Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Where Is this U.S. Recession Already?

by Friday, August 29, 2008

Note: This piece is by Christian Menegatti of RGE Monitor, where this piece first appeared.

So, good news on the real U.S. GDP growth front: 3.3% in Q2 2008. But is it really good news? Let’s dig a bit deeper, maybe past the headlines…

Personal consumption was revised slightly upward from 1.5% of the advanced release (adv) to 1.7%. Not a major change. Notwithstanding the stimulus package consumption failed to stay above 2% (in 2007 it averaged about 2.3%) and continues to grow at the slowest pace since 1991.


Gross private domestic investment was revised upward (from -14.8% to -12%), but remained a drag on GDP contracting at a pace consistent with the one seen in the two previous recessions (1991 and 2001) (the biggest negative contribution to GDP growth in Q2 -1.82%). The improvement is explained by the change in inventories that were less of a drag than previously estimated (their contribution to growth was revised from -1.92% up to 1.44%). Residential investment were basically unchanged with respect to the advance release, (-15.7% versus -15.6%), this is an improvement with respect of an average of about -24% in the previous three quarters.


So, what explains the upward revision? Largely the external sector.

Is this really good news?

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German Government and Business Responses to Sovereign Wealth

by rziemba Friday, August 29, 2008

Note: This piece is by Rachel Ziemba of RGE Monitor, where this piece first appeared.

Last week, the German cabinet approved a new takeover new law which (primarily) would make it easier to block acquisitions of more than a 25 percent stake in German firms by foreign entities not based in the EU if such a purchase might be deemed to pose a threat to public security or order. Sovereign investors especially from Russia, China and possibly the Gulf are likely targets. This is the latest legislation introduced by Merkel’s government which has been trying to put in place an investment review process for some time since the EU overturned the so-called Volkswagen law that limited foreign investment in German companies.  Germany’s renewed process to implement a takeover law were partly triggered in part by a Russian bank’s stake in EADS (see here for a summary)  and past drafts, which could have blocked other EU member states, did not pass EU muster.

German businesses aren’t that happy about the bill even though its thresholds are not necessarily that onerous in comparison to other countries because they fear its sends a protectionist message. Many countries and most G10 nations have a threshold above which deals are assessed for security implications. And in many countries (the U.S. for one the barriers for scrutiny are much lower – 5-10%). Other entities assess for competition policy.

This move is reflective of a move towards greater scrutiny of foreign investment and trade, one prong of a three pronged response to sovereign wealth which also includes pressure on sovereign funds to be more transparent about holdings/risk management and some (very limited) attention to exchange rate management. While concerns of protectionism could of course deter investment, it is the regulatory framework including financial regulation, ease of doing business and profit expectations that influence investment decisions most. But with the economy slowing the politics of foreign investment are heating up.

Thomson notes that Temasek’s bid to take over Shipping company Hapag-Lloyd might be an example of a deal that would produce more scrutiny. The Singaporean government investor is one of several bidding for the company whose workers have called on the government to block the takeover.However others not that it is a container production company not one controlling ports. Given the interest in shipping globally (despite oil prices pushing up transport costs), its not surprising that there is a lot of interest. Ports in the Middle East and North Africa in particular are booming.

Despite the fact that Germany has had less investment from the petrostates (aside from growing trade with Russia and GCC investments in Daimler) – there are clearly some Germany companies seeking out capital or business from sovereign investors, including two that dominated press attention this week.

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Growing Sovereign Wealth?

by rziemba Wednesday, August 27, 2008

Note: this post is by Rachel Ziemba of RGE Monitor, where this post also appears. Many thanks to Brad for letting me fill in again.

Today (August 26) two of the most transparent sovereign investors, the Norwegian Pension fund- