Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

It is good to be the king (of oil)

by Brad Setser Sunday, June 29, 2008

If oil stays at $140, the Gulf — based on projections that imply GCC spending and investment will rise so that the GCC needs $55 to $60 oil to cover its import bill — the big GCC funds and central banks should add close to $400 billion to their foreign assets in 2008.


That isn’t bad for a region whose total GDP was about $400 billion as recently as 2003 (see the IMF).

It is also a reminder that the institutions that manage the Gulf’s foreign assets will do more than determine the size of some investment bankers’ bonuses. They increasingly will shape global capital flows.

The graph showing the estimated overall increase in the GCC’s assets also shows the estimated inflows into individual funds. That is my little contribution to increasing global transparency.

Each of the big Gulf funds is worth getting to know a little bit better.

SAMA is the Saudi Arabian Monetary Agency. It now has around $365 billion in foreign assets — and manages additional funds for the Saudi pension system. Its asset allocation isn’t disclosed, but it is likely to be the most conservative of the big Gulf funds.

ADIA is the Abu Dhabi Investment Authority. It has a revamped, but still not very informative website. SAMA isn’t as slick, but it releases more data – and the Saudis aren’t known for their transparency. Business Week’s profile of ADIA has far more information than the web site). That said, we now pretty much know that ADIA doesn’t have as much money as some investment banks are claiming. The IMF’s Moshin Khan has said as much. So has Abu Dhabi’s emir— Sheik Khalifa. He is among the few who certainly knows ADIA’s true size. Unless someone has better information (or believes that Sheik Khalifa is understating ADIA’s size), I would argue that journalists should stop using $825 billion as an estimate for ADIA’s size — let alone the $1.25 trillion estimate sometimes thrown around. It is very big — especially given Abu Dhabi’s small population — but not quite that big. There is a risk that the Setser/ Ziemba estimate ($650b at the end of 2007) may be a bit on the high side. $250 billion was bandied about a little less than two years ago.

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Does the Fed’s mandate now extend to Beijing, Moscow and Riyahd?

by Brad Setser Friday, June 27, 2008

The Financial Times, in a leader, says yes.

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed itself would — I suspect — argue that it has to worry about a fall in the dollar, a rise in commodity prices or a fall in the dollar that spurs a rise in commodity prices only to the extent that such developments risk prompting a rise in US inflation, and thus affect the Fed’s ability to guide the US economy. That is a formulation that doesn’t generate any conflict between the Fed’s domestic mandate and the dollar’s global role. The Fed only should care about the dollar’s external value to the extent it influences the Fed’s ability to meet its domestic objectives.

The FT leader goes much further. It argues that dollar pegs generates such large benefits to the US — namely cheap financing — that the US should be willing to adopt a monetary policy that is right for the entire dollar zone even if it is wrong for the US. The FT:

The Fed has another reason to worry as well. The greater the inflationary pressure, and the more Asian countries are forced to raise interest rates, the greater the risk that they dump their pegs to the dollar. The results for the US would be unpleasant: a currency crash and even higher domestic inflation. The US benefits from the dollar’s use as a reserve currency; the price is that the Fed cannot forget the effects of its policy on the wider world.

The Fed’s Vice-ChairDon Kohn seems to disagree. He argues, more or less, that if US monetary policy isn’t right for fast growing economies in the emerging world, they should importing US monetary policy. Dollar pegs — not US rates — should change. That at least is what Krishna Guha of the FT inferred from Kohn’s speech:

[Kohn] appeared to call on fast-growing emerging markets to drop their exchange rate pegs to the dollar and adopt independent monetary policies – so they no longer import Fed monetary policy. Mr Kohn said “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability”.

The Fed vice-chairman did not specify what steps he thought should be taken to restrain demand in these overheating countries. However, he said economies “benefit from having independent monetary policies that provide room to respond flexibly” to different economic shocks. He added “these benefits could be increased if exchange rate flexibility were to become more widespread”.

