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Just how stabilizing?

by Brad Setser
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.

Let’s cover each point in turn.

First, the roughly $50 billion that sovereign investors have invested in banks needing to be recapitalized (here I am setting aside investments made prior to the credit crunch, and ICBC’s purchase of a stake of South Africa’s Standard Bank) represents around 3% of the over $1.5 trillion (or more) in new funds that central banks and sovereign funds have been asked to invest over the last year. The $1.5 trillion number is my estimate, but it is based on real numbers: the IMF’s COFER data, the increase in SAMA’s non-reserve assets, reported inflows into Norway’s government fund and estimated inflows into the big Gulf funds and the estimated increase in the assets of Chinese state banks and the CIC. $50 billion represents an even smaller share of the total stock of sovereign investments.

This point applies with particular force to China. The $5 billion the CIC invested in Morgan Stanley represents less than 1% of the likely increase in the foreign assets of the government of China once all the funds that have shifted to the state banks are added in.

Evaluating the overall impact of sovereign funds, central banks and state banks managing sovereign money requires looking at overall sovereign flows, not just the very visible capital injections into (formerly?) private financial institutions.

That leads to my second point – namely, central banks and sovereign funds haven’t provided enough information to evaluate their overall impact on the market.

In the first quarter – and I suspect the second quarter as well, though the IMF data won’t be released for a while – emerging market central banks that do not report even basic data about the currency composition of their reserves accounted for almost two times as much global reserve growth as emerging market central banks that do report data to the IMF ($225 billion or so v $112 billion). Industrial country central banks – who do disclose the currency composition of their reserves – added another $30 billion. But China’s state banks, who also don’t disclose much, accounted for another $15b in the first quarter. Sovereign funds — on the assumption that about $75 billion was shifted to the CIC and the oil funds chipped in another $50 billion – accounted for another $100 to $125 billion. Sum it all up and the IMF had data on the currency composition of about 1/3 of the $450-500b in sovereign flows in the first quarter.

The IMF has no information of the bond/ equity split of the reserves of even reporting central banks – and no information to determine whether sovereign investors have been taking on credit market risk or shedding credit market risk. Central banks don’t report that kind of data as part of the COFER process, and there is no analogue to the “COFER” data for the foreign assets of sovereign funds.

This makes me suspicious of arguments that sovereign funds have been a stabilizing force in the market. Unless the IMF has access to additional information that allows them to see how the portfolios of sovereign funds have evolved over the past year, I would think the IMF should be arguing that sovereign investors have not disclosed enough information about the broad contours of their portfolio to allow the IMF to make an informed judgment about their overall market impact. They may be stabilizing. They may not. Absent a bit more disclosure, it is impossible to know.

I don’t think sovereign funds can have it both ways: if they want to argue that they are a stabilizing force in the market, they need to disclose enough information for outside observers to be able to verify their claims. Ted Truman has this right. He writes:

it is elitist to argue that SWFs should be judged by their past investment track records as privately evaluated, for example, by so-called market professionals. The current IMF-facilitated effort to increase the accountability of SWFs via increasing their transparency should be directed at establishing track records for the inspection by the citizens of the countries with the funds and the citizens of the countries in which they invest.

Absent more disclosure and a public track record, it is impossible to know exactly how sovereign investors are influencing markets. But the available evidence suggests a flight away from credit market risk, not a flight toward credit market risk. That is my third point.

We know that demand for corporate debt from “sovereign wealth fund and central bank” hubs like London has plummeted. That likely reflects the unwinding of SIVs and conduits, not a big fall in sovereign demand. But it is also indirect evidence that sovereigns haven’t been buying what the financial institutions now need to sell. We know that if you sum up private purchases of Treasuries and Agencies are added to recorded official purchases to produce a proxy for “true” central bank purchases, central banks have purchased something like $525 billion of Treasuries and Agencies over the past year (and another $50b of short-term debt). We know that there has been a very strong increase in FRBNY’s custodial holdings.

We also know a few other things.

– India has shifted its deposits out of commercial banks and into the BIS and other central banks. This suggest a flight away from credit market risk, not a flight toward risk on the part of one major sovereign investor.

– Russia has – as noted above – shifted away from the Freddie and Fannie and towards Treasuries and perhaps Agencies with an explicit “full faith and credit” guarantee from the US government. Again, at the margin, this is a shift away from credit market risk.

– China’s state banks – who could be the fifth largest source of sovereign investment in the world, trailing only China’s SAFE, the Bank of Japan, the Bank of Russia and the combined portfolio of Abu Dhabi’s proliferating sovereign funds – have reduced their exposure to US credit market risk.

The evidence here comes from the data the PBoC releases about the foreign currency “portfolio investments” of China’s banks. Such portfolio investments rose from about $125 billion at the end of 2005 (and a bit under $90 billion at the end of 2003) to a peak of around $195 billion in q2 2007 (with most of the increase coming in 2006) before falling back to around $165 billion at the end of 2007. China’s hasn’t updated this data for 2008 (More evidence of a fall in China’s overall transparency as the number of institutions managing China’s foreign exchange has proliferated) but I get a sense that the basic trend hasn’t changed.

