Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Record reserve growth, record dollar reserve growth and no evidence of diversification among the countries that matter

by Brad Setser Monday, March 31, 2008

That would be my summary of the IMF’s latest data on the currency composition of the world’s reserves. My headline — "record dollar reserve growth and little real evidence of diversification" — is more consistent with the Dow Jones story on the IMF data than with the Bloomberg story on the same subject.

Of course, my summary is subject to two huge caveats. One: China, the country that matters the most, doesn’t report data on the currency composition of its reserves to the IMF. Two, the Gulf, whose combined official asset growth now trails only China, doesn’t report much data to the IMF, both because the Gulf’s central banks don’t seem to report data on their reserves and because most of the Gulf’s foreign asset growth comes from their sovereign funds.

But the IMF data still paints a stunning picture.

The emerging economies that do report didn’t reduce the dollar share of their reserves in any significant way, whether in q4 or over the course of 2007. Given the huge increase in the pace of their reserve growth, that meant buying a ton of dollars. Keeping the dollar share of their reserves constant meant that $394 billion of the $577 billion overall increase in their reserves stayed dollars. 68% of the growth in their reserve flowed into dollars over the course of the year, even though the dollar’s share of their total reserves is only around 60%. For q4, 74% of the $184 billion increase in their reserves flowed into the dollar – or $134 billion. They had to buy proportionately more dollars to make up for the dollar’s slide v. other currencies.

The majority of the world’s reserve growth though comes from emerging economies that do not report, at least when the non-reserve foreign assets of the Saudi central bank are added in. Let’s assume the central banks of emerging economies that do not report data acted roughly like the emerging economies that do report data, i.e. they held the dollar share of their reserves roughly constant.

If that is true, total reserve growth — counting about $75b from Saudi non-reserve foreign assets growth and another $70b from the Chinese state banks and the China investment Corporation CIC – reached $1330b and dollar reserve growth reached an estimated $960b.

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What happened to financial globalization?

by Brad Setser Monday, March 31, 2008

Net (private) financial inflows to the US in q1 2007: $466b

Net (private) financial inflows to the US in q2 2007: $552b

Net (private) financial inflows to the US in q3 2007: $238b

Net (private) financial inflows to the US in q4 2007: $195b

Notice a change?

All these numbers are a bit overstayed because they count some official flows as private flows. The 2007 current account data hasn’t been revised to reflect the most recent survey. But the scale of the under-counting didn’t change radically over the course of the year.

Private inflows into the US fell dramatically after August.

Private outflows to the US also fell.

The best explanation for this is the unwinding of the shadow financial system – one that was largely based offshore. A lot of entities (to use the terminology of the shadow financial system) were legally domiciled offshore. However, they were issuing short-term dollar debt to American investors to finance the purchase of long-term US dollar debt. Carlyle Capital is the perfect example. It was legally based in London for tax reasons but managed out of New York, issued short-term dollar debt and held long-term US debt.

A chart that plots quarterly private inflows and outflows as a share of GDP shows the change.


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I hope Norway’s government fund didn’t short Iceland this time around

by Brad Setser Monday, March 31, 2008

Iceland believes it has been "attacked" by a group of big hedge funds and broker dealers — presumably a different group of hedge funds than the funds that were playing the krona carry trade. Ibison of the FT:

Iceland’s Financial Supervisory Authority has begun an official investigation into alleged speculative attacks by international hedge funds on the country’s currency and stock market, according to people close to the probe.

Simultaneously, Kaupthing, one of Iceland’s leading banks, is considering legal action against Bear Stearns, the troubled US bank, for the role it played in a trip to Iceland by a group of hedge funds last January.

The double moves highlight Iceland’s exasperation with the alleged role professional international investors are playing in undermining its currency, the krona, and its stock market.

Iceland is both open and small — both relative to other economies and relative to many financial balance sheets — so moves by a few large financial firms can have an outsized impact on its market.   Hong Kong is a much bigger market.  But it isn’t all that big, and in the face of large speculative bets against both its currency and domestic equity markets back in 1998,  the HKMA ended up intervening heavily in its domestic stock market (see Krugman).

I have to think that if Norway’s government fund was aggressively shorting Iceland’s banks (as it supposedly did the last time Iceland faced trouble), that would be a huge political issue around now. Norway’s government fund has argued that its short position last time around was "just business" — a purely commercial bet. Iceland didn’t see it that way.

The possibility that CITIC might have been caught up in the Fed’s decision making around Bear suggests at least to me that the risk that sovereign funds will result in the "general politicization" of financial decision-making is real.

Rock Chalk Jayhawk

by Brad Setser Sunday, March 30, 2008

There is one big reason why haven’t quite gotten around to focusing on the economic data and financial market moves this weekend.

Next Saturday is going to be interesting. UCLA-Memphis and Kansas-North Carolina. Wow. I wonder how many entries in Econbrowser’s pool had all four number one seeds advancing.

