Rachel Ziemba

This post is by Rachel Ziemba filling in for Brad Setser.

The move towards a voluntary code of conduct for sovereign wealth funds took on new momentum today (see the previous developments). The Treasury Department just released policy principles for sovereign wealth funds agreed to in a meeting with representatives of the governments of Abu Dhabi and Singapore and the leaders of their sovereign wealth funds.

On all sides this seems like an attempt to show that they are serious about what is at stake. The treasury likely wants to avoid protectionist responses from Congress but still attract investment when it is needed. For Abu Dhabi and Singapore, they want to show themselves as responsible actors and play some role in setting those rules. It may a fire under the IMF discussions about good practices for sovereign investment. Recent discussions in the US and EU were clearly intended to make sure that some usable outcome came out of the IMF discussions.

There’s not much too contentious in here – funds should make explicit their non-political motivations, more disclosure is good and can reduce uncertainty as is risk management. and funds should abide by the regulations where they invest.

But even these funds have made no promises about disclosure. They only agree that disclosure may build trust and aid in assessment of systemic risks. This won’t go far enough for some. 

In return, recipient countries should avoid protectionism, have proportionate responses to any national security concerns and strive to build as predictable an investment regime as possible. Furthermore, similar institutions should be treated similarly.

But it may not really change much. yet. The bigger issue is in whether sovereign funds will continue to (return to) investing or whether they might sit on the sidelines with cash for the duration.

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Rachel Ziemba

Note: This post is from Rachel Ziemba, not Brad Setser.

“Like private firms, pension funds, and other institutional investors, Abu Dhabi’s investment organizations have always sought solely to maximize risk-adjusted returns. …The Abu Dhabi Government has never and will never use its investments as a foreign policy tool.”

So writes Yousef Al Otaiba, the Director of International Affairs of the Abu Dhabi Government in a letter to Treasury Secretary Paulson, other G7 finance ministries and international institutions. The letter which expresses Abu Dhabi’s investment guidelines is unprecedented as a public response from sovereign funds, the government investment funds of many countries that have been under the spotlight. These funds are large – Brad Setser and I have estimated they manage $2 trillion – and growing – they could add $500 billion this year. In 2000, they managed around $500 billion. The availability of funds (including leverage) has helped them make higher profile purchases in search of higher returns. After all, sovereign funds respond to a desire to diversify assets and make higher returns than those possible with holdings of US and other government bonds. They are increasingly a go-to capital source. Just today, Dealogic suggested that they accounted for $48.5 billion in cross border M&A in 2007 and about $24 billion so far this year. In 2006, it was $19 billion. Their investments in fixed income, smaller equity stakes and alternatives are even larger.

The following graph – which adds the Russian oil stabilization fund and Saudi Arabia’s non-reserve foreign assets to that of dedicated investment funds of Asia, the Gulf and Norway- gives a sense of how quickly these funds have grown. Oil’s surge has fed the growth of sovereign funds 3/4 of the assets managed by sovereign funds are oil funds. About half of the almost 20 funds that we routinely track were created after the year 2000. Sovereign wealth really is a new superpower.

As estimates of SWF assets proliferated, so have concerns from policymakers (summary here) questioning how the prominence of state-directed investors will affect the financial system. Sovereign wealth funds now seem to be responding to concerns. The head of Singapore’s GIC suggested in December that it might increase disclosure. Other funds already disclose more about their holdings, management and investment decisions – Norway, Temasek, the funds of Alberta and Alaska. Even China has been a little more publicly conciliatory to the process. But most are likely wary of having the rules dictated to them. This is the time to play a part in fashioning the rules both at the IMF and in the public domain. Sovereign wealth funds will likely be a big topic at the IMF/WB spring meetings – though systemic risk and a deteriorating global outlook will loom large.

Abu Dhabi’s investment strategies.

- To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi.

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Jeffrey Frankel

Note: this post is from Jeffrey Frankel filling in for Brad Setser

If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
- by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
- by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
- by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch‘s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.