The US balance of payments data for China – released on quarterly basis – also shows a fall in “private” Chinese purchases of US securities. Chinese investors have gone from purchases (on a rolling four quarter basis) of around $20 billion to net sales (in the four quarters through q1) of around $15 billion ….

chinese-state-banks-1.JPG

To be clear, these sales are dwarfed by recorded official Chinese purchases. Moreover, the recent US data understates China’s purchases (it will be revised up soon to reflect the last survey results, and then it will be revised up more in a year to reflect the June 2008 survey). My guess is that – given the scale of China’s foreign asset growth – China’s true purchases of US assets are in the $400-500 billion range – or about twice what the US balance of payments data now shows.

chinese-state-banks-2.JPG

You can argue that the state banks are banks, not sovereign investors. But that argument seems thin to me. The banks are owned by the CIC after all (which makes it hard for me to take the CIC’s claims that it doesn’t take controlling stakes seriously; at best that argument only applies to their external investments). And they are managing funds placed with them by the CIC and the central bank, whether through the use of fx as part of their recapitalization, swaps with the central bank or the foreign exchange that they are now likely holding as part of their reserve requirement.

Moreover, I wouldn’t be surprised if some other sovereign investors who previously had been dabbling in credit risk also have pulled back.

The overall story is one where sovereign investors – who now control big bucks – have piled into safe debt and safe assets while shying away from riskier assets. That has kept real rates on Treasuries very low. But it also has contributed to wider credit spreads – and thus a fairly high cost of borrowing for many actors in the US.

I would postulate that if full information was available about the activities of the official sector, the mostly likely conclusions to emerge would be that sovereign investors:

– Helped to stabilize the banks’ capital position, though perhaps they also contributed to a sense among the banks that they didn’t need to take decisive action to clean up their balance sheets.

– Helped to keep long-term Treasury rates stable, and quite low, given the rise in inflation. The fiscal deficits of the Bush Presidency have been financed almost entirely by the world’s central banks.

– Helped to keep the dollar stronger than it otherwise would have been, including against the euro. Reporting central banks bought $117 billion of dollars in q1 2008, and only $27 billion of other currencies — a flow that was heavily tilted toward the dollar when the dollar was under a lot of pressure. Here though it is important to note that institutions that don’t report data to the IMF could have easily overwhelmed the institutions that do report data to the IMF, as institutions that don’t report now account for the majority of official flows.

– Added to instability in the credit markets – and thus hurt the very banks that they – or their brethren — were recapitalizing. Sovereign funds have seemed more willing to buy the equity of banks that are heavily exposed to credit risk than to actually take on credit risk themselves.

– Perhaps added to pressure in the commodities market by buying into commodity funds. Abu Dhabi’s Taqa certainly seems keen on buying oil and gas assets, even though that hardly helps to diversify Abu Dhabi’s commodity exposure. Taqa is a (leveraged) state enterprise, not a sovereign fund. I would not be surprised if some sovereign funds have been dabbling in commodities.

But absent more disclosure on the part of sovereign investors, it is impossible really know. Particularly in a world where the sovereigns that disclose the least are adding the most to their assets.

UPDATE: For an example of an article asserting that sovereign funds have stabilized credit markets, see this Market Watch article.

“The [sovereign wealth] funds played a role in stabilizing the global credit markets over the last six months, injecting more than $80 billion in bank shares or bank-equity stakes in major American investment banks such as Citigroup”

The actual amount committed to US banks and broker-dealers is more like $40b — not the $80b mentioned in the article. I don’t even think adding in Barclays and UBS would quite get you up to $80b. But $40b is still a substantial sum, and putting capital in a bank allows it to support a larger portfolio of risky debt. However, evaluating the overall impact of sovereign funds (and more importantly all sovereign investors) would require looking at how sovereign investors have acted directly in the credit market, i.e. have they retreated from credit market risk.

John Jansen also reports that Agencies remain well-bid, and that Russia’s decision to cut its Fannie and Freddie holdings is atypical.

43 Comments

  • Posted by shrek

    There clueless just like all governments. The private sector is always the best allocator of resources. China deserves alot of blame for the current mess and I have zero sympathy for losses they are going to take. They should not be allowed to do what they are doing with there currency. Its causing way to many distortions and risks eventual confrontation.

    Wanna bet stocks rally for another week and rates blow out causing SWF to be on the wrong side?

  • Posted by Dave Chiang

    Shrek,

    Funny how when the AAA-rated US Subprime mortgage fiasco exploded across the mainstream US Business media, all of the talking heads on CNBC were talking about the trillions of dollars in losses the Chinese were going to be forced to writeoff. It’s as if just wishing the Chinese were the major investors in US subprime garbage would somehow make it true. Well it turns out that US Investment banks, Hedge Funds, and European banks were the primary holders of the US Subprime garbage. The state-owned Bank of China retained the largest exposure to US Subprime garbage with $9.7 billion of securities, the most of any Asian company. The Bank of China operates an ethnic banking retail operation in New York and San Francisco Chinatowns. The other state-owned Chinese banks don’t have any significant exposure to the US financial markets since they aren’t chartered to operate any banking operations in the United States. The Chinese aren’t losing their shirts from the US subprime mortgage meltdown. The Bank of China declared a writeoff of 90% of the $9.7 billion of US mortgage securities. Case closed.

  • Posted by bsetser

    dc — the chinese banks collectively held about $195b foreign securities (and perhaps more), with data suggesting at least 75% were in the US. I am not sure what exactly they held, but they held something — there peak total exposure was at least $150b.

    your broader point tho is true. Most “chinese” holdings are still treasuries and agencies and those claims haven’t taken the kind of hit associated with the most risky mortgages/ CDOs based on mortgages. that said, China’s real risk isn’t credit risk but currency risk — and they have a ton of that/ are poised to take huge losses there. I wouldn’t brag too much about China’s ability to steer clear of subprime; The pboc’s dollar assets are gonna be much smaller than its rmb liabilities.