UPDATE.  Econbrowser question answered: 16 entries, including one by Dr. Hamilton himself, correctly picked this year’s final four.    

The 2007 US current account data

by Brad Setser Thursday, March 27, 2008

The US recently released its current account data for the fourth quarter. Among other things, the data showed another $150b in official inflows in q4, bring the total for 2007 up to around $400b. In both q1 and q4, official inflows awere almost as large as the US current account deficit. Official flows in q2 and q3 were smaller.

The official flows data – I suspect – will be revised up, both to reflect the 2007 survey and eventually the 2008 survey. Sovereign funds and central banks likely combined to add about $1400b to their assets in 2007. I doubt only $400b was invested in US assets. A growing sum is likely managed by private fund managers and thus not registering in the US data. The $50b increase in official holdings of Treasuries in the 2007 data looks awfully low to me, not the least because the Fed’s custodial holdings of Treasuries for foreign central banks increased by $70b.

I’ll take credit for arguing (or perhaps insisting) that the US data understates official inflows – and for arguing that the official sector’s already large purchases of US debt would likely have to increase during a US slump to avoid a dollar right. The argument that dollar depreciation was a necessary part of the process that would bring the US deficit down also seems broadly right.

But I also got one big part of the US current account wrong.

Back in 2006 I predicted that the income balance would deteriorate quite significantly in 2007. My logic was pretty simple: the average interest rate that the US was paying on its (mostly dollar-denominated) external debt was well below the average interest rate the US paid on its (mostly dollar-denominated) external lending. I expected the US borrowing rate would rise faster than the lending rate, and that – together with the ongoing rise in US external borrowing – would drive a significant deterioration in the US income balance.

That has not happened. The income balance actually improved in 2007. Richard Iley (see our debate in late 2006) was right. Consider the following graph. I expected the gap between a line plotting the US current account deficit (as a share of US GDP) and the line plotting the US trade deficit (goods and services) to get bigger. It didn’t.*


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Scandinavian understatement …

by Brad Setser Thursday, March 27, 2008

Iceland, if you haven’t noticed, has been having a bit of trouble.

Macroman likes to note that you can’t spell risk without ISK — the Bloomberg (or ISO) symbol for Iceland’s currency. Borrowing yen to finance the purchase of Iceland’s currency used to be an easy way to make a lot of money. This year though it has been an easy way to lose a lot of money. The yen is up. The krona is down. A lot.

The FT leader writers are sympathetic to Iceland’s plight.

Not so long ago, Iceland’s big problem was all the money that poured into high yielding Icelandic assets. Given the small size of Iceland’s economy, that created problems — not the least (for the time) a very strong currency. The FT argues that Iceland’s underlying fundamentals — including abundant fish and cheap zero carbon geothermal energy — remain solid. Its current account deficit, while still large, is coming down.

But Iceland’s banks borrowed heavily to expand abroad. They seem to be having a bit of trouble rolling over their debt, and could face additional risks if depositors start to pull their deposits. A world that is deleveraging rather than gearing up isn’t good for them.

And, well, I am not entirely sure that are arguing that Iceland’s banks are in no worse shape than Wall Street banks is all that reassuring.

Thor Herbertsson, co-author of an influential report in 2006 on Iceland’s economy …. said Iceland could be thrust into crisis as a result of the global economic situation. “Let’s say Iceland is not in more danger than some Wall Street banks” .

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China’s currency is not really appreciating

by Brad Setser Tuesday, March 25, 2008

Those aren’t my words.

They are the title of a chart — "the CNY is not really appreciating" — in Standard Chartered’s March 19 FX alert, an alert produced by Callum Henderson, David Mann and Stephen Green. Their point is simple: The RMB’s appreciation against the dollar, which unquestionably has picked up since November, has been offset by the dollar’s depreciation against a host of other currencies.

Between the end of 2007 and March 19 2008, the RMB was up 3.2% against the dollar. But the RMB was also down 3.2% against the euro and 9.4% against the yen. Subsequent currency moves haven’t changed the basic story all that much.

From the beginning of 2006, the RMB is up 12.2% against the dollar but down 16.0% against the euro. And Europe, not the US, is China’s largest export market — and the main source of Chinese export growth. The US was the world’s consumer of last resort through 2005. More recently, though, it has been Europe. The Standard Chartered team writes:

"Last year we calculate, the US only bought 22% of China’s goods — and only provided 13% of the increase in exports. Europe in contrast, bought 27% [of China’s exports] and was responsible for 31% of the growth."

The Standard Chartered team now expects the RMB to appreciate by 15% v the dollar in 2008, making up for some of its past depreciation against the euro.

They concede that there forecast is ahead of the policy consensus in China. They expect, though, that the new Chinese economic policy team will be pulled in their direction by ongoing dollar weakness, low US rates, inflationary pressure and the risk of even larger hot money flows.

