Brad Setser

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Cross border flows, with a bit of macroeconomics

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

by Brad Setser
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.


And yes, this graph implies that Chinese reserve growth has been quite correlated with the price of oil. That in some sense is the core source of the world’s imbalances: China is running a big surplus and building up its foreign assets at an extraordinarily rapid pace even as the oil exporters’ surplus soars.

The pattern of revisions to foreign holdings of Treasury and Agency bonds further suggests that China accounts for more of the Treasury and Agency bonds purchased through London than the Gulf. See the charts at the end of my last post on the TIC data.

I’ll provide one more example of a false correlation involving London — one I know well because I was almost convinced that I had discovered something important a year ago, but fortunately didn’t publish it because I couldn’t quite make everything match up.

Up until the end of 2006, rising oil prices and UK purchases of US corporate debt (a category that includes all asset backed securities that lack an Agency guarantee) were highly correlated — at least if you looked at the 12m sum of corporate bond purchases and the 12m average oil price.


That correlation, though, completely broke down in late 2007.


The rise in UK purchases of US corporate debt seems to have reflected the expansion of London-based SIVs and the “shadow” banking system far more than “petrodollars.” These flows collapsed after August. Oil prices — and one assumes, petrodollars, kept on rising.

It is also interesting to note that purchases of equities by UK investors — a category that might be expected to pick up purchases of US equities by London-based fund managers playing with Gulf money — hasn’t tracked the oil price all that closely recently. I suspect this is more evidence that a lot of Gulf money is on the sidelines than evidence that the Gulf isn’t the ultimate source of demand for a lot of the UK’s purchases of US equities. But I am just guessing.

London hosts so many different kinds of institutions that it is hard to know — a priori — precisely which set of investors is behind any given flow. We might have a better idea if the UK made an effort to produce decent capital flows data. But there isn’t much evidence that the British government is all that interested in understanding the origin of the money that passes through London. And as a result, we are all left making informed guesses.


  • Posted by Rien Huizer

    The oil producers’ perennial surplus position may well become reality if one believes the following (decent academic pedigree, sponsored by BP, Shell plus the quiet and non-senstaional government of a country with it own oil and gas.

    That report with its plausible theory (also used in internal scenario analysis in an oil major) would put the equilibrium price in the suggested “new” oil pricing regime at around USD 110 pb. Quite a bit highet than the long term projections of the US EIA..

  • Posted by Sam

    “Look at the US economy in 19th century and UK in 18th century, its like a sine wave on an upward trend. Free, flexible economies go through ups and downs,”

    From the empirical evidence I have seen, I am not a big believer in the Kondratieff Waves. Technologies and productivity revolutions have certainly contributed long cycles like the steam engine (early 19th cent), automobile (1920s), consumer good (1950-60), and the Internet and PC (90s). However, I only mentioned the volatility of the economic cycles of rising powers to underscore the paucity thereof in China. Animal spirits in a free economy cause the boom-bust pattern that Soros and Keynes have written about. However, recessions and dislocations purge the excesses of the last cycle and sow the seeds of the next boom (eg Wall St and the City right now). People like DC think a government can micro manage its way to perpetual growth and ever-rising living standards, but the historical record of both emerging powers and central planning economies contradicts this notion. I cannot see how the extraordinary 25-year boom China has experienced and the policies that have caused significant imbalances/distortions in the economy do not end in a violent shakeout. I also do not see how China will be immune to what is occurring in the US, European, and Japanese economies now. This does not mean I desire it to happen, nor that the Chinese economy is doomed forever.

    Let’s remember that much of China’s economic policy success is directly attributable to the liberalization and free-market reforms of Deng. This may not have been the Washington Consensus in its pure form, but it was much more liberal and reform-driven than the collectives and central planning of the disastrous policies under Mao and Zhou that caused starvation, upheaval, and severe contractions in agricultural output that left millions starving.

  • Posted by RebelEconomist


    Thanks for taking time to read my argument. One way forward for the eurozone might be to make room for reserve inflows by setting up a debt-funded sovereign wealth fund that sells debt specifically designed to appeal to reserve managers, and invests in a diversified portfolio of many currencies, including yen and sterling, but also convertible growing currencies like Canadian dollars, reais, rand etc. Obviously, the eurozone governments would have to underwrite the exchange rate risk, but if the exorbitant privilege really exists, the expected financial return from the project should be positive. And no doubt the French would enjoy eclipsing the dollar anyway!

    Clearly, though, as China’s economy continues growing relatively fast (and unlike Twofish, I do believe that China will become the dominant economic and political power in my lifetime, if only because of its sheer size), it becomes increasingly difficult for the rest of the world to accommodate their investment while it is difficult to invest in renminbi.

    I usually avoid getting into fruitless geopolitical debates with DC because this blog is supposed to be economic, but I will say that if China’s line is that nations “mind their own business”, they should apply that to Taiwan, Tibet, Xinjiang etc. In my opinion, unless it is obviously some kind of opportunistic resource-grab, regions of a country should be allowed self-determination, like Slovakia in Europe, and potentially even Scotland in the UK. While I admire China’s drive, I sometimes find Chinese nationalism disturbing, and I hope it will be muted at/by the Olympics.