    But we should get back on topic — i really want this post to generate a discussion of sovereign flows and investment strategies, not a debate over China’s broad policy choices

  • Posted by s

    Agree with shrek. This ends badly, very badly for the US. The Sov are doing the same thing that the banks are doing: forstalling writedowns, closing their eyes and hoping that this is just a passing storm. Don;t think we get back to the abnormal consumerism for development arbitrage. Butr so long as the US can print money and the RoW suckers buy it the game can go on. This fantasy will come to an end as well. Qestion is when. But with treasury suggesting a 50 year bond, it should bring into focus the long term issues facing the US. No easy way out here, other than vastly lower living standards.

  • Posted by anon

    “the argument that official investors (notably sovereign funds) have played a stabilizing role in the subprime crisis”

    What’s the definition of “stabilizing”?

    And who’s making the argument?

    And why would the judgement be based on share of official flows? It should be based on share of problem resolution – e.g. share of bank capital issues.

  • Posted by s

    Excellent question on stabilizing? I would argue that the propping of I banks per Fed Facility (cheered by ECB with its own version), the Japanese ZIRP policy and the Chinese Currency regime are all part of the destabilizing policies that got us here. Deploying the spoils of this perverse regime misses the point, no?

    In the context of the current system, the SOV have played the mission critical role by buying Treasury paper in support of the deeply flawed fiat regime. That said supporting a bank’s reserve build or ibank capital injections is really beside the point. Propping up an unstable credit creation machine doesn’t fix anything. it merely pushes the horizon. If said Ibank closed tomorrow, debt would be liquidated and losses apportioned. Credit would contract to a more normal cleanse level. The bankers, top the extent there is need, would restart the next day at Newco. Bank failure follow a similar cleansing process, which is natural. The system has become so perverse that the natural is now viewed as a 6 sigma event.

  • Posted by Dave Chiang

    http://www.financialsense.com/editorials/engdahl/2008/0722.html
    The steps taken by the Bush-Cheney Administration to encircle Russia with a new Iron Curtain of NATO member states, including strenuous efforts to push Ukraine and Georgia into NATO, and to establish an advanced nuclear missile defense system which, from a standpoint of military strategy, far from defense, puts the world on a hair-trigger to nuclear holocaust in the few years ahead.

    Russia asks that the West recognize the inevitability of the rise of non-Western powers such as especially China and cease trying to block their ascent by sabotage and military action such as occupation of Iraq and key oil sources.

    Perhaps the most bold and most obvious, Medvedev proposes reshaping the present failed global economic order that was built up after 1944 around a US-dominated International Monetary Fund as a de facto neo-colonial weapon of securing cheap raw materials and imposing North dominance on Africa, Latin America and Asian nations. He proposes instead the North share some of its gains with the South before it is too late.

  • Posted by bsetser

    many have been making the argument that sovereign funds are stable long-term investors who have contributed to crisis resolution through the purchase of shares in troubled banks; it is almost standard in any statement about sovereign wealth funds.

    the definition of stabilizing used in the fx side is buying (relatively) more of what is going down, i.e. a policy of maintaining a constant dollar porfolio share means buying (more) dollars when the $ is going down.

    I would settle for not selling assets whose value is declining… i.e. not acting like a leveraged forced seller. Russia’s sales of Fannie and Freddie are clearly not stabilizing.

    and my argument is that looking at bank capital issues is a bad way of judging the share of “problem resolution” because the problem is broader than undercapitalized banks — it also includes illquid/ disfunctional credit markets. My guess is that sovereign funds have been significant contributors to total bank capital raising (especially if their indirect contributions via investment in PE firms and the like are counted … ) but sovereign investors writ large have added to credit market distress, as they have a ton of money and have either been not buying credit risk or have been net sellers. so in a sense my core argument is that “problem resolution” is a lot broader than bank recapitalization. judging the official sector’s overall impact on the basis of bank capital raising leaves out too much.

    there is also an argument that prepetuating an unsustainable arrangement is long-term destabilizing even if it is stable in the short-run, but i’ll set that aside.

  • Posted by shrek

    markets need to be the domain of the private sector. China and SWF are too government dominated and cannot allocate rseouces efficiently enough. This whole system is so out of whack that at some point its going to fail.

    There are too many government and close to government players that are preventing private players from allocating resources.

  • Posted by shrek

    Dave,

    There is no power struggle or geopolitical risk with China. How can there be when the Chinese are financing the US government?

  • Posted by anon

    “many have been making the argument that sovereign funds are stable long-term investors who have contributed to crisis resolution through the purchase of shares in troubled banks; it is almost standard in any statement about sovereign wealth funds.”

    I think they have contributed. Some may trade their positions. That’s allowed. But others like Temasek had the foresight even to be able to up the capital ante on reasonble economic terms – i.e. yesterday’s Merrill issue. That’s a reasonable approach and contribution to financial stabilization.

    European banks have taken 50 per cent of the subprime write-offs. SWFs have probably contributed new capital in line with that.

    But I don’t think stabilization means that official flows have to recapitalize the entire world or take on outsized positions in credit risk in order to reinvigorate a moribund US economy.

    The imbalances issue itself is larger than the subprime crisis. And easy fed policy was more responsible for the criminality of subprime “teaser rates” than foreign bond buying.

  • Posted by fatbrick

    There are too many government and close to government players that are preventing private players from allocating resources.
    ——————————————-

    Well, tell that to subprime debt issuers.

