Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Back to the future: Is China’s new RMB policy China’s old RMB policy?

by Brad Setser Thursday, July 31, 2008

The odds that the US slipped into a recession around the turn of the year have increased. Nouriel Roubini is convinced. Jim Hamilton isn’t. The risk that US growth may slow later the in year are rising. So far, US export growth has remained robust – supporting growth. The pace of export growth hasn’t risen recently — if has been strong for a long time — so much as the pace of import growth has slowed: Imports have contributed positively to growth for the last three quarters, meaning real imports fell (see Dean Baker for more). But there is a growing risk that export growth will slow with a slowing global economy.

Signs of trouble are now visible in Europe. And not just in housing and finance-dependent economies like the UK – where consumer confidence has really plummeted. Anything that includes the phrase “worst since 1974” cannot be good. Europe, writ large (i.e. counting “new” Europe) has been a more important engine of global demand growth that the US since 2005, so a European slowdown matters for the world. Especially if Europe slows before the US resumes sustained growth.

Japan hasn’t had much momentum for a long-time. It isn’t likely to find new momentum now.

Of all the major economies – and with a $4 trillion GDP and $1.4-$1.5 trillion in goods exports this year, China is far too big to be considered anything other than a major economy – China has by far the strongest growth.

Its exports have held up quite well as the US – and Chinese exports to the US — slowed. Thank Europe – and booming sales to India and a host of other emerging economies. Many emerging markets fear cutting tariffs on Chinese goods far more than cutting tariffs on US and European goods. But forward looking indicators* suggest a broader slowdown in exports. Chinese manufacturers and policy makers are worried.

And it increasingly seems like China took a policy decision to slow the RMB’s appreciation against the dollar (and thus to slow the RMB’s likely appreciation against all the other large oil-importing economies) in order to support China’s export sector. That decision came even though China has the strongest domestic economy and the largest current account surplus of all the large oil-importing economies.

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Just how stabilizing?

by Brad Setser Wednesday, July 30, 2008

Russia’s central bank has indicated that it has cut its holdings of Fannie and Freddie debt by about half since the beginning of the year. Russia’s central bank claims its $100 billion portfolio has been pared down to $50 billion. Russia presumably also holds Ginnie Mae and other “Agency” bonds that have an explicit government guarantee – the US data suggest that Russia’s holdings of Agencies are higher than its reported holdings of Fannie and Freddie debt.

So much for the notion that all sovereign investors are always long-term investors, willing to hold difficult positions through thick and thin. Russia likely concluded that the political cost of holding Fannie and Freddie paper isn’t worth the extra yield. Russia’s net sales likely put at least some pressure on Agency spreads.

That raises something that I have been meaning to write about for a while now – the tendency to accept uncritically the argument that official investors (notably sovereign funds) have played a stabilizing role in the subprime crisis. To be sure, Merrill, Morgan Stanley, Citi, UBS and Barclays would be in more trouble now if not for the capital they raised from sovereign funds. The sale of convertibles and common stock to sovereign funds (and in the case of UBS, a large “private” investor in the Gulf) in December and January has proved to be a good deal for the banks and a bad deal for the sovereign funds. But it is still, I suspect, a stretch to conclude from these investments that official investors have played a stabilizing role in the crisis, for three reasons.

— Purchases of bank shares represent a very small share of total official flows

— Many key institutions don’t disclose enough information to evaluate whether or not their overall activities have been stabilizing or destabilizing

— The available evidence suggests a flight away from credit risk by some sovereign investors, which added to distress in parts of the market.

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Beware: Correlation doesn’t always mean causation … London doesn’t just handle petrodollars

by Brad Setser Monday, July 28, 2008

Capital flows through London are often taken as a proxy for petrodollars. Bloomberg’s Daniel Kruger, for example, argues that the buildup of Treasuries (and I would assume Agencies) in the UK reflects oil money.

The Organization of Petroleum Exporting Countries held $153.9 billion in Treasuries at the end of April, Russia had $60.2 billion and Norway owned $45.3 billion, according to the Treasury Department. Combined, that represents a 113 percent increase from 12 months earlier. Oil producers own a majority of the $251.4 billion in Treasuries held in the U.K., an 85 percent increase.

Unicredito’s Dr. Harm Bandholz also uses capital flows through London as a proxy for petrodollar flows.

This isn’t unreasonable. London probably manages more petrodollars — and more Gulf sovereign wealth fund money — than any other financial center. And there is a reasonably close correlation between the UK’s purchases of Treasuries and the price of oil (or my estimate of oil foreign asset growth).


Correlation though, doesn’t imply causation. There is also a close correlation between purchases of Treasuries and Agencies through London and China’s reserve growth.