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The Economist has an excellent article on hot money inflows to China

by Brad Setser Thursday, June 26, 2008

The Economist’s article draws heavily on the work of Logan Wright of Stone and McCarthy, who has done superb work on this topic.

Logan Wright, a Beijing-based analyst at Stone & McCarthy, an economic-research firm, has done some statistical detective work to make sense of the figures. The first problem is that reported reserves exclude the transfer of foreign exchange from the PBOC to the China Investment Corporation, the country’s sovereign-wealth fund. The reserve figures have also been reduced in book-keeping terms this year by the PBOC “asking” banks to use dollars to pay for the extra reserves that they are now required to hold at the central bank. Adding these two items to reported reserves, Mr Wright reckons that total foreign-exchange assets rose by an astonishing $393 billion in the first five months of 2008 (see chart), more than double the increase in the same period last year.

I literally have nothing to add! Do check out the chart that accompanies the article; it highlights that China’s current foreign asset growth, annualized, is a lot closer to a trillion dollars than half a trillion dollars.

Logan Wright’s article on the bureaucratic rivalry between SAFE and the CIC — itself a spillover of the rivalry between the PBoC and the Ministry of Finance — is also well worth reading.

When I visited Beijing last November, a journalist based there quipped that the PBoC and the Ministry of Finance have been at each others’ throats since 1949. Their rivalry historically hasn’t had much impact on the rest of the world. Now each influences – as the CIC is consider closer to the Finance Ministry than to the PBoC, though it reports to the State Council — a rather substantial pool of funds to invest abroad. And given how fast China’s foreign assets are growing, each could soon control a lot more funds.

A tale of two Asias: China, and almost everyone else

by Brad Setser Wednesday, June 25, 2008

Many emerging Asian economies — Korea, India, perhaps some others — are now intervening to keep their currencies up rather than trying to hold them down. Raphael Minder of the Financial Times reports:

South Korean authorities on Tuesday sold as much as $1bn to shore up the won, according to currency traders in Seoul, underlining concerns in several Asian countries about weakening currencies in the face of oil-fuelled inflation … South Korea’s predicament is shared by other Asian nations that have seen an abrupt currency reversal compound inflationary pressures as oil and food prices remain near record highs.

Other Asian central banks likely sold dollars as well. An Indian newspaper reports:

” Central banks across Asia region likely to have intervened in the foreign exchange markets. The Bank of Korea, Bank of Thailand, Banko Sentral ng Pilipinas and Reserve Bank of India are all suspected to have sold US dollar to boost domestic currencies in order to contain inflation,” Sherman Chan, Economist, Moody’s Economy.Com said.”

China, like many other emerging Asian economies, imports oil. but it otherwise is in a rather different position than many other Asian economies. The hike in oil prices has yet to put much of dent in its trade surplus. Its larger current account surplus is expected to remain constant in dollar terms this year. And its central bank is still buying dollars, not selling dollars.

If the latest leaked data is accurate, China reserves increased by $40 billion in May. I would estimate that China bought about $44 billion in the market, after adjusting the $40 billion total to reflect a slight fall in dollar value of China’s exiting holdings of euros in May. $44 billion (over $500 billion annualized) is a huge sum. But it likely leaves out another $22 billion that China’s banks accumulated, as China’s central bank continues to ask China’s state banks to meet their (rising) reserve requirement by holding dollars rather than renminbi. $66 billion — almost $800 billion annualized — is a very big number.

It is a smaller than the $75 billion increase in China’s reserves in April — a number that rises to $80 billion after adjusting for valuation gains and rises to above $100 billion if the April rise in China’s reserve requirement is factored in. Slowing down the pace of RMB appreciation in April (it has subsequently picked up somewhat) may have helped slow the pace of hot money inflows — or China’s efforts to tighten the enforcement of its capital controls may have had an impact.

But Michael Pettis is right. The overarching story is that China’s reserves and foreign assets continue to increase at a stunning pace. Throw in another $45 billion in June reserve growth, and the increase in China’s reserves — after adjusting roughly for valuation effects — in the first half of 2008 could approach $290 billion.