  • Posted by Sam

    “Such portfolio investments rose from about $125 billion at the end of 2005 (and a bit under $90 billion at the end of 2003) to a peak of around $195 billion in q2 2007 (with most of the increase coming in 2006)”

    More evidence of China buying high, at the top of the credit market, and selling low (not buying now). China has incurred tens, perhaps hundreds, of billions of losses on currency risk that cannot be managed efficiently due to the closed capital account. The currency risk would not exist if USDCNY could go lower as it should solely based on the terms of trade vis a vis the US. I can assure you that China has also lost billions on MBS securities; investment banks have had Chinese-speaking salespeople selling US agencies/MBS for years just as LVMH has Chinese salespeople selling LV bags. Most currency trading desks now call SAFE “the bank that likes to say yes”. The negative gamma position on these securities alone has resulted in billions of losses, much less the spread widening we’ve seen this year.

    As far as SWF’s being a stabilizing force, it is an interesting question. It’s not levered money so it’s less subject to mark to the market constraints that hedge funds and banks have to deal with. However Japanese banks mark on an accrual basis and there was no shortage of distress there in the late 90s early 00s. i do know that some SWF’s sell volatility often, but im not sure I would call that stabilizing. Moreover, I’m continually amazed at how non-transparent some of these guys can be when they routinely abuse liquid markets. Ask a EUR FX dealer what they think of China as a fair counterparty, or an Eastern European FX trader what they think of Russia as a trading partner. But it’s a fascinating question, unfortunately I think we lack the data and it’s likely too early to determine.

    It says a lot about China’s FX policy that they continue to assume these risks while infrastructure and development needs would be much more sustainable and economically viable investments than funding US excess consumption while assuming tremendous currency risk. So again I ask, If China does nothing out of benevolence for foreigners (its historical record) and is upset with US meddling in its own affairs, then why does it continue to do sanction the existing, antiquated monetary arrangement of vendor financing? It must be in their interest for some reason, on which our resident China expert Dave Chiang has yet to edify us. I’m wise enough to understand that I have no clue why they do, unlike DC or Bloomberg News

    Shrek – agree completely that private sector allocates capital much better than public.

    DC – “The Bank of China declared a writeoff of 90% of the $9.7 billion of US mortgage securities. Case closed.”
    How is China’s investment in Blackstone doing these days? Buffett sold his massive Petrochina stake in Sep and October at the highs.

  • Posted by don

    A point made by DC in an earlier post brings to mind the question of the weight of Japanese investments in all of this. In my view, the exuberance of the yen carry trade is in no small way dependent on the implicit guaranty that Japanese authorities stand ready to limit yen appreciation. These flows are huge in the overall global picture and I wonder where they have been directed. They surely play a role is the overall U.S. trade deficit.

  • Posted by bsetser

    don — i agree that the expectation of the intervention by japan’s government plays a role in the yen carry trade. but even if you take the maximum flow from the yen carry trade (say the entire Japanese current account surplus), it would produce flows in the $200-300b range, far less than China’s flow or the oil surplus.

    the us data isn’t picking up big inflows from japan, which is indirectly evidence of a carry trade intermediated through private institutions in london and the carribbean. but i would bet that the yen carry trade is proportionally more important for the aussie dollar and the kiwi than for the US. just a guess tho. the dollar is no longer a “high carry” destination currency.

  • Posted by Dave Chiang

    “I can assure you that China has also lost billions on MBS securities.” – Sam

    In your wet dreams, the China Central Bank has lost billions on subprime MBS securities. The Chinese Central Bank isn’t a high-rolling US hedge fund. With direct oversight from the State Council, the Chinese government agency only purchases the highest quality US Treasury bonds and GSE mortgage backed securities (ie. Ginnie Mae, Fannie Mae, and Freddie Mac). If you truly think the China PBoC operates like a Chinatown street vendor selling counterfeit Gucci bags and pirate DVDs, you are truly dimwit that knows absolutely nothing about China.

  • Posted by bsetser

    sam — i would be interested in more details about the SWFs selling vol — either here or via email (bsetser at cfr dot org).

    and you are right that eur fx guys have a view on the impact of SAFE on the market ..

    the core thesis for why sovereign money could be destabilizing even if not geared (and in some sense the pboc is geared, as it has large domestic liabilities, but in some it isn’t as it has infinite capital) is that they have a very high degree of loss aversion. credit loss that is — currency risk they take, but lending a dollar out and not getting a dollar and change back is often a big problem.

  • Posted by s

    Brad

    Could you comment on krugman’s comments in response to the Rogoff piece. Seems to be saying that tighter fed policy is not the same as breaking BWII. Don’t the 2 roads lead to the same place?

    Krugman blog: http://krugman.blogs.nytimes.com/2008/07/30/the-rogoff-doctrine/

    “Dollar bloc countries have slavishly mimicked expansionary US monetary policy”

    and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

  • Posted by Dave Chiang

    “How is China’s investment in Blackstone doing these days? Buffett sold his massive Petrochina stake in Sep and October at the highs.” – SAM

    The China CIC investment in Blackstone is a long term investment just like the investment in the Visa IPO charge card corp. The Visa IPO netted the China CIC a several billion dollar profit. No one has a crystal ball to see tommorrow’s closing share price. Although I personally disagree with the Blackstone equity investment, the Chinese government obtains a wealth of knowledge, expertise, and high level political connections from Blackstone for overseas acquisitions of corporations around the world. For instance, the recent 100% takeover by China SinoSteel of an Australian Iron Ore reserse company. In regards to PetroChina, with $250 billion market capitalization as the world’s 3rd largest energy corporation after Exxon and Petrobras, Warren Buffett’s former holdings in the stock amount to pocket change.

