Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Official purchases and the bond yield conundrum

by Brad Setser Friday, February 29, 2008

Actually, the title really should be official purchases, data revisions and the bond yield conundrum. This is a rather wonky post.

The Economist View highlighted a paper by Tao Wu of the Federal Reserve Bank of Dallas (and a coauthor of Rudebusch, Swanson and Wu) that cast doubt on the impact of foreign official demand on Treasury yields.

Tao Wu’s Chart 3 in particular caught my eye. According to the data presented, official purchases (or Treasuries) fell sharply after 2004, but bond yields remained low. The conundrum out-lasted official demand.

That — together with some econometric work that failed to find the expected relationship between official demand and treasury yields (or rather only found the expected relationship after 2000) — casts a bit of doubt on my preferred explanation for low US rates over the past several years. It also is a conclusion at odds with Warnock and Warnock.

Perhaps as importantly, the sharp fall in official demand for Treasuries in graph 3 didn’t match my sense of what has been happening. That called for a bit more investigation. I also wanted to look at whether one key difference between Rudebusch and Wu and Warnock and Warnock (updated here)– namely that Warnock and Warnock look at official demand for Treasuries and Agencies not just official demand for Treasuries might explain the different conclusions. Some Agencies are fairly close substitutes for Treasuries.

My conclusions? To make a long story short, data revisions matter. The fall in official demand for Treasuries so apparent in Wu’s chart largely disappears if you look at the revised data (which is only available on a quarterly basis). Essentially, the shift in reserve growth from Japan, Korea and Taiwan to China, Brazil, India and the oil exporters reduced the share of official demand for Treasuries that appears in the monthly TIC data more than in reduced official demand for Treasuries.

The evidence?

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$1 trillion, $100, $1.50

by Brad Setser Thursday, February 28, 2008

A lot of milestones have been passed in the last few days. Most aren’t positive for the United States.

Nouriel Roubini is no longer the only economist putting the eventual toll of the financial crisis at close to a trillion dollars.

It takes about $100 to buy a barrel of oil that could have been bought for about $20 a few years back.

It takes $1.50 (a bit more actually) to buy a currency that could have been bought for 80 or 90 cents six years ago.

George W. Bush efforts to push the Gulf to democraticize aren’t going anywhere. In some sense they cannot go far when Ben Bernanke is encouraging US financial institutions to look to non-democratic governments for additional capital.

The US financial system no longer seems like a model for the rest of the world. Apparently SIVS are only one category of potentially troublesome off-balance sheet conduits. Read Dr. Feldstein’s important oped. US banks and broker-dealers rather clearly lacked sufficient capital to sustain the risks they were taking.

The absence of lending by US and European banks has led private equity firms to encourage some of their large investors to lend them money directly. It isn’t, though, clear to me what ADIA gains financially by lending to a firm that it already likely managing ADIA’s money. Any gains on the debt will come out of its equity returns.

There is an overarching logic that ties these developments together. A weak US financial system needs low rates and time. Low rates contribute to a weak dollar. A weak dollar – especially in a still-sort-of-strong global economy – contributes to higher commodity prices, at least in dollar-terms. Or high commodity prices contribute to a weak dollar. No one is quite sure. High oil means the big Gulf funds have more money. It also means American consumers have less money – and either have to consume less or save less. Gulf “liquidity” substitutes for US liquidity. Pressure on the dollar means more exchange rate intervention in Asia. China is once again cracking down on hot money inflows. Rising reserves and faster RMB appreciation create pressure for China to seek higher returns, and either to expand the CIC or let SAFE invest more aggressively.

But rather than launching into (yet) another lengthy post on sovereign wealth funds, let me just highlight two excellent articles on sovereign funds – the William Mellor and Le-Min Lim’s Bloomberg feature on the challenges facing the CIC and Landon Thomas’ New York Times profile of ADIA.

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Regulating sovereign wealth funds: does the US have any leverage?

by Brad Setser Tuesday, February 26, 2008

Bob Davis’ Wall Street Journal article – which reports that the US Treasury is pushing Singapore and Abu Dhabi to increase their transparency and to signal that their funds will be managed commercially as part of the IMF’s effort to develop best practices – has prompted a flurry of online commentary.

Both Felix Salmon and Yves Smith doubt that the US has any real leverage over the sovereign funds.

Felix highlights the meaning of the term sovereign: sovereign funds are not accountable to any government other than the government of the country that is sponsoring them.

"Sovereign" means it’s not up to anybody else what you are or are not allowed to do.

Yves, echoing Zachary Karabell, argues that the debtor – and in today’s global financial system the US is the debtor – cannot set the rules of the game, but rather has to accept a global financial system defined by the creditors. He writes:

Consider the elements of fantasy at work in this discussion over these efforts to set guidelines on SWF investments:

1. We are pretending that a large stake in and of itself won’t lead to influence

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Rebalancing from the US to Europe — evidence from shipping containers

by Brad Setser Monday, February 25, 2008

Alas, the rebalancing in this case is a shift from exporting to the US to exporting to Europe — not a shift from export-led growth toward domestic-demand led growth.