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Why not more articles on China’s reserve growth? And just who are Chinese banks lending to?

by Brad Setser Tuesday, June 24, 2008

Yves Smith asks why the stunning $75 billion increase in China’s April reserves hasn’t attracted more press attention. It is a good question.

Part of the answer is that many — journalists as well as the public — still find it a bit difficult to figure out why rapid reserve growth is a problem. Simon Rabinovitch and Eadie Chen of Reuters an exception; their article highlighting the problems associated with the rapid growth in China’s reserves is excellent. Hong Liang and Eva Yi of Goldman now estimate that the monthly losses on China’s reserves are close to $15 billion — an annualized loss of around 5% of China’s GDP. Part of the answer is that the FT’s Richard McGregor, who covered these issues well, is on book leave. And part of the answer is that the April reserves number hasn’t been formally released, only informally leaked. Building an article around a leaked number that seems too big to be true is a risk.

But the body of evidence that support the story in the April data is growing. China just released data on its net international investment position for the end of 2007. China’s total foreign assets increased by $661 billion in 2007, rising from $1627 billion at the end of 2006 to $2288 billion at the end of 2007. That is a huge increase. And the trend is up. The increase in 2005 was around $300 billion. The increase in 2006 was around $400 billion.

The vast majority of China’s foreign assets — $1540 at the end of 2006 and roughly $2170 billion at the end of 2008 continue to take the form of reserves, bank lending and holdings of debt securities. Chinese FDI abroad is still quite small.

The details of the data hint at another interesting story: Chinese investors — setting SAFE aside — stopped buying portfolio debt in 2007. Instead Chinese banks starting lending tons of money to the rest of the world. In 2006 China bought over $110 billion of debt — leading total holdings of debt securities to rise from $117 billion to $229 billion. In 2007, total holdings of foreign securities only rose by $10 billion. Look at the following chart, which shows the annual increase in China’s foreign assets broken down by the main categories in the balance of payments.


Other data sources — including the data on banking system’s foreign currency holdings that the PBoC used to release fairly regularly — tell a similar story. The Chinese were net sellers of portfolio debt in the second half of 2007. Those sales likely followed losses on the debt Chinese banks purchased in 2006 and early 2007.

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It is 2004 all over again. Central banks haven’t shifted away from safe, liquid assets

by Brad Setser Monday, June 23, 2008

Sovereign funds have attracted a lot of attention recently. With some cause. They have the potential to get very large very fast. Not all sovereign funds are content to be pure portfolio investors. Sovereign funds are evolving as they are expanding.

But their current impact on financial markets is easily (and often) over-stated. The overwhelming majority of the enormous increase in government foreign assets still comes from the growth in central bank reserves. The majority of central banks’ foreign assets are still invested in Treasury and Agency securities. The shift to a world where sovereign investors primarily buy equities has yet to happen.

That is what the US balance of payments data for q1 shows. The following graph, which draws on the monthly TIC data to show the rolling 3m sum of foreign purchases of long-term Treasuries and Agencies relative to both official purchases of equities and the rise in official holdings of short-term Treasuries and Agencies, tells the same story.


Immediately after the August crisis central banks piled into short-term Treasuries and Agencies. In December and January, some well-established funds — together with the CIC — famously bought some equity in US banks, generating the upward blip in official purchases of equities. But those investments haven’t worked out so well. Now central banks are back to buying enormous sums of Treasuries and Agencies.

Here is is important to remember that the TIC data understates official purchases of Treasuries and Agencies and purchases by emerging economies. Remember all those London purchases? The pattern of revisions to foreign holdings of Treasuries suggests after the US survey data is released suggests that a large share of China’s purchases, not just the Gulf’s purchases, comes through London.

Indeed, I would argue that central bank purchases are likely to be closer to total foreign purchases of Treasuries and Agencies than recorded official purchases. I actually am not going out on much of a limb here. The US Treasury agrees with me. Read the fine print of the latest survey. The Treasury writes (p. 14):

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The London Times’ take on Chinese equity investment abroad

by Brad Setser Sunday, June 22, 2008

I found the Times’ article (hat tip, SWF Radar) on the China’s plans to invest abroad to be somewhat confusing.