  • Posted by Sam

    DC – one, I never compared PBoC to a street vendor. two, MBS securities are inherently short vega (implied volatility) and long a risk premium over treasures. Fixed income delivered volatility has crushed the short vol position and the spread widening over treasuries has burt even the highest rated Agencies and MBS. [EDITED by BSETSER, PLEASE REFER TO ARGUMENTS NOT PEOPLE].

    bsetser – the vol sales come as part of a position that they like to get into. for instance, if they sell a put on the S&P when volatility is high, then they hope to collect the premium. However, they also know that they are happy to buy the S&P at those levels (selling put means someone has right to sell to you at a certain level). So if the S&P crashes through and causes the put to increase, then they are happy to buy stocks at that strike price on the put. This is much more common in fixed income options than equity, but I suspect it will proliferate as an income producing strategy in most asset classes, including commodities, particularly when they are happy to take delivery of the underlying (Ten year bonds for instance is most common). In fact I would attribute the decline in risk premiums and volatility from 2003-2007 in part from these volatility strategies, except it was done by hedge funds and some of the more savvy asset managers. But as of now, as with most SWF information, the data is non-existent.

    Mohammed El-Erian says in his new book that one will have to understand what SWF’s will buy and what they will sell to really add alpha to investment strategies. I hope to see more work in this vein and get a better understanding of how they operate. However, as it stands now it’s a learning process and likely too early to draw definitive conclusions.

  • Posted by jin

    SAM,

    Basically you mean you really have no data on SWFs, so people would have to take your argument on word?

  • Posted by Dave Chiang

    Sam,

    Fact, the China PBoC only owns US Treasury and GSE issued bonds. Even Brad Setser agrees with that fact. Volatility in the short term fluctuation pricing of the GSE bonds isn’t an issue if you don’t use leverage and you hold to final maturity. For instance, a typical Ginnie Mae bond fully matures in approximately 7 years. The China PBoC doesn’t use any leverage and holds to final maturity of the GSE securities. The China PBoC isn’t a high-rolling US Hedge Fund with extreme leverage you dimwit.

    As much as Western Economist pundits would love to see the Chinese government lose all of their money, the US taxpayer is on the hook to pay back its debt obligations. Comrade Hank Paulson is guaranteeing through federal legislation that the GSE debt is backed by the full faith and credit of the US Treasury and taxpayer.

  • Posted by bsetser

    no one has good data on SWFs, so we are all blind men trying to describe an elephant based on what little bit of the elephant we can touch …

    Sam — interesting. I can heard of central banks using such strategies in the fixed income market (i.e. basically selling insurance v big moves in the market/ big changes in interest rates, hoping to pocket the premium but willing to buy say a treasury at a lower price– and get a higher yield — if needed) but wasn’t aware that they (or SWFs) used similar strategies in other markets. Currencies i can see. But hadn’t thought about equities.

    incidentally, if you are a big buyer of treasuries and are confident that you will keep buying, selling insurance against a big move makes some sense … you are signalling to the market that you aren’t going to destablize it/ stop buying.

    DC — no name calling please.

    SAFE incidentally now owns some equities, is a limited partner in a PE firm and likely has a few other exotic positions that we don’t yet know of …. the bulk of their portfolio is in treasuries and agencies but not all. And I would suspect that they make use of options tho i don’t know that for a fact.

  • Posted by Dave Chiang

    Since Brad Setser now sits on the Elitist Council of Foreign Relations, why not address the “real” source of the global economic imbalances on his CFR blog.

    Insane fiscal policies of the US has budget deficits of 300 to 500 Billion dollars a year. This amount is being financed by foreigners (they are paying for Bush’s idiotic war with Iraq) and have caused them to in turn do equally stupid things in retaliation.

    Not to mention the Fed slashing rates to 1% and fueling a global housing bubble. The point being all central bankers are to blame, but the US is the worst irresponsible offender in the world.

    America’s Joe6pack doesn’t need this “military protection” against the “national strategic threat” of the month club. It is driving up the costs of goods to hyperinflation, it has not saved a single damn job, and gas prices have gone sky high because of all this foreign policy idiocy.

  • Posted by Beau Butts

    Dr. Setser,
    One thing that puzzles me about the Asian/Gulf Suplus countries investment strategies is their fondness for longer term agency debt from Fannie/Freddie as opposed to buying more of the shorter term discount notes from the federal Home Loan Banks. The discount notes have T-Bill length maturities and therefore more liquid while at the same time the risk profile is as good as or better (identical currency risk, and at least so far less credit risk) than the other GSE’s.

    Such a change could undermine stability if it made portfolio changes a more regular occurence but might be beneficial if they ultimately the SWF’s more calm about the credit risk profile.

  • Posted by Sam

    Jian – as BS says, nobody has data on the SWF’s so it’s difficult to surmise what they are doing, how sensitive to market volatility they are, etc. It is not my word, it is what I know and what I have seen SAFE, PBoC, Russia, and the other mercantilist central banks DO in the markets.

    BS – It will be interesting if they begin using these strategies beyond FX and fixed income. Commodities immediately come to mind but liquidity is an issue. But given the proliferation of commodity trading desks and counterparties this decade, sourcing liquidity may not be so cumbersome as it was. I still think US should sell a bunch of $90 crude oil puts and release crude from the SPR (which btw, is one of the most profitable “trades” in history, unlike China now amassing its reserve at a nose-bleeding $125 per barrel, funded by dirt-cheap and currency-subsidized exports) My point is that SWF’s have different time horizons, strategic interests, and leverage ratios than profit-maximizing funds and banks or mark-to-market hedgers. This will open up all sorts of new asset classes, of which selling volatility is one and I suspect alternative energy, tourism, and infrastructure/agriculture will emerge prominently in the next 5-10 years.