Alan Beattie, in the FT.

Mark Page, research director at Drewry Shipping, a consultancy in London, says Asia-US container trade saw a big slowdown that began in the middle of 2007, with demand for the whole year perhaps only 2 per cent higher than in 2006. But ships were redeployed to the routes between Asia and Europe, north Africa and the Middle East, where container trade grew by around 20 per cent.

It is hard to fudge container data. The rise in shipping from Asia to Europe and the Middle East helps to explain how the Baltic freight index decoupled from the US economic cycle (UPDATE: NOTE COMMENT AT THE END). The Baltic dry index rose strongly for most of the year even as the US (non-oil) import growth slowed in 2007. Things obviously changed a bit in November.

It also explains why Europe is increasingly putting pressure on China to appreciate against the euro, not just the dollar — and why Europe seems to worry more about about the risk that it might attract too much investment from sovereign funds than to worry about the risk that it might attract too little.

What then would happen if European demand also falters? Beattie is not optimistic:

For the moment, Mr Page says, most shippers are confident that such growth will persist in Europe and the Middle East. But if demand from Europe does slow, Japan seems highly unlikely to take up the baton and global trade will suffer.

That would be true even if the big emerging markets do manage to generate enough domestic demand to absorb a lot more of the goods that they produce. Despite all the talk of an emerging Chinese middle class that could buy the goods coming out of its factories, its economic growth in recent years has instead owed much to its high trade surplus.

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It is nice to have a bit of high profile support

by Brad Setser Monday, February 25, 2008

At least on the case for more exchange rate flexibility in the Gulf. Former Fed Chair Alan Greenspan.

Former Federal Reserve Chairman Alan Greenspan said on Monday near-record Gulf Arab inflation would fall "significantly" were the oil producers to drop their dollar pegs, in contradiction to Saudi policy.

"In the short term, free floating… will not fully dissipate inflationary pressure, although it would significantly do so," Greenspan told an investment conference in Jeddah.

And, in Abu Dhabi

" Referring to Persian Gulf countries, he said “letting the currency float is probably the best way to stop the flow of foreign exchange into the economy and cause inflation.”

(cause looks like a misprint; curb is more consistent with his other comments)

Dr. Greenspan though doesn’t seem to share my concerns about the impact of the expansion of sovereign funds on global markets. Oh well. One of two isn’t that bad.

I am more concerned by the policies that gave rise to large funds — policies that have impeded adjustment in the global balance of payments — than the funds themselves.

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Those stabilizing speculators …

by Brad Setser Sunday, February 24, 2008

Credit — according to one widely quoted Deutsche bank report — is on sale. All of it. Corporate bonds can be bought now for a lot less than a few months ago (see McCulley and Toloui’s figure 4).

Treasuries didn’t have the best of weeks last week. But Treasuries and other safe assets with little credit risk (so long as the US government stands behind the Agencies if push comes to shove) are not on sale. Treasury yields — at least for maturities out to ten years — are consistently lower than (headline) inflation.

So are sovereign investors — you know, the ones with long time horizons that enable them to buy the assets that leveraged private players have to cough up in times of stress — snapping up "credit"? Or are they piling into safe assets?

We of course don’t really know, as the available data is full of holes and comes out with significant lags. But take a look at a graph (prepared in large part by the CFR’s Arpana Pandey) showing the 12m increase in central bank holdings of the safest dollar assets — short-term deposits, short-term T-bills and short-term Agencies.


It sure seems like central banks started to increase their holdings of low-yielding safe short-term US assets just after the "subprime" crisis broke in August.

That may be smart. But it also isn’t exactly helping the credit market recover. Central banks — who are still piling up reserves — are a big potential source of "liquidity" to the credit market, not just a source of funding for the sovereign funds who supplied the banks with a bit of additional risk capital earlier this year.

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What do the US, Saudi Arabia and China have in common?

by Brad Setser Thursday, February 21, 2008

What does the US have in common with two of its most important creditors?

One answer: all have a significant population worried about how to make ends meet right now.

China exports a ton of goods, but imports oil and grain. And the price of both is rising. Back in November, there was a story circulating – perhaps apocryphal – that some Chinese workers wanted their wages indexed to the price of pork.

The Saudis are a net exporter of oil. But not everyone has shared equally in the oil windfall. Government employees living on a constant salary aren’t pleased by rising prices …

High wheat prices aren’t bad for Kansas, but not all that many Americans make
their living producing grain — or, for that matter, selling US bonds and parts of some US firms to sovereign investors. Reading the Pew Survey (hat tip: curious capitalist) is a good reality check for privileged New Yorkers working on the fringes of the financial sector.

A majority of Americans cite the rising price of basic necessities as their biggest economic concern.

Not the budget deficit

Not the credit crunch.