The article’s headline claimed “Plans are are afoot to diversify its [China’s] holdings of reserves without causing political rows.”

But what are those plans? Well, the CIC “will help [China’s] state-owned companies to expand overseas in a shift of strategy” and specifically will “assist inexperienced Chinese companies in financing, foreign-exchange risk management and handling trade barriers.” Yet it isn’t at all obvious — at least to me — that using a sovereign fund to assist state firms is a strategy for avoiding political rows.

The article jumps between three very different ways China’s government is looking to gain equity market exposure abroad:

1) Supporting Chinese firms — Haier, Baosteel, no doubt others — looking to expand expanding abroad;
2) Handing funds over to private equity funds and other external managers;
3) Buying equities in the public market.

These are conceptually different different activities, and raise different policy issues. The CIC seems to be doing all three. SAFE doing the last two — though the foreign exchange it has placed with the state banks is also available to support Chinese state firms.

Much of the confusion in the Times article comes because it starts by indicating that Beijing has decided to use the CIC/ SAFE to support Chinese state firms and then jumps to a list of the various investments the CIC and SAFE have made without really explaining how these investments relate to this new reported strategy. And best I can tell, there is no connection. China has plenty of funds to commit to all three strategies.

The Times article does include some useful new information though. Caijing apparently has reported that the State Council has authorized SAFE to invest up to 5% of its portfolio in equities.

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China’s sovereign economic development fund

by Brad Setser Friday, June 20, 2008

It looks like one of the CIC’s mandates it to support the outward expansion of Chinese firms, particularly in strategic sectors.

Via SWF Radar and the Wall Street Journal comes news that the CIC is interested in being a part of a consortium of Chinese steel firms bidding for a Brazilian iron ore mining company.

A consortium made up of Chinese steelmakers and China’s sovereign wealth fund is entering the initial round of bidding for a stake in the iron-ore unit of Brazil’s Companhia Siderurgica Nacional SA, people familiar with the situation said Thursday. The group’s interest, though preliminary, shows the importance China places on securing supplies of ore and other natural resources amid the current commodities boom …. CSN, one of Brazil’s leading producers of both steel and iron ore, has invited bids for all or part of Nacional Minerios SA, or Namisa, its unlisted iron-ore unit. Major Chinese producers including Baosteel Group Co., Shougang Group and Shagang Group, as well as China Investment Corp., a $200 billion investment pool run by the Chinese government, are interested in the unit, one person familiar with the matter said. But the final composition of the consortium isn’t finalized yet, this person said.

If this story is true, the debate over whether the CIC’s mandate includes supporting the outward expansion of Chinese firms would be settled.

On one level, it would be positive for the global economy if China’s balance of payments surplus financed deficits elsewhere in the emerging world — not just deficits in the US and Europe. Redirecting some of China’s foreign asset growth away from the US and Europe could contribute to such an evolution, as would willingness on the part of those emerging economies receiving inflows from China to allow their currencies to appreciate. Brazil would use money borrowed from China to buy more US and European goods, helping the global economy to adjust.

On another level, it is a little hard to see how China can argue that the CIC is a purely commercial investor when it is actively supporting Chinese state firms. It is hard to see how a government fund that has to choose to finance the overseas ambitions of some Chinese companies and not others could be insulated from domestic political pressure. Moreover, the CIC is supporting one of the strategic goal of China’s state, namely helping — in China’s view — to secure a reliable supply of the mineral resources China’s economy needs. There is a fair debate over whether owning resources abroad truly is necessary to secure supply, or whether resources will always be available to the highest bidder. But China’s government seems to believe that greater Chinese ownership of mineral resources would help it navigate a world where China’s economy is much less self-sufficient than in the past. China only became a large net oil importer fairly recently.

Vertical integration is a common commercial strategy. But vertical integration supported by a government fund investment fund feels more like a scramble by states to secure access to strategic resources than pure commerce.