    I do believe it’s very early to draw broad conclusions on SWF behavior in terms of how they differ from conventional, profit-maximizing market and economic participants. If the Abu Dhabi pioneer fund is any proxy, then we can expect capital that is attracted to liquidity premiums (illiquid assets), volatility premiums (strategic volatility sales & buying distressed assets), and holding period risk premiums (buy and hold / buy on dip eg Swensen Yale model). And if Abu Dhabi is also any example, then we should expect lots of money to flow into Swiss and Singaporean private banks as unnamed accounts. Maybe it is time to buy UBS after all???

  • Posted by Dave Chiang

    http://www.globalresearch.ca/index.php?context=va&aid=9707

    Controlling China’s economic emergence is an un-stated strategic priority of United States foreign and military policy and has been since before September 11, 2001. The only delicate point in the business is the fact that China, with well over $1.7 trillions of foreign exchange reserves, most believed in form of US Treasury securities, could trigger a complete dollar panic and further collapse of the US economy should she decide for political reasons it were too risky to continue holding its hundreds of billions of US dollar debt. In effect, by buying US Government debt with its trade surpluses, China has been indirectly financing US policies counter to Chinese national interest such as the Iraq war, or even the $100 million or so annually that Condi Rice’s State Department spends on Tibet.

    China is refusing to play by the rules of the Anglo-American neo-colonial game. It does not seek IMF or World Bank approval before dealing with African countries. It makes soft loans, regardless who might be running the country. In this it does nothing different from Washington or London. The Chinese see American influence in Africa less entrenched than in the rest of the world, thus offering unique opportunities for China to pursue its economic interests.

    It may or may not be cynical. It may be Realpolitik. If it results in the ability of certain African countries to use China as a political counterweight to the one-sided Anglo-American domination of the Continent, that itself could be a major benefit to Africans depending on how they use it.

    Clearly, it has been extremely positive for Chinese access to vital economic minerals for its economy as well as oil from places such as Darfur and southern Sudan, or Nigeria.

    Mineral wealth has once more put Africa on center stage of a battle for mineral riches between East and West. This time, unlike during the Cold War era, however, Beijing is playing with far more assets, and Washington with far less.

  • Posted by bsetser

    Sam — I wonder if the whole “I want to be like Swenson-Yale” model is a bit overdone; everyone — us public sector pensions as well as SWFs — seem keen on that model. And there is a part of me that says that not everyone can have the same strategy and succeed. All the SWFs/ public pension funds for example seem enamoured with private equity. But right now the PE funds don’t have access to the kind of leverage they used too, and may not produce the kind of returns that now seem expected …

    just a thought. I would be interested in learning more about ADIA’s volatility selling strategies — and also why you say ADIA (as opposed to the private office of the ruling family) makes use of Swiss and Singapore private banks …

  • Posted by bsetser

    Beau –

    I suspect Russia holds a bit of the Home loan banks’ discount paper. they have the largest short-term agency portfolio of all the big players. lots of bills.

    as for why the others don’t also like the home loan banks, my guess is that:

    a) they want the higher yield that usually comes with slightly longer maturities

    b) they prefer not to have to roll over their portfolio too often (lots of work, not much reward?)

    central banks seem to hold relatively speaking fewer t-bills than coupon paying notes for these reasons

  • Posted by PeeDee

    Great discussion (from most parties).

    Question, being essentially political entities, wouldn’t fuller disclosure of SWF holdings and flows be de-stabilising? If they have to report their losses (or their holdings so others can infer their losses) there would be a powerful temptation to window-dress. I’m inclined to extend them the same courtesy of anonymity (subject to the leakage faced by all market participants) that private investors seek and have. Surely the profit motive is enough to make them counter-cyclical. Publicity could only provide a perverse incentive to look good in the short run.

  • Posted by bsetser

    Peedee = perhaps. But norway discloses and it hasn’t window dressed or shied away from disclosing poor performance, in part b/c it invests in a way that has been ratified by its constituencies. I do suspect (but cannot prove) that SWFs that don’t disclose have tolerated higher volatility in their returns to try to get higher overall returns. but i am not convinced that such a strategy couldn’t be disclosed and approved by the relevant constituencies rather than done in secret.

    plus, a lot of secrecy has a less benign motive — notably in the gulf, many funds i suspect do not want to disclose the size of their US investments b/c it might generate awkward questions.

    all in all, i would assign a higher risk to a world where sovereign funds are big enough to have a big impact on the market but there isn’t enough data to evaluate how they are impacting the market, so everyone ends up quessing.

    p.s. public pension funds in the US and Europe disclose far more than most sovereign funds, and they strike me as a better analogue to SWFs than say a hedge fund.

