Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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At least we know how the US financed its trade deficit in April (and March too); Record central bank financing continues …

by Brad Setser
May 2, 2008

The US likely needs to attract a net capital inflow of roughly $65b a month to finance its current account deficit.

The increase in the Fed’s custodial holdings for foreign central banks between March 5 and April 2: $69.8b ($29.2 Treasuries, $40.6b Agencies)

The increase in the Fed’s custodial holdings from April 2 to April 30: $66.8b ($40.7b Treasuries, $26.1b Agencies)

Over the last week of April alone, central banks added $27.4b to their US custodial holdings, including $18.7b of Treasuries.

Pick how you want to do the math. $68.3b in average monthly purchases works out to around $820b a year. $17.1b in average weekly purchases (over the last 8 weeks) works out to more like $890b annually. Either way, it is more than enough to finance the (expected) US current account deficit if US investors don’t add to their foreign portfolios and existing foreign investors don’t abandon the US.

Incidentally, the $8.7b in average weekly purchases of Treasuries over the last 8 weeks would – if sustained — be enough to finance a $454b budget deficit without selling a single Treasury bond to private investors. Sometimes I think the US should drop the façade of auctioning off Treasuries and just negotiate private placements with the People’s Bank of China and the Saudi Monetary Agency.

What’s more, all this financing was provided more or less unconditionally, with the United States creditors taking on the risk of future dollar depreciation. Further dollar depreciation against the euro – and, perhaps more importantly, the risk of further dollar depreciation against their own currencies.

It goes without saying that this flow is far, far larger than the $30b or so sovereign funds committed to troubled US financial institutions in December and January ($40b if UBS is considered a US financial institution). Yet it has attracted far less attention.

For all the rhetoric that sovereigns are stable long-term investors able to take the long-view and buy beat down financial assts (super-senior tranches of CDOs based on mortgage-backed securities anyone), the enormous growth in central banks custodial holdings with the Fed suggest that central banks are buying the expensive, safe financial assets everyone else now wants – not taking a long-view and looking for value in the debt market.

The world of sovereign investors is now quite big. Almost unimaginably big – with China and the oil the exporters leading the way. Total sovereign asset growth likely topped $300b in the first quarter. It includes a lot of different institutions pursuing a lot of different strategies.

Some clearly have invested in risky assets than sovereigns have typically invested in – whether US financial institutions or European oil companies. But I would bet that if we had real time aggregate data on sovereign flows, the real story of the past six months has been a flight by sovereign investors away from risky assets. That certainly seems to be the story of the last two months, judging by the enormous growth of the Fed’s custodial accounts.

But if an informed reader has a different view, I am all ears …

Update: For the sake of comparison, I went back and looked at the growth in the Fed’s custodial holdings in the first six months of 2004, a period marked by unprecedented Japanese intervention in the foreign exchange market (at the end of 2003 and in early 2004) that fueled very large purchases of US Treasuries (in the first half of 2004).   The average monthly growth in the Fed’s custodial holdings in the first six months of 2004 was just a bit under $28b — well under half the monthly growth in the the last two months.

There is a real story here.

51 Comments

  • Posted by Guest

    I saw the Bank of Thailand’s governor speak last year at the FRBSF; she seemed very skeptical of BWII but, with nothing better to replace it, she basically expressed the idea that you have to go with the ‘devil-you-know’ (not her words). I don’t think she’s alone.

    Until someone can articulate a better alternative for ‘second tier’ CBs, then as long as China and Saudi Arabia are committed to BWII it seems the rest of the emerging world has no choice but to follow along.