Four bits of information to help understand China a little better …

by Brad Setser Thursday, June 19, 2008

Energy use is subsidized – even though China is a net importer of energy. Even after increasing domestic gasoline prices by 17%, Chinese prices will remain below the world market price. The World Bank estimated that November price hike increased domestic prices to the equivalent of $78 a barrel. My very rough calculations suggest that the recent price hike consequently should raise domestic prices to a per barrel equivalent of the low 90s — perhaps more if exchange rate moves are factored in.

Exports continue to contribute significantly to Chinese growth. The latest, highly recommended World Bank Quarterly – written in large part by Louis Kuijs — calculates that net exports contributed 1.5% to Chinese GDP growth in the first quarter, and more in April and May (see p. 4). That is less than in 2005, 2006 an 2007. But it is still a positive contribution. Real import growth has slowed more than real export growth. The (small) fall in China’s trade surplus relative to last year is all due to the rise in import prices.

The World Bank’s data has one surprising implications: Net exports contributed more to China’s growth in q1 than to US growth (1.5% v 0.8%).

Given that China still manages its exchange rate primarily against the dollar and the RMB has depreciated v the euro because of the dollar’s slide, I guess that shouldn’t be a complete surprise. It does though suggest that the hard work of global adjustment hasn’t really even begun. The World Bank forecasts that China’s current account surplus will stabilize at around $370 billion in 2008 before resuming its rise in 2009 once the effect of rising oil prices wears off.

Both China’s government and its state banks are accumulating an amazing amount of foreign exchange. That shines through the World Bank’s analysis. Stephen Green of Standard Chartered reports that the hike in reserve requirements – combined with pressure to meet that requirement by holding dollars — has led China’s banks to increase their foreign exchange holdings by $160 billion.* Think a bit under $100 billion in 2007 (mostly in q4) and a bit more than $60 billion in the first four months of 2008. If China’s state banks were a sovereign country, they would rank second in the global “reserve” growth league table over the past twelve months – outpacing both Russia and Saudi Arabia. Only the People’s Bank would top them.

The state banks now are sitting on a huge pile of foreign exchange. Far more, incidentally, than the CIC. About $70 billion of the CIC’s $210 billion flowed back to the PBoC when the CIC bought Huijin’s stakes in the big state commercial banks. Another $20 billion was handed over to the CDB. That leaves $120 billion max – less than the fx the state banks have accumulated to meet the reserve requirement. I still haven’t quite figured out what the state banks have been doing with all this cash though; at least in late 2007, they don’t seem to have been buying foreign debt securities.

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Why has the dollar tended to go down as oil goes up?

by Brad Setser Wednesday, June 18, 2008

I did a podcast for that presents my thinking on this topic.

The simplest reason why oil is up and the dollar is down is that the world economy has been far stronger than the US economy. Weakness in the US economy translates into a weak dollar. Still solid global growth translates into strong demand for oil at time when supplies are a bit tight.

It is also striking, at least to me, that the countries that subsidize oil consumption the most also tend to peg to the dollar or manage their currencies against the dollar. US economic weakness consequently has translated into low US interest rates — and low US rates have translated into low nominal rates – and even lower real rates — in the other, booming dollar zone economies. See Martin Wolf. Combine low real rates with subsidized (or at least below-world-market-prices) oil and there has been a big increase in demand for oil in many countries that peg to the dollar or manage their currencies against the dollar.

I also was persuaded by the analysis of Goldman’s fx team. They argue that there are fundamental reasons to think that a rise in the price of oil should be bad for the dollar. The US economy is energy and oil intensive. The US has the largest existing external deficit of any major oil-importing region. The US exports relatively little to the oil-exporting economies. And the oil-exporting economies seem a bit less inclined to hold dollar-denominated financial assets than in the past.

That said, I wish I had concluded by noting that there are two clear paths that could end the current “oil up, dollar down” pattern.

Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil to fall.

Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.

The dollar isn’t always weak when oil is strong. And the dollar isn’t always strong when oil is weak. But so long as global growth is far stronger than US growth, there is reason to think that oil prices will respond to global demand while the dollar will reflect conditions in the US.