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Too big to fail? Or too large to save? Thinking about the US one year into the subprime crisis

by Brad Setser Thursday, July 24, 2008

Emerging market financial crises in the 1990s followed a fairly consistent pattern.

The country lost access to external financing.

The sector of the economy that had a large need for financing – firms in Asia, the government elsewhere – had to dramatically reduce its need for financing. Asian investment collapsed. Argentina swung from a fiscal deficit to a fiscal surplus (helped along by its default on its external debt). Turkey began to run large primary surpluses.

Financial balance sheets shrank; credit dried up.

The country’s currency fell sharply. And its current account swung into balance, if not a surplus.

That process was incredibly painful. Falls in GDP of 5% or more were not unknown. It also meant that after a year or so, most emerging markets had reached bottom. Their economies had adjusted, as had their currencies.

A year – almost – after its crisis, the US economy hasn’t endured a similar period of adjustment. Economic activity has slumped, but not fallen off a cliff. US households are pinched (and unhappy), but spending hasn’t collapsed. The US current account deficit has fallen, but not by much – the rise in the oil deficit has offset the fall in the non-oil deficit. Banks have depleted their capital, but I don’t think that they have – in aggregate – shrank their balance sheets. Then again some of the expansion of their balance sheets may not have been entirely voluntary, as off-balance sheet assets and liabilities moved on to the formal balance sheet.

Residential investment has fallen significantly as a share of GDP.

But in other ways, the US hasn’t adjusted.

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How fast will China’s economy slow? And will China also slow the pace of RMB appreciation?

by Brad Setser Tuesday, July 22, 2008

Chinese policy makers are concerned that China’s economy is slowing.

The stock market is obviously well off its highs, taming some animal spirits.

Housing prices in Shengzen are no longer rising.

Complaints from the export sector are growing – even though China’s exports are still up substantially relative to last year. Some forward looking indicators suggest that the global slowdown is catching up to China’s export sector – and a slowdown in exports could spillover into a slowdown in investment.

At the same time, China is worried about ongoing hot money inflows, and the ongoing difficulty sterilizing extraordinary fast reserve growth. A host of controls have been tightened. Controls on exporters. And now controls of FDI inflows. Yu Yongding of the Chinese Academic of Social Sciences characterizes China’s new capital account policy as “easy out, difficult in”. He is right. Note as well Dr. Yu’s comments on the “unattractiveness” of QDII)

And to make matters worse, there are fears that the recent rise in inflation has changed domestic expectations about future inflation. Dr. Yu writes that “inflation expectations have been firmly established among the public.”

Key members of the state council recently went south to hear the complaints of exporters first-hand. And Chinese policy makers are now meeting, reportedly to set the course of China’s economy policy over the course of the remainder of the year. Michael Pettis relays a report in the South China Morning Post:

The nation’s [China’s] top decision-making body, the Politburo, will meet this week to consider major economic policy for the mainland for the rest of the year amid growing concerns over slowing growth, rising inflation and, in particular, a dramatic decline in exports as the global economy slows. All the most senior leaders completed fact-finding missions to economic strongholds and key export bases early this week, according to reliable sources.

The policy choice is fairly binary: Should policy be directed at controlling inflation, or supporting growth?

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Just how much money does China have? How fast are China’s foreign assets growing? And how much is hot money?

by Brad Setser Monday, July 21, 2008

Answering these questions has been a long-term obsession of mine. I am not sure I have the answers, even now. China’s government doesn’t make tracking the growth of its foreign assets easy.

But I do have fairly detailed estimates. What’s more, these estimates are generally based on data that China itself releases, often in somewhat obscure places – though, given data lags, I sometimes have made estimates to bring a data series up to date. Of course, both my interpretation of the data and the assumptions I have used to produce data through the end of June could be off. These are estimates.

Based on the assumptions laid out in the technical notes, including an assumption that the transfer of foreign exchange to the CIC was largely completed by the end of q1 2008, I estimate that China’s government currently manages between $2.3 and $2.4 trillion in foreign assets. The central bank (SAFE) manages $1.8 trillion, the CIC manages $109 billion (my assumption), and the state banks manage $430 billion. This implies that China’s state banks have become one of the largest reserve managers in the world — their combined portfolio trails only the reserves of Japan and Russia. The combined portfolio of the CIC and the state banks it formally owns would make it the second largest SWF in the world.