  • Posted by Dave Chiang


    Taiwan, Tibet, Xinjiang were a part of China from over 400 years ago. Unless the United States is prepared to return back the entire North American continent back to the native American Indians, the topic of breaking China into subserviant states to the Western powers is non-negotiable. What is most disturbing is the Western media double standards to justify unilateral aggression by the United States to invade Iraq and threaten to attack Iran, Syria, and North Korea. Saddam Hussein is long dead and buried, but the United States continues to insist on the right to occupy Iraq by military force for at least another 100 years, in the words of Senator John McCain. The United States no longer has the legal or moral authority to tell the rest of the developing world to do anything. It’s not too much to ask for the US to mind its own damn business and leave the rest of the world alone to solve their own problems.

  • Posted by shrek

    Bottom line is the refusal to address global imbalances threatens the entire global economy. I cant stress enough how much interest rates need to rise. Eventually inflation will destroy the chinese economy and other economies

  • Posted by Sam

    Shrek – yes the imbalances are unsustainable. US overconsumed and China kept its currency undervalued, real rates negative, and money supply/bank credit out of control. US consumers now paying the price, only a matter before China does for the distortions of the overconsuming US consumer / mercantilist China monetary arrangement.

    DC – I assume you live in US since your comments surface in US time zone. [EDITED]America was built on Italians, Irish, Chinese, and Hispanics who came here looking for a better life and integrated into society. Most have done that successfully and are proud to be American for affording that opportunity to them. I’ve met people like you who enjoy the American living standard but bash and fault it at every turn. [EDITED]

  • Posted by running bear


    I confess that I cannot discern by eyeballing a closer correlation between oil and China “foreign asset”.

    I will defer to your hard work.

    Looking at your UK holdings patterns with exception of 2001 there is a build up through, and then apparently a sell off, coinciding with end of financial year. Could this be related to company transactions then? Or is it distribution?

    Must say I was initially favouring oil due I think to timing of increases in UK deposits from BIS data. Also I think I remember a pattern of large increases in UK deposits in Citicorp annual report.

    This of course could be due to either of the parties you are mooting.

  • Posted by bsetser

    running bear — the rise in treasury/ agency purchases over the course of 07 preceded the rise in oil prices, hence the apparent correlation with “China.” My point tho was that all three have been rising, so it is hard to know if it is China or oil. I think the correlation may be cleaner tho if you look at the rolling 3m sums.

    the apparent sell off in UK holdings isn’t a real sell off — it is the product of the data revisions that follow the release of the US survey data in June. Basically, some treasuries and agencies that the US thought it sold to investors in the UK (tracked via the TIC data) turn up in the hands of investors around the world, not in the hands of UK investors when the US surveys actual holdings rather than tracking sales. And the real reason for the “China” not “oil” argument is that the biggest upward revisions (offsetting the downward revisions for the UK) have come from China.

  • Posted by Rien Huizer

    Once again DC,

    It hurts to see someone with a Chinese looking name (but not spelled in Pinyin) show so little understanding of Chinese history beyond the propaganda, primary school or readers digest level. As you should know, China (Kangxi Emperor) had a few frortesses on an island (previously under tribal control, like most of the western Pacific islands at the time) then usually called Formosa, primarily inhabited by non-Han people, taken from the Dutch East India Company, who had in terun tken it from the Portuguese (the pirate admiral Coxinga did this at great cost with some help from the Portugues/Jesuits who were accepted at Kangxi’s court) . Kangxi then decided to populate part of the East coast of the island with Fujianese people, who were not particularly keen. For 250 years the Island was neglected until the Japanese obtained it in the late 19th cntury. Contrary to the Koreans, the Taiwanese were not unhappy with the Japanese because they finally had a government that did not quite treat them s equals, but at least built schools, hospitls, railways and introduced modern sanitation. In the 1920s (as several Taiwanese friend have assured me), Taiwan was probably the most developed part of what is now China outside Shanghi and Tianjin. In 1949 the mainlanders came and made a big portion of the Taiwanese even more pro-Japanese than they already were. I could go on..I hope you catch my drift.

    But anyway, can you explain what makes you utter all these nonsensical comments that no one takes seriously and take up a lot of space. Does it have some function?

  • Posted by A. P. Simkin

    Dr. S!

    Jesper may be right, but with bank lending so weak in Japan and with the banks there very liquid and looking for business, why would anyone buy Japanese money market paper in London? Enlighten me, please.

  • Posted by flow5

    “But there isn’t much evidence that the British government is all that interested in understanding the origin of the money that passes through London. And as a result, we are all left making informed guesses.”

    Nothing has changed. Russia, formally the epitome of state controlled economies, did not use the ruble in its foreign exchange operations. Since all trade with the Soviets was monolithic, it was to their advantage to establish a single money center bank through which all foreign financing could be channeled. Their LONDON BANK was one of the first to become a part of the Euro-dollar system, an unregulated system of money creating banks operating on the principle of prudential reserves, as contrasted to regulated legal reserves.

    London Banks could not compete without offering privacy, security, and protection of their international clients’ assets and information, i.e., a tradition of bank secrecy.

  • Posted by RebelEconomist


    I dare say that European foreign exchange reserves managers buy yen treasury bills in London because they do not want to get up early enough to buy them direct from Tokyo!

  • Posted by A. P. Simkin

    Rebel Economist:

    It’s not that bad. There’s only a 7 or 8 hour difference between Frankfurt and Tokyo.

  • Posted by flow5

    “Why have they let money growth outpace GDP for so long?”

    If China’s money & credit growth is spent on projects which increase productivity and reduce waste, the expenditures are beneficial no matter how financed. The initial inflationary effects of bank financing are quickly overcome by the larger output and lower unit costs.

    Debt incurred which reduces unit costs of production and promotes the health and welfare of the population obviously is “good” debt.