  • Posted by Rien Huizer

    Brad, excellent piece

    1. like the use of the term “sovereign investor” (“SI”=sovereign investor/investment), rather than a formal one like central bank or a subjective one like SWF.
    2. Stability itself is as we know an elusive concept and discussions about an elusive concept without meaningful data can only be speculative academically or have a rhetorical purpose politically. But I would not know what term to use instead for what you are trying to do. IMF WP 2004/187 tries do shed some light on this but not satisfactorily.
    3. Good to see the small amount of SI used for western bank capital increases put into perspective
    4. Very good to see the antagonistic effects of capital increases and portfolio credit risk reduction highlighted. Apart from the apparent paradox (but the institutions fleeing to quality do not have to be the same recapitalizing the banks) this is also part of the bigger question of possibly (undesirable) interventionist effects in recipient economies Whether it increases stability or not, as a matter of positive international law sovereign states should be able to block unilateral foreign sovereign intervention in their economies if they (academically justified or not) prefer to do so. Intervention of the UBS etc type could very well interfere with domestic market competition, hence should always be in agreement with local supervisor (as appears to be the case with the published purchases). Your phenomenon (antagonistic effects investment behaviour of one investor category collectively) may well warrant special international supervisory attention If the market context is one of imminent systemic crisis, which, in my opinion has ben the case since last Fall. The crisis did not materialize (yet) as a variety of costly measures were taken to postpone some of the problem areas from snowballing. In an imminent crisis it should not be left to a -possibly opportunistic- sovereign investor to pick his own favorites and possible ruin the asset market for the remaining competitors, more or less as a hedge fund might do if it had the resources and the opportunity.
    5. This subject (what is (the effect on) (financial) stability (of SI) . Is increasingly important as the stock of financial assets in OECD countries shrinks (secondary market sell off still going on) and especially the stock of financial institutions risk capital (in market value terms). The effect would be that an unprecedented proportion of total capital for investment in the open market economies will be controlled by sovereigns, often from non-democratic countries with weak accountablity and disclosure of government financial activity (empirical work on central bank credibility in authoritarian or post communist-still socialist-dominated countries shows that both the value of credibility to those leaderships and their maintenance is brittle, setbacks can easily lead to abrupt policy shifts). Especially in economies where debt is the major source of finance for investment, from banks, near- banks or well informed specialized securities markets, highly levered control investments in the banking system on the psrt of an authoritarian sovereign would be unacceptable, whether manifested as a CB, a SWF or a state conglomerate (a la Temasek or possibly CIC in the future) This especially since governments in general lack the skills to evaluate credit risk and allocate credit efficiencly.
    6. A note on he Singapore Inc investments in UBS, Citi and Merrill Lynch (in addition to its very large stake in Standard Chartered and several Indonesian banks) (a) those investments tend to be in the form of interestbearing (but risky) ad hoc instruments rather than marketable stock (which makes loss observation difficult) (b) they appear to fit into Singapore’s developmentalist stragegy to become the premier private banking and asset management centre in Asia (it already has the strongest bank secrecy features of any developed country)
    7. A final issue is the use of the epitheton “sovereign” for the GCC states. Of course they are sovereign states in the legal sense, but their wealth is family wealth, not very different from, say a Li Ka Shing in Hong Kong, except that mr Li does not have to pay for armed forces and that the prdators he faces are quite different.. But anyway, I would definitely leave the GCCs (especially the small ones) out f general discussion of financial stability. For all practical purposes they seem to behave exactly as very wealthy private (or possibly, :”charity”investors

  • Posted by a

    Maybe the U.S. has thrown a head feint? Making it seem like Agencies are risky so that foreigners pile into Treasuries, only to have the U.S. government take on trillions of new obligations so that Treasuries become far more risky.

  • Posted by aim

    When any institution controls alot of money it can really move markets. As big investors, sovereign investors are only stabilizing if they diversify their investments. I think there is alot of evidence that they don’t do this effectively. So they end up piling into positions and causing de-stablizing bubbles. Like the current credit crisis.

  • Posted by master of none

    swf are behind latest commodities surge. think about it

  • Posted by don

    Brad –
    Re: 15. Thanks.

  • Posted by flow5

    “Insane fiscal policies of the US has budget deficits of 300 to 500 Billion dollars a year.”

    Indeed, cut the budget deficit. From an economic point of view, only the interest expense is “UNTOUCHABLE”.

  • Posted by bsetser

    Rien — thanks for your comments. Most appreciated. To be sure, the evidence that the impact of “sovereign investors” has been antagonistic (nice word), as risk reduction in parts of some sovereign portfolios has offset some funds decision to recapitalize big institutions is anecdotal/ partial. complete data isn’t out there — which is my main point. And absent more data, we shouldn’t assert that sovereign investors have been stabilizing. Forcing sovereigns to act as stabilizers in a systemic crisis is hard, but it shouldn’t be impossible to get agreement that sovereigns should supply someone (like the IMf) with data that can be aggregated.

    As for whether the Gulf funds are “sovereign funds” or the personal funds of the ruling family, the evidence is mixed. Qatar’s PM and foreign minister is also the head of the QIA and runs a big private porfolio. his personal fund put money into Barclays along with the QIA. Dubai’s sheik Mohammed runs the Dubai sovereign funds and his own private investment vehicles. ADIA supposedly is the funds of Abu Dhabi, but the Al-Nayhan family has its own private office as well. No doubt the various members of the Al-Saud family do as well. My sense is that these distinctions matter in the respective countries, though ultimately the same folks control both the SWF and their private funds.

    i do suspect though that the prototypical Gulf SWF looks more like a private office of a very wealthy family in terms of its governance, disclosure and risk profile. Norway looks more like classic public money.

    master of none/ aim — note that “diversification” into a new asset class (like commodities) could contribute to instability in that asset class if the flows are large. There is also a debate over whether commodity funds demand for “paper” commodities contributed or not to the rise in real commodity prices. I go back and forth on that.

