Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Does the China investment corporation (CIC) have a coherent investment strategy?

by Brad Setser Sunday, December 30, 2007

I personally would say no.  And I am not alone.  Tan Wei of reports (in the FT)

“a source familiar with the Chinese government’s thinking … who has direct access to the Chinese government officials”  …  says that until now CIC has lacked a clear strategy and will in future focus its investments in the natural resources sector.”

That jibes with Jamil Anderlini’s reporting in late December:

“Such a concentration of the country’s wealth in one entity has inevitably drawn intense interest, not just from every fund manager on the planet but also from powerful forces within the state bureaucracy.  Each of these groups has its own ideas on how the money can best be spent.”

It now seems likely – despite protests to the contrary (“The deal was struck over a matter of months rather than a few weeks”) – that the CIC’s decision to invest in Morgan Stanley wasn’t entirely the product of a careful deliberative process.   Tan Wei reports that the CIC jumped on the Morgan Stanley deal after the China Development Bank (itself soon to be recapitalized by the CIC) missed out on a big stake in Citi because it wasn’t ready to move quickly enough.  

“An insider at Citigroup revealed that the US investment bank had first approached the China Development Bank (CDB) to see if it was interested in acquiring a stake in the bank. CDB had shown strong interests in doing so, the insider said, but told Citigroup that it would need three days to make a decision because it needed, as a state-owned bank, to get government approval. At that same time, Abu Dhabi was also offered the opportunity to invest and was able to move forward with the purchase right away. The insider added that it was for this reason that CIC didn’t hesitate when approached by Morgan Stanley about acquiring a stake, having learnt from CDB’s experience that it needed to act quickly.”

Wei’s account jibes with Keith Bradsher’s story that the Morgan Stanley stake came as a surprise to the CIC’s staff.  If Wei and Bradsher are right, the decision to take a punt on Morgan Stanley sounds rather like the decision of jump at the chance to get in on Blackstone’s IPO even before China had formally set up an investment agency.  The CIC almost certainly lacks the staff needed to do much due diligence on its investments in large US financial institutions.   The balance sheet of a big US broker-dealer presumably doesn’t look all that much like the balance sheet of a big Chinese state commercial bank.

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The IMF’s data for global reserve growth in q3

by Brad Setser Friday, December 28, 2007

I would caution against reading too much into the fall in the dollar's share of global reserves in the latest IMF COFER data release for two reasons:

First, most of the fall in q3 is explained by the rise in the dollar value of the world's existing holdings of euros and pounds.  The euro rose from around 1.35 to a bit over 1.42 in the third quarter.  The rise in the dollar value of the world's existing holdings of euros from currency moves explains at least $50b of the overall increase in euro holdings.

Second, the diversification that is taking place is coming from the world's advanced economies, not the world's emerging economies.   After stripping out valuation gains, the advanced economies added $10.7b euros to their stockpile — a far larger sum than the $3.1 billion increase in their dollar holdings.  Either Japan diversified at the margin or a host of European countries continued to shift away from dollars.   Those emerging economies that report data to the IMF, by contrast, bought three times as many dollars ($61.4b) as euros ($21.2b). 

If emerging economies that do not report detailed data on the currency composition of their reserves acted like other emerging economies, dollar reserve growth remained very strong — though not quite as strong as in q1 or q2.    Central bank financing of the US hasn't ended.  (UPDATE: supporting data has been added below)


The reserves of reporting emerging economies rose by $132.7b, with a $61.4b increase in dollar reserves and a $53.8b headline increase in euro holdings.    But valuation changes explain over $30b of the increase in euros.  I have yet to break out the impact of valuation gains on the remaining $17b of the $132b overall increase — but valuation changes undoubtedly were a factor there as well.

Consequently, to me the big story remains the ongoing increase in overall reserve holdings.   Valuation gains explain a big chunk — probably around $100b, but I need a bit more time to do the analysis (update: valuation changes look to have added more like $80b)– of the $317b headline increase in q3.   But around two thirds of the increase comes from ongoing intervention in the foreign exchange market.  Valuation gains also explain a portion of the $1287.2b increase in global reserves over the last four quarters.   But the core story remains the enormous — indeed, unprecedented — overall growth in global reserves and the enormous growth in central bank holdings of dollars.

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Holiday ice-blogging

by Brad Setser Monday, December 24, 2007

Kansas isn't quite as icy as it was two weeks ago, but it did snow two days ago.


(photo credit: Carole Setser)

I plan to focus on eating and drinking over the next few days — I'll resume posting next week.   I am already quite confident that Santa will disappoint me on December 31st (when the IMF publishes its COFER data).

Happy holidays to all and, if it fits, Merry Christmas. 