Not falling housing prices

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The debate over the pace of hot money flows into China

by Brad Setser Wednesday, February 20, 2008

Are hot money inflows to China falling? Or rising?

Are hot money flows a constraint on the PBoC’s ability to raise domestic Chinese interest rates to try to curb inflation, or not?

And, more broadly, can China sustain a gradual pace of RMB appreciation? Or even a a gradual pace of appreciation against basket, not just the dollar, as Li Yang has suggested? Or does an expected , gradual appreciation invite unlimited inflows and thus pose impossible-to-solve problems for a "stretched" central bank, leaving only one way out — a large one-off revaluation?

These are all big questions. And the leading analysts at major banks do not agree on the answers.

Morgan Stanley’s Stephen Jen thinks hot money inflows are picking up. He wrote on Monday:

.. just look at how much capital flowed into China last year (US$200 billion), over and above the large trade surplus (US$260 billion). Much of the former was a result of the expectation of CNY appreciation. I believe that these inflows have accelerated since November, when Beijing moved USD/CNY into overdrive

Jon Anderson of UBS thinks hot money inflows remain contained — and have actually fallen off their pace of earlier this year. Anderson in a recent report, as quoted by Michael Pettis:

Another very common argument is that can’t successfully pursue a gradual renminbi strategy, since letting the currency appreciate by 8% to 10% per year would bring in a flood of speculative capital and overwhelm the PBC’s ability to control the money supply. And in the first half of 2007, it seemed that this was precisely the case: "hot" money was visibly returning to the mainland once again in large amounts, and the central bank was forced to slow down the pace of exchange rate appreciation so as not to encourage further speculation.

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Why no auction rate securities?

by Brad Setser Tuesday, February 19, 2008

Or for that matter asset-backed commercial paper? Or leveraged loans? Or mortgage-backed securities that lack an Agency guarantee? Danske bank has pulled together a nice survey of all the parts of the market that are hurting.

Sovereign investors are — at least according to their talking points — intrinsically stabilizing, long-term investors. Never mind that some sovereign investors are also big investors in the leveraged, short-term focused hedge funds and private equity firms they like to contrast themselves to.

But right now the most important sovereign investors are piling into the safest assets precisely that the moment private investors have lost their appetite for risk. Chris Giles of the FT reports:

Managers of foreign exchange reserves within central banks have become much more risk-averse since the global credit squeeze started, with safe assets back in favour.

A survey of investment managers within 51 of the world’s central banks responsible for reserves totalling $2,390bn (£1,220bn, €1,630bn), said the pressure on them to search for higher yields remained but riskier assets necessary to achieve higher returns were rapidly going out of favour.

Compared with a year earlier, more than 80 per cent of reserve managers surveyed said junk bonds, asset-backed securities and mortgage-backed securities were less attractive, according to a Royal Bank of Scotland/Central Banking magazine survey. By contrast, highly rated government securities were seen as more attractive by large majorities.

(Hat tip Rebel Economist)

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by Brad Setser Monday, February 18, 2008

A number of oil exporters have, through their sovereign funds, effectively invested some of the fiscal surplus from high oil prices in troubled US and European banks. The Abu Dhabi Investment Authority has a stake in Citi; Kuwait’s investment authority has stakes in Citi and Merrill, and Qatar’s investment authority is buying Credit Suisse shares as well. A member of the royal family of another Gulf country supposedly is interested in a UBS stake as well.

Singapore’s GIC – which in effect manages some of Singapore’s reserves (though the GIC reports to its own board, not the Monetary Authority) – has invested in a US major bank, has committed funds to a large Swiss Bank and supposedly will be the lead investor in a TPG fund that will invest in the distressed financial sector as well. TPG is a large private equity firm.

Another Singapore Fund – Temasek, which that originally managed Singapore’s domestic state-owned firms but then diversified – has also invested in a big international banks (Standard Chartered), big Chinese banks (China Construction Bank, Bank of China) and a broker-dealer (Merrill). The line separating the GIC (a portfolio investor) from Temasek (a direct investor) is increasingly blurred.

Korea’s investment corporation (KIC) also has invested in Merrill. The KIC reports to a steering committee, is capitalized with funds from the government and manages funds from the Ministry of Finance ($13b, counting the $10b pledged for 2008) and the Central Bank ($17b) — see its website. It may also be looking to raise funds from Korean pension funds.

China’s Investment Corporation – which is funded by the Finance Ministry by special bond issues but reports to the State Council not the Finance Ministry – has taken a significant stake in a large broker-dealer and, according to the FT’s SWF guru Henny Senders, is the "sole investor" in a JC Flowers fund as well.

And China’s State Administration of Foreign Exchange – which manages China’s foreign exchange reserves and reports to the People’s Bank of China – may be joining the GIC in the TPG fund investing in distressed banks as well. Henny Senders:

The State Administration for Foreign Exchange, an arm of the Chinese government with responsibility for managing the country’s official $1,530bn in foreign exchange reserves, might also come in as a big investor in coming weeks.

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