The pace of growth in China’s foreign assets is equally impressive – I estimate China added, after adjusting for valuation changes, something like $785 billion to its foreign portfolio over the last 12 months (i.e. from June 2007 to June 2008). Just a bit under $420 billion of this comes from the increase in the central bank’s reserves. The CIC got an estimated $107 billion (after adjusting for its purchase of Huijin and the funds it injected into the CDB), and the banks holding of foreign exchange increased by a little more than $250 billion. Most of that increase ($200 billion) comes from the fx held as part of the banks reserve requirement; the remainder comes from an apparent increase in the banks swaps position with the central bank in the second half of 2007.*


For the first half of 2008, China added – as best as I can tell – about $430 billion to its foreign assets, with $250 billion coming from the increase in China’s reserves (after adjusting for valuation gains), $90 billion coming from the increase in the CIC’s foreign assets and $90 billion coming from the increase in the banks reserve requirement. This estimate is close to the estimate of Michael Pettis and also to the estimate of Logan Wright.

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The 2008 oil shock

by Brad Setser Saturday, July 19, 2008

Dubai is rather frothy. Landon Thomas of the New York Times reports that rents are up 40%. New supply has to be coming onto the market, but I guess it has yet to catch up with demand. And it isn’t hard to see why. Oil is — thankfully — off its recent highs. But at close to $130 a barrel, it is still well above its average 2007 price of around $70 a barrel.

The rise in prices between 2008 and 2007 has, obviously, come a lot faster than the rise in prices from say 2003 to 2007. The following chart* shows the estimated export revenue of the world’s major oil exporting economies as a share of world GDP if oil averages $120 a barrel this year. An average price of $120 a barrel requires $130 oil for the remainder of the year.


I also plotted the y/y increase in oil export revenues — both in billions of dollars and as a percent of world GDP. If oil averages $120, the 08 rise in oil export revenues would be comparable in size — relative to world GDP — to the rise in 74 and 79. An average oil price of $120 a barrel would increase the export revenue of the oil exporters by about $900 billion.


This calculation assumes that the oil exporters will export about 45 million barrels a day of oil.
Each $5 increase in the average price of oil increases the oil exporters’ revenues by about $80 billion, so if oil ends up averaging $125 a barrel this year rather than $120 a barrel, the increase in the oil exporters revenues would be close to a trillion dollars.

I consequently was a bit slow putting this post up. If I had put it up a few days ago, I could have talked about the “Trillion dollar oil shock.” I learned the value of a catchy headline last week.

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So a Gulf sovereign fund still has 60% of its assets in dollars? And SAFE is a SWF …

by Brad Setser Thursday, July 17, 2008

My initial reaction to Henny Sender’s front page FT article was probably the opposite of most. I wasn’t all that surprised that sovereign funds are reducing their dollar exposure — though cutting their dollar exposure when the dollar is under pressure does suggest that they, unlike central banks, haven’t been a stabilizing force in the foreign exchange market. I was, though, surprised that “one big sovereign fund in the Gulf” had 80% of its assets in dollars a year ago, and still has 60% in dollars now. 60% is substantially higher than I would have expected. It also is a bit higher than the IMF assumed in its modeling of sovereign funds: their well-established diversified fund was assumed to have 38% of its portfolio in dollars (see the appendix of the IMF’s recent SWF paper)

Moreover, if a major Gulf fund is 60% in dollars and the Gulf’s central banks have an even higher share of their assets in dollars (the UAE’s central bank recently indicated that 95% of its assets are in dollars), the Gulf as a whole has even more dollar exposure than Rachel Ziemba and I thought.

Sender’s article is full of interesting tidbits.

The obvious question to ask is which big sovereign fund in the Gulf had 80% of its assets in dollars until recently. I would assume that major excludes Oman and Bahrain — and I would also assume that the reference to “sovereign wealth fund” excludes the Saudi Monetary Agency. If Saudis, who are widely thought to keep most of their foreign assets in dollars — had cut from 80% to 60% that would truly be news. That leaves the funds of Abu Dhabi, Kuwait and Qatar. The Qataris seem to have a lot of exposure to the UK — and a wildly diversified real estate portfolio — so they don’t seem like the most probable candidate. Plus, they have previously indicated that about 40% of their portfolio is in dollars. ADIA’s reported portfolio* is also geographically diversified, and its holdings are pegged “to global economic growth.” It is hard to see how a portfolio linked to expected growth could be so over-weight the dollar, though Sender reports that currency risk is all managed by a central trading desk. Consequently, some of the currency exposure implied by ADIA’s diverse equity exposure could have been hedged. But it is hard to see how ADIA could be anywhere close to its current rumored size if it had that much dollar exposure and thus missed out on currency gains from holding euros and the financial gains from holding non-American equities over the past few years.

That leaves Kuwait — which hasn’t disclosed much about its portfolio. It was also fairly conservative until recently. But even there the fit isn’t perfect — Kuwait has hinted in the past that its large stakes in BP and Daimler imply that its equity portfolio at least is geographically balanced.