A Saudi investment authority?

by Brad Setser Sunday, December 23, 2007

The FT broke a major story — at least in my world — late on Friday. The Saudis are about to set up a sovereign wealth fund:

Saudi Arabia plans to establish a sovereign wealth fund that is expected to dwarf Abu Dhabi’s $900bn and become the largest in the world.

The new fund will be a formidable rival for other government-owned investment funds in the Middle East and Asia, which are playing an increasingly active role in channelling capital to western companies, particularly financial companies hard hit by the US mortgage meltdown.

….  The effort is likely to be spearheaded by Saudi Arabia’s Public Investment Fund, which has a mandate to invest only internally. Previously, the Saudis’ oil wealth had gone partly to the kingdom’s central bank, the Saudi Arabian Monetary Authority, and partly into the coffers of the ruling family.

While the balance sheet of SAMA is public information, bankers say the figures capture only a small percentage of the total wealth of the country. The myriad investment vehicles of the various members of the royal family have never been transparent.

Until now, SAMA’s investment policy has been conservative and largely limited to investment in bonds, especially US Treasuries, and shares. That contrasts with the mandate of its peers in the Gulf, which is increasingly geared to higher returns for when oil runs out, by investing in alternative assets such as private equity and hedge funds.

…. King Abdullah, Saudi Arabia’s ruler, is believed to be a key sponsor of the investment initiative.

This is big news, in a lot of different ways.

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To worry or not to worry – more (sort of) scary graphs

by Brad Setser Friday, December 21, 2007

Has the US slowdown, the credit crunch (See Krugman), the resulting fall in the current account deficit and rise in the risk of a recession (Read Summers) reduced the risks associated with the United States’ need to finance its still-large current account deficit?

That is the crux of the recent debate that I had with Richard Iley, a senior economist at BNP Paribas — a debate got rather technical, even by the standards of this blog.   But despite some points of agreement – the technical debate did draw out an important difference in how Richard and I view the world.  

Richard is impressed by the resilience of US capital flows and the strong recent improvement in the US current account deficit in the absence of a recession; I am more impressed by the fall in private demand for US assets and the resulting increase in US dependence on financing from central banks and sovereign wealth funds.

I tried to reduce everything to a single graph – one that I think explains why the US is turning to the CIC and Abu Dhabi for a little bit of financing ($15b isn’t that large relative to either the US deficit or official asset growth in China and the Gulf) and central banks for a lot more.


All data is presented as a rolling four quarter sum.


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How quickly the world changes

by Brad Setser Thursday, December 20, 2007

My guess is that when Hank Paulson went to Washington, he hoped to be the one who would really open up China’s largely closed domestic financial market to investment from private US financial firms.   Paulson always seemed more passionate about financial liberalization than exchange rate appreciation.  It now seems more likely that by the end of Paulson's tenure as Treasury Secretary, China’s government will have increased the scale of its minority stakes in large US banks and broker dealers while private US firms will still not have majority stakes in large Chinese banks.    

Beijing needs places to invest, not more inflows.  Chinese banks do not need another round of cash from Goldman or anyone else, and wouldn’t sell at anything like the same price.   The Chinese state banks — and as well as their ultimate owner, the CIC – all have plenty of cash to invest in troubled US banks.   They are exceptionally liquid.

The Bush Administration has clearly opted to focus on the need to keep the US market open to foreign investment of all kinds, including investment from large government funds — not on the risks of "state control" and the associated challenge to the logic of market capitalism.    That opens up space for China's government and large Chinese state banks to buy into the US financial system. 

Naked Capitalism (happy blog birthday!) has an interesting discussion of the trade that got Morgan Stanley into trouble.  I am not sure I fully understand the details (“long $14B super senior, short $2B mezz “), but it seems like Morgan effectively held seven times as many higher-quality mortgage backed securities (super-senior tranches of CDOs constructed from mortgage backed securities) as it had sold short lower-quality securities (mezzanine tranches of similar CDOs), with the bigger position in the higher quality securities offsetting the interest cost of shorting the lower quality securities.  

If you cut through the correlation analysis — from the comments at Naked Capitalism: “I heard that they had a correlation delta neutral position of Longer super senior/short junior mezz which would tally with the 14long/2short position you report. Sadly for them in a crisis correlation tends to 1 and they were long correlation on the 2/short on the 14" —  it seems like Morgan Stanley bet that the subprime crisis would be bad (making it worthwhile to be short the lower-quality stuff) but not too bad (in which case the long position on the higher quality stuff would bite).    


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The alliance between China’s (nominally) communist government and Wall Street deepens …

by Brad Setser Wednesday, December 19, 2007

The China investment corporation (the CIC) is investing $5b in Morgan Stanley, taking a 9.9% stake.

That is a bit of a surprise, at least to me.   After the CIC's (mark to market) losses on Blackstone, I expected the CIC to shy away from similar high-profile, visible stakes — especially ones that risk further losses.    I got that wrong.   Very wrong.