There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically (see graph below).

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Jeffrey Frankel

Note: This post is from Jeffrey Frankel not Brad Setser.

It is hard to remember now, but mineral and agricultural commodities were considered passé less than ten years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times.In Alan Greenspan’s phrase, GDP had gotten “lighter.”Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services.The Economist magazine in a 1999 cover story forecast that oil might be headed for $5-a-barrel oil.

Since then, of course, we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms. Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

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I will be away most of this week and will not be posting regularly.

In the interim though, the quality of this blog is likely to go up.

Jeff Frankel of Harvard (who recently started his own blog) has agreed to contribute a few guest posts. And Rachel Ziemba of RGEmonitor — who co-wrote a series of papers with me on the Gulf’s sovereign funds and contributes to RGE’s economonitor — will be chipping in as well.

There no doubt will be plenty to discuss.

CITIC — according to Felix — never closed on its investment in Bear. If I was a bit more skilled with blog formatting, I guess I should scratch Bear and write JP Morgan. Talk of a spectacular collapse. And if I had to guess, I would bet that Chinese financial institutions are going to be a bit more reluctant to invest in large US banks and broker dealers going forward.

CITIC isn’t the only institution happy not to have made a set of big investment — or at least not closed — over the past several months.

The China Investment Corporation (CIC) hasn’t been in any rush to place large sums in US and European markets. It has spent an extended period of time selecting its external fund managers. But, at least to my knowledge, it hasn’t actually awarded a set of large mandates yet. It may already have picked a few hedge funds to manage its money though …

Certainly the CIC didn’t buy a bunch of foreign exchange from the PBoC in January. If it had, China’s reserves wouldn’t have gone up by as much. The large Ministry of Finance bond issue was held in RMB at least through the end of January, and perhaps longer.

It actually may not be in the CIC’s interest to put its money to work quickly. By holding on to its RMB, the CIC kept its assets in an appreciating currency. And it avoids taking market risk.

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Steven Pearlstein of the Washington Post — the source of the quote in the title — writes:

“In the face of what is turning into the most serious financial market crisis since the Great Depression, the Fed has been more aggressive and more creative in using its limitless balance sheet – in effect its ability to print money – than at any time in history. …

Last week it was a $200 billion cash for bond swap for the banks. This week it was a $200 billion bond for bond swap with the big investment houses.”

Pearlstein’s phrase – “central bank intervention … unprecedented in scale and scope” doesn’t just apply to the Fed’s intervention in the US market for mortgage backed securities.

It applies equally well to the actions of the emerging world’s central banks, who, in my judgment, are engaged in intervention of “unprecedented scale and scope” in the foreign exchange market.

China’s enormous $62b — see Richard McGregor — January 2008 reserve accumulation is just the most prominent example (even if it is more like $55b after adjusting for valuation gains, it is still huge). All in all, central banks added at least $150b to their reserves in January. February likely will be a bit lower, but it isn’t unreasonable to think that central bank intervention in the foreign exchange market in the first quarter will total close to $400b – a sum equal to the Fed’s intervention.

That implies central banks globally will have $400b to invest in the major markets as well as well – and, depending on how they allocate their assets, they will either be buying up some of the Treasuries that have been released from the Fed’s balance sheet into the market, or will add to the bid for Agencies and other mortgage backed securities from broker-dealers and banks now able to use those securities as collateral with the Fed. Or, if they bought euros, they could add to the pressure on the euro …

Most students of central banks have focused on how they manage their liabilities – remember, cash is a liability of the central bank. Right now though the way central banks manage their assets may be having an equally large impact on global markets.

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The Fed’s dramatic policy announcement has justifiably overshadowed the January trade data, which didn’t tell us much that we didn’t already know. Suffice to say that the rise in the overall deficit reflects a rise in the US imported oil bill.