I personally would be surprised by a 15% move. Not because such a move doesn’t make economic sense. But rather because, as the Standard Chartered team notes, "the default mode in Beijing has been caution." Right now though a faster than expected pace of RMB appreciation against the dollar cannot be entirely ruled out. China presumably doesn’t want all of the necessary real appreciation of the RMB to come from higher inflation. $50b or so in monthly reserve growth likely has caught the authorities attention. As has the possibility that the US may not be through cutting rates.

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Record reserves, Record reserve growth, record reserve currency angst –

by Brad Setser Tuesday, March 25, 2008

Over the past several weeks:

Thailand’s reserves topped $100b. Thailand, lest anyone forget, basically ran out of cash reserves back in 1997 (counting its forward commitments) – sending a clear signal to all emerging economies that they needed to hold far more reserves than had been the case previously.

Brazil’s reserves marched steadily closer to $200b. They are about a month away. And Brazil was under-reserved and close to default as recently as 2002.

India’s reserves topped $300b (counting gold).

Russia’s reserves topped $500b. Russia was out of cash in 1998.

As impressive as Russia’s $500b is – and on a per capita basis, it is huge – it is nothing compared to China’s reserve growth. China is on track to add well over $500b to its reserves in a single year. Right now China is adding about $50b to its reserves every month, or $600b a year.

January reserve growth was a bit higher than $50b, even after adjusting for valuation gains. February’s $57b in reported reserve growth falls to around $48b after accounting for (likely) valuation gains. But China’s trade surplus was also small in February – so $48b in reserve growth is still quite impressive.

Moreover, the $600b pace of growth likely understates the real increase in China’s foreign assets, since it doesn’t count the foreign exchange the banks have been asked to hold as part of their reserve requirement.

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There is now little doubt: the US relies on central banks and sovereign funds to finance its deficit …

by Brad Setser Sunday, March 23, 2008

This is Brad Setser once again. I am back from my spring break. I want to thank Dr. Frankel and Rachel Ziemba for taking my place last week.

No one in their right mind paid much attention to the TIC data release last Monday. Too many other things were going on. A major broker-dealer doesn’t come close to collapse every day.

I also would guess I am about the only person who finds the release of the Treasury’s survey data on foreign portfolio holdings interesting. It was released a bit earlier than I expected – at the end of February rather than the end of March. But I didn’t notice until I checked the TIC data — and it doesn’t seem like many others have noticed either.

Both data releases tell the same fundamental story. The US now relies very heavily on foreign central banks for financing.

The January data also hints at another important but less obvious story, namely that central banks seem to be less willing to take credit risk than in the past.

So long as they are piling into safe US assets, central banks are contributing the "liquidity" to a market that doesn’t need any liquidity. They are helping to push Treasury rates down. And their activities, while rational from the point of view of conservative institutions seeking to avoid losses (beyond those associated with holding the dollar), also may be aggravating some of the difficulties in the credit markets. Private funds fleeing the risky US assets for the emerging world generally end up in central bank hands and currently seem to be recycled predominantly into safe US assets.


The January TIC data

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Petrodollars: How to Spend It

by Brad Setser Thursday, March 20, 2008

Rachel Ziemba

Note: This post is by Rachel Ziemba, filling in for Brad Setser

Despite the fact that the price of oil and in fact almost all commodities has slid in recent days, they are up substantially in recent months. This year so far the price of oil has averaged over $95 a barrel and over $93 in the last six months – a tremendous jump up from the 2007 average of $71.5 (all figures a simple average of WTI, Brent and Dubai Fateh, as used by the IMF).oil2.jpg

Source: EIA, federal reserve, my calculations.

Such levels may not continue, particularly in light of US economic weakness. Oil demand is falling in the OECD. Much depends on the value of the US dollar and how long financial investors are long commodities.  But some factors do point to sustained high oil prices, despite a US economic slowdown. After all much of the demand growth for energy comes not from the US but from emerging markets, and they may find it more difficult to lower demand. Furthermore as I discus below, oil exporters have become more accustomed to higher oil prices and might find it harder to rein in their spending should oil prices drop. 

So where has the oil windfall gone? Oil exporters have been spending a significant share of new oil revenues – as much as 2/3 of incremental revenues, meaning that they are starting to erode the imbalances – despite their large headline current account surpluses.  How might those patterns change over the next five years. How oil exporters, especially in the emerging world spend the windfall at home and abroad has major implications for global and local economies and the cost of assets. And also on the price of oil,  because most are choosing not to invest much in an energy sector with rising costs – Saudi Arabia is reportedlly spending more to achieve the same output as some of its fields are depleted. This post draws upon an updates a few previous  works,

The central banks of emerging economy oil exporters added over $400 billion in foreign exchange reserves last year. Their oil funds likely added at least another $100 billion. This is of course about what China added in reserves over the course of the year.


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