I apparently am not the only one who was surprised. Keith Bradsher reports:

[The investment in Morgan Stanley by] China Investment Corporation … also marks an abrupt shift in strategy for the $200 billion fund, and underlines the extent to which the government fund appears to be under the direct control of China’s leaders.

Lou Jiwei, the fund’s chairman, said in a speech at a financial forum on Nov. 29 that the fund sought liquidity and would mainly invest in financial instruments like index products. Mr. Li also said that the fund, which has fewer than two dozen employees, would start hiring foreign experts before making more overseas investments.

….The investment fund declined to comment late Wednesday on its acquisition of nearly 10 percent of Morgan Stanley. But a person familiar with the fund’s activities said that the decision had been sudden and little expected by the fund’s staff.

“I am also surprised,” said the person, who insisted on anonymity because of the sensitivity of the deal. [Emphasis added]

I can see why the fund's staff was surprised — in late November, Lou Jiwei seemed to indicate that the CIC wasn't yet ready to make a large investment in a major financial institution.  This kind of investment wouldn't have been made without the approval of China's State Council — not after Blackstone.   Indeed, Bradsher's reporting suggests that the impetus for the deal came from the State Council rather than the CIC's staff.

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Yes, Virginia, the world’s central banks are financing most of the US current account deficit (my rebuttal to Richard Iley)

by Brad Setser Tuesday, December 18, 2007

Back in the summer of 2004, Nouriel Roubini and I published a paper arguing that large trade deficits implied a deteriorating US net international investment position and a deteriorating “income” balance.  

Our analysis was couched in the terms of the debt-sustainability analysis then the rage at the IMF.    But it basically made a very simple argument: if you borrow a ton to spend more than you earn, your debts will rise and you will eventually have to start borrowing even more to cover the interest on your debts.   And if you cannot borrow ever larger sums, you will have to cut back.  

Seems reasonable, right?

Alas, we were wrong.   At least our forecasts were wrong.   The US has run large deficits ever since we wrote the paper.  $640b (revised) in 2004.  $755b in 2005.  $810b in 2006.    Maybe $755b in 2007 (assuming a $190b deficit in q4).     That sums up to a bit less than $3 trillion in cumulative deficits.    The United States net international investment position hasn’t deteriorated by anything close to $3 trillion.  It didn’t actually deteriorate at all between 2003 and 2006 if US FDI abroad is valued at market rates (data).  While we don’t yet know the total for 2007, the dollar’s slide should generate another round capital gains on America’s investments in Europe.    

The income balance (the difference between the interest and dividends the US receives from the world and what it pays to the world) also has not swung into deficit.   Interest payments on US debt are rising.  But income on US direct investment abroad has increased faster.  The BEA didn't help by revising the income balance up by around $40b when there published their comprehensive data revisions earlier this year.  However, the 2007 income surplus looks to be bigger than the 2006 surplus.  That isn’t explained by a new method for calculating US interest payments. 

Nouriel and I didn’t ignore valuation gains from currency moves.    We did though argue that the US couldn’t consistently count on valuation gains from the dollar’s slide to offset large deficit – foreigners would eventually demand an interest rate to compensate them for the risk of dollar depreciation (see Delong).   Alas, there is little evidence that happened.  And we didn’t consider the possibility than foreign equity markets would consistently outperform US equity markets –

The (revised) bottom line: large US deficits won’t lead to a deterioration in the US net international investment position so long as the US can consistently finance its deficits by selling the world depreciating assets.  Or, if not depreciating assets, assets that underperform America's own foreign assets.  

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A strong October TIC data release, but the BEA’s data only deepens the mystery of how the US financed its current account deficit in the third quarter

by Brad Setser Monday, December 17, 2007


The big story of the October TIC data is, obviously, the rebound in net capital flows to the US.   That in some sense had to happen: a large deficit cannot be financed without net capital outflows.   

Foreign demand for US securities doubled, more or less, from September – rising to $118b (more like $105b after adjusting for ABS payments).   US demand for foreign securities somewhat surprisingly fell sharply, from $41b in September to $5b in October.    Central bank demand didn’t appear to dominate long-term flows — though a bit of caution is in order as the TIC data tends to understate official flows.  But central banks were quite active on the short-end: the increased their deposits and short-term securities holdings by almost $20b, offsetting a fall in private short-term claims.  Total official flows ($41.6b) were only a bit smaller than total private flows ($56.2b).   And remember the TIC data tends to understate official flows.  My strong suspicion is that the official sector financed the bulk of the q4 current account deficit.  China and the oil exporters are piling up cash —

Foreign demand for Treasuries was strong — $45.9b from private investors and $4.0b from the official sector (if you believe the TIC breakdown) – as was foreign demand for equities.    Agencies and corporate bonds are now out of favor.   In effect, there is currently demand for the safest US assets, and what might be considered the riskiest – but not demand for much in between.