    Thanks for a good discussion; it helped me

  • Posted by anon

    A few humble comments and a question…

    1. A note about transparency to sam’s important suggestion that SWF express views through vol trades.

    Norway is the gold standard of disclosure – yet they are highly sophisticated users of derivatives and as far as I understand, are not required to disclose derivative positions. If in theory, for whatever reason, Norway wanted to take positions using any instrument other than underlying debt or equity, it could move or dominate a particular market or pose a systemic risk, and could do so without breach of disclosure requirements (remember the Icelandic banks?) Transparency and disclosure, while helpful to a certain extent, are no panacea. They might even be misleading and worse, give a false sense of comfort. Worrying.

    It is easy for those sovereign investors who may be ill-intentioned or big risk takers to tick certain disclosure boxes and still make trouble – if that’s what they’re looking to do. It’s not as simple as making a long list at the end of the year of all the equity and debt positions they are long. One can find all sorts of creative ways to express investment views through very large liquid markets using multiple instruments. Better to focus on the “who is ill-intentioned” and “who is a big risk taker” part. I for one am not so worried about Norway. But not because they publish an annual report.

    2. Sam’s point about sovereign investors and leverage is very key. The fact we have anyone who can pony up the cash right now has to be a stabilizing effect. Let’s hope the credit markets come back soon for everyone who dwells in the private sector.

    3. I’m really sorry DC – “Fact, the China PBoC only owns US Treasury and GSE issued bonds” Re: SAFE, for at least several years they were officially able to buy down to AA corporates. They also buy European Sov bonds across currencies, as well as KFW, EIB all the supras and agencies around the world (many incl those denominated in USD), as well a covered bonds…they have to invest all that money somewhere, right? Also Brad is right about recent equity/other purchases. Don’t know about their derivatives positions either tho. Will be highly curious to see how their investment strategy evolves.

    4. Brad – quick question on the “Sovereign funds have seemed more willing to buy the equity of banks that are heavily exposed to credit risk than to actually take on credit risk themselves.” I don’t know how many teams of RMBS,CMBS or CDO specialists reside within various SWFs – my guess is not a lot (tho there is plenty of “talent” floating around these days) but if I were a citizen of Singapore, I’d feel better about an equity investment in an investment bank that is trying to work out of a hole than an investment in blocks of toxic securities I know less about. Leave that to Lonestar. Do you think SWFs should be buying this stuff off the banks right now?

  • Posted by bsetser

    You are right re: Norway and derivatives. Tis an important point that I should have noted. I still think there needs to be more disclosure (At least at an aggregated level) but there are some things that won’t be disclosed. here tho I would note that central banks that subscribe the IMF’s SDDS standard for reserve disclosure do disclose their forward commitments and other derivative positions, so it isn’t impossible.

    On 4) No, not really — mostly because they aren’t in a position to understand it. But i also wouldn’t have bought equity in banks that are holding a big book of stuff that i don’t have the capacity to understand. Basically, if you buy a bank or broker dealer, you bought a lot of exposure to toxic securities.

    Incidentally, some sov. funds are starting to use leverage — QIA, Mudadala, ADIC, Taqa (an SOE with SWF characteristics). And I would be curious to learn more about SAFE’s purchases of AA corps. The TIC data suggests significant Chinese purchases of corps over the past few months. However, the purchases of corp bonds from mid 06 to mid 07 (which were big enough to be noticeable — around $30b) disappeared in the survey — i.e. the survey showed almost no increase in chinese holdings of us corporate bonds between mid 06 and mid 07.

    Anecdotes and the PBoC’s data on the state banks suggests that the state banks turned into net sellers (as noted above), so the recent purchases of corp bonds might be from SAFE — but it is something that I haven’t really been able to get a good grip on.

    Incidentally, I wouldn’t be surprised if thes state banks were buying some of the paper US banks issued to fund their portfolio back when they were buying in 06, not just ABS/ MBS. I would be interested if you have any information on the type of corp bonds various Chinese actors have bought …

    p.s. I presume China can buy covered bonds issued by European banks, not just by various European Agencies .. but correct me on this.

  • Posted by Judy Yeo

    Incidentally, was wondering if citizens in these countries with SWFs had better information upon which they could assess their performances and had a greater say in the investment policies or direction, do you think they will go the way the SWFs have chosen to go in the last year?

    Frankly, brad, the old saying; be careful what you wish for comes to mind.

    Perhaps it’s precisely because they know there is that certain level of tolerance beyond which political pressure sets in that SWFs have had to balance high profile rescue/investments with investment options that reflect the preference for safety?

  • Posted by Rien Huizer

    Judy:

    “political pressure sets in that SWFs have had to balance high profile/rscue…safety”. Are you thinking of political pressure in the SWF’s home country here?. How many SWF countries (except Norway and Canada) have governments that face political pressure on any issue. Or do you mean political pressure from the government to the SWF. But I always thought that SWFs were under the full control of the gvt (which does not preclude disputes between civil servants (in by book anyone who works for the government or a government owned enterprise/agency is a de facto civil servant, unless he/he is a military servant) and their political bosses)? But those disputes are irrelevant..

  • Posted by bsetser

    I am not sure that more transparency would have precluded the rescues; those were large enough that they in effect were transparent (to the chagrin of some investors). I do suspect that SWFs in countries where the government is democratically accountable would have shied away from these kind of investments. the only democracy that participated was Korea (KIC, in Merrill) and, well, they aren’t all that happy now. But i am not sure that this would have been a bad thing — taking in investments from non-democratic countries allowed the management of the big banks to defer some hard decisions/ pay bigger bonuses than they should have at the end of last year, and it probably came at some cost to the United States policy flexibility. i am not convinced that if a big bank/ broker-dealer fails, the us realistically could write down the SWFs equity without causing a political problem. Think about bear if bear was 10% owned by the CIC.

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