funds than it needs. 

Until more emerging economies follow the example of Eastern Europe rather than the example of China, I don’t quite see how sovereign wealth funds can finance the emerging world.  One surplus country (Saudi Arabia) cannot finance another surplus country (China).   While everyone has been debating how sovereign wealth funds will change the world, central banks have quietly gone on piling up assets.    The latest data from the BEA showed $440b of central bank inflows to the US in 2006 – and an increasable $380b in central bank purchases of traditional reserve assets (more here).   Central banks now buy Agencies as well as Treasuries, but otherwise, 2006 looks a lot like  2004.  

Moreover, the BEA data almost certainly understates central bank purchases in the second half of 2006.   Remember, the data for the first half has been revised to reflect the findings of the most recent survey, but the data for the second half has yet to be revised.  Expect that a lot of the private purchases of Treasuries and Agencies in h2 2006 will turn out to come from central banks.  The revised 2006 data – which won't come out until mid-2008 —  is likely to show $500b or so in in official inflows. 

After all, we know from the IMF’s data that central bank reserve growth accelerated over the course of 2006, so there is good reason to think central bank purchases of US bonds picked up in the later half of the year.   

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Just about everyone’s trade balance with China is deteriorating

by Brad Setser Monday, June 18, 2007

About the only thing I didn't like about Floyd Norris' Saturday New York Times article was the title "Not Everyone Is in the Red on Trade With China."   And to be honest, the title — which seems to allude to the by now outdated argument that China's surplus with the US is offset by a deficit with the rest of the world — didn't really match the content of the article, or fully match the conclusions that emerge from the useful charts that accompanied the article.  

The article essentially argues that China's the rise in China's overall surplus is no longer simply a product of strong growth in Chinese exports to the US. 

Norris notes that:

  • China now runs a very large trade surplus with Europe
  • China's exports to the US are growing more slowly than its exports to Europe and the rest of the world.    In part, that is because the US is growing more slowly than Europe and the rest of the world.   But I suspect it also has something to do with the fact that the RMB has appreciated — albeit very modestly — against the dollar while it has depreciated against many other currencies.

Norris uses the Chinese trade data, but he also recognizes its flaws: the Chinese data overstates Chinese exports to Hong Kong and understates Chinese exports to the US and Europe, and thus understates China's surplus with the US and Europe.  And even graphs based on the Chinese data — see the graphics that accompany Norris' article — tell the basic story behind the recent rise of China's global trade surplus well.  

Indeed the charts — though not the text of the article itself, highlight a third key point. 

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