Seasonally adjusted oil imports were $39.5b in January, up from $24.84b last January. The average price of imported oil was $84.09. If the net oil import bill (seasonally adjusted) averages $35b a month — its January level — the net petroleum balance would deteriorate by $125-30b. That though may be a bit too optimistic given recent moves in the oil market. Any way you cut it, oil will be a big drag — and likely keep the overall trade deficit up.

Non-oil imports though are falling, in both nominal and real terms. January non-petroleum goods imports were around $133b, down from $136-137b in q3, and $138b as recently as November. Real imports are also falling.

Nominal exports are still rising, but real exports seem to have mostly stalled. The following graph — prepared with help from Arpana Pandey — shows real goods exports and real goods imports (from the BEA data) since 2004.

The rise in dollar terms reflects higher agricultural prices and the like. Ag exports are up 43% in nominal terms — paced by a doubling of soybean exports and big increases in corn and wheat exports.

The bilateral data for China is also interesting. Overall non-oil imports (seasonally adjusted) are up 2.5% y/y — but consumer good imports are essentially flat.

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Chinese inflation soared to 8.7% — above expectations. An ominous sign, particularly given how fast reserves are growing and the potential difficulties sterilizing all the "hot money" flowing into China? Or by product of a lot of snow-related transportation bottlenecks, a temporary pig shortage and a global rise in commodity prices that won’t continue?

China’s February trade surplus was smaller than expected, with the y/y pace of export growth dropping off sharply). A sign that China’s trade surplus is now heading down on the back of the US slowdown and the RMB’s recent appreciation against the dollar? A sign of the extent of the weather related delays? A base effect, as exports were unusually strong last February for tax reasons? (The usual lunar new year effect doesn’t show up in the 2007 February data)  Payback for unusually strong export growth in January?

Frankly, it is too early to tell.

My own read is that export growth is indeed decelerating, as one would expect given the slowdown in the US. The y/y increase for January and February combined was around 17% — below the y/y increase of around 22%. If you project out 17% export growth and 30% plus import growth, then China’s surplus will fall quickly.

On the other hand, there isn’t a particularly good reason to project out 30% plus import growth. Oil prices were in the $50-60 a barrel range early last year. They have basically doubled. The y/y increase in China’s oil import bill embedded in the January and February data isn’t likely to be sustained for the entire year.

One other interesting bit of information: China’s bilateral surplus with Europe now tops its bilateral surplus with the US.  $10b v $9.6b.

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Paul Krugman noted that his discussion of the Fed’s recent policy steps was rather wonkish. If that is true, my comments will be off-the-wonkish charts.

I want to try to bring the actions of foreign central banks into Krugman’s discussion of recent Fed efforts to use the “asset” side of the Fed’s balance sheet to stabilize financial market conditions.

Krugman argues that the literature on sterilized central bank intervention in the foreign exchange market can be used to understand the Fed’s recent policy steps.

When the central bank sterilizes, the “liability” side of the central banks’ balance sheet doesn’t change. It doesn’t print any more money, or issue any more bills. That is what “sterilization” means.

What changes is the asset side of the central banks balance sheet. It might for example sell US Treasury bonds and buy German government bonds. That increases the supply of US Treasury bonds in the private market, and reduces the supply of German government bonds in the private market.

Krugman – building off the thought-provoking work of Mr. Waldman – argues that the Fed is effectively reducing the supply of “Agency MBS” in the market while increasing the supply of Treasuries in the market. It is trying to keep a surge in private demand for Treasuries (and a surge in private sales of Agency MBS) from pushing up the price of Treasuries and pushing down the price of Agencies (increasing the “spread” between the two bonds well beyond historical norms). He writes in today’s column:

Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

Krugman (with some support from Delong) then applies the standard critique of sterilized intervention to the Fed’s actions – namely, that just as central banks fx purchases and sales are too small to have much of an impact on the a multi-trillion dollar fx and bond market, the fed’s purchases of Agencies will be too small to have much of an impact. Krugman, from his blog:

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