* The data in Business Week indicating that North America accounts for between 40 to 50% of ADIA’s portfolio explicitly excludes ADIA’s investment in private equity, hedge funds, real estate, infrastructure and cash. It consequently could understate ADIA’s dollar exposure. And ADIA could have hedged out the currency risk on its European and Asian portfolio.

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The May TIC data (with special attention to Agencies and London)

by Brad Setser Wednesday, July 16, 2008

The TIC data for May doesn’t lend itself to any overall story line.

Net long-term inflows were OK — with foreign purchases of over $90 billion of US long-term debt offsetting the $25 billion or so in US purchases of foreign stocks and bonds. Foreign demand for US corporate debt reemerged (total official and private purchases topped $55 billion) but a little under half that demand came from the Caymans — which is always a bit suspicious. Recorded official inflows were a bit low — only $16.7b. But that is too be expected now that most official asset growth is in China, Russia and the Gulf. The US data consistently undercounts flows from all three. Chinese purchases of long-term US debt — $35.6b — were particularly strong (they exceeded total official purchases, which raises some interesting questions). However, China financed some of the long-term purchases were financed by running down short-term holdings, which fell by $15.9b. Overall Chinese purchases of around $20b are still low relative to Chinese foreign asset growth.

Moreover, as I’ll explain below, it makes sense to add the UK’s purchases of Treasuries and Agencies ($39.6b) to the “official” total — which would bring official purchases of long-term up above $50 billion — a more realistic level.

However, net TIC inflows were quite bad. After adjusting for amortization payments and the like, the net increase in foreign long-term claims on the US was about $45 billion. That wasn’t enough to offset a $56b fall in short-term claims on US banks. On net, $2.5b flowed out of the US. That cannot last for long. But I still don’t have a clear idea why short-term claims fell so dramatically.

Given all the interest in Agencies, I wanted to update some of the data I presented earlier this week.

Central bank demand for Agencies was fairly robust in May — with $10.8b in recorded purchases of long-term Agencies and another $15.6b in likely purchases through London. But that rise was to a degree offset by a fall in official holdings of short-term agencies (on the assumption that other short-term custodial liabilities are a reasonable proxy for short-term Agencies). Total central bank holdings of long-term Agencies rose to $814.4b. I estimate for central bank holdings of short-term Agencies fell to $112.8b (75% of $150.8b of short-term custodial claims other than short-term Treasuries), bring total estimated official holdings up to $927.3 billion.

But the UK now holds — based on adding recent flows to the UK’s stock — about $140 billion of Agencies. I would bet, based on the pattern of past survey data revisions, that $110b or so of those Agencies are really owned by central banks — which would bring total official holdings over $1 trillion.

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A bit more on the Agency portfolios of the world’s central banks

by Brad Setser Monday, July 14, 2008

My post over the weekend attracted a bit of attention. I thought I would clarify a few points that came up in the discussion, refine a few calculations and try to put central banks’ Agency purchases into context.

One key point that I didn’t initially emphasize is that that different central banks hold slightly different Agency portfolios. China holds a lot of Agency “MBS” (also called Agency pass-throughs). These are mortgage backed securities that the Agencies guarantee, as opposed to the debt the Agencies issue in their own name to finance their retained portfolio. Other central banks, by contrast, tend to own the debt the Agencies issue themselves, not the debt they guarantee.

There are a couple of ways of seeing this. Compare for example the “Agency” portfolios of China, Russia and Korea (using the data released in the Treasury survey).


In June 2007, the US data indicates that China had $11 billion of short-term Agency debt, $170.1b of long-term Agency debt and $206.2b of Agency MBS.

In June 2007, the US data indicates that Russia had $38.6b of short-term Agency debt, $75.3b of long-term Agency debt, and $0.001 billion of Agency MBS.

Here I want to note that my initial $155 billion estimate for Russia’s current Agency holdings is significantly higher than the $100 billion the Russian central bank claims to hold. That may reflect a reduction in the central banks’ holdings since April (the last data point), or the limits of methodology. My estimate makes two key assumptions: first, Russia’s central bank accounts for almost all of Russia’s total holdings of Agencies (i.e. private holdings are minimal) and second, almost of all of Russia’s holdings of short-term negotiable securities, CDs and other custodial liabilities are short-term Agencies. That was true in June, 2005, in June 2006 and in June, 2007 (the survey showed $38.6b of Agencies, v $42.1b in short-term custodial holdings). But it is possible that things have changed since then. I assumed that all of Russia’s 66.6b in short-term custodial holdings are in Agencies, which is a big assumption.

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