Almost all the demand for Treasuries came from Europe – not Asia.   Europe bought $38b net – though the $30b in UK purchases almost certainly were then sold to investors around the world.    Latin America bought $5.6b and the Caribbean another $7.5b.    Asia was basically flat – Japan was a net buyer, but the emerging Asian economies were large net sellers.   Or perhaps some existing bonds just matured and they bought new bonds through London.     It does though seem like most emerging Asian central banks – not just the PBoC – are reducing the Treasury’s share of their reserves.  There has been a big shift toward agencies generally (though not in October).     Korea and Singapore bought US corporate bonds in October; if that demand came from the Bank of Korea or Singapore’s government investment corporation, they acted as stabilizing speculators, selling the Treasuries the market wanted and buying the corporate bonds the market didn’t.

Private demand for equities also rose to $30b; official demand is still negligible.   The TIC data doesn’t provide much support for the widespread thesis that sovereign wealth funds have lent a lot of support to US equities, but then again, the TIC data probably isn’t capturing most official equity purchases (it did pick up $1.8b in net purchases from the Gulf in October, but there is no way to know if that came from an official account).  Americans sold $5b in foreign equities — generating $35b in net equity financing.  

Most of that demand seems to be coming from offshore financial centers – London ($6.7b), the Caymans and similar islands ($6.5b) and Hong Kong ($4.8b).   Hong Kong is kind of interesting … it could well represent demand from the mainland.  The other large buyer of US equities, strangely enough, was France. 

Those looking for the inflows from China should look in the short-term data, and specifically the banking data, not the long-term data.  Chinese bank deposits were up $23.8b.  Total short-term claims were up $16b, as China reduced its holdings of short-term securities.    Interestingly, the rise in Chinese deposits wasn’t matched by a rise in total official deposits – suggesting either that another central bank reduced its deposits, offsetting the PBoC, or that the rise in deposits came from state banks and state firms. 

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Weekend extra-credit –

by Brad Setser Sunday, December 16, 2007

Weekend reading for all those waiting for the US current account and TIC data on Monday.

Time for a strong rupee policy?  This weeks’ Economics focus column intelligently discusses the policy dilemmas facing India in general and the Reserve bank in particular.  India is on track to “spend” close to $100b keeping the rupee from rising this year (reserves, counting gold, are up $96b through the first week of December, a bit less if adjustments are made for valuation gains).    Affeciondanos of this blog though know that the “cost’ of borrowing rupee to buy dollars, euros and pounds reserves (India has a VERY diversified portfolio, currency wise) that India doesn’t need is the gap between domestic interest rates (high, in India’s case) and the return on its reserve portfolio, together with the expected appreciation or depreciation of the rupee against its currency basket. 

If Abu Dhabi can backstop Citi, why shouldn’t it also backstop Dubai?   Chip Cummins of the Wall Street Journal picks up on an under-reported story – the role of debt in financing Dubai’s boom and its large foreign acquisitions.   Dubai is going through the biggest boom in the Middle East, and it actually doesn’t have much oil … If Dubai were a separate country, not an emirate bundled together with the richest oil exporter of them all (neighboring Abu Dhabi) it would be running a large current account deficit.    Several state-owned Dubai companies are quite leveraged.   No worries though – Abu Dhabi has way more cash than the IMF and it may only lend to US companies, not its neighbor, at a penalty rate  …

New York: global discount mall.    It sure seems like a weak dollar is encouraging Europeans to come to the US to buy (Asian-made?) goods.     Floyd Norris’ charts also show that the US export growth took off after the dollar depreciated in 2003.   

Charles Wolf isn’t convinced that the absence of more dollar depreciation against the RMB makes difference, largely because he doesn’t see any link between changes in the exchange rate and changes in the savings and investment balance.  I personally see two links for China  – profit margins on exports contribute to high business savings, and China’s government has reigned domestic spending/ investment to keep the Chinese economy from overheating during the export boom.   

Europe, like the US, but with a lag.   At least when it comes to the debate on China.  The rise in political heat is generating pushback from “liberal” (in the European sense) economists.  Patrick Messerlin – who supervised my Sciences-Po dissertation –and Razeen Sally argue in the FT that the cheap Chinese goods are good for Europe (or at least European consumers) and that the RMB’s depreciation against the euro isn’t the reason for China’s soaring surplus, as it simply reflects a sight in the final location of Asian production. 

"The EU imports more from China, but correspondingly less from other east Asian countries: the EU’s trade deficits have simply shifted from the latter to China. That is because China has become the final-assembly hub for goods exported to the rest of the world. Its corollary is increasing Chinese imports of parts and components from the west and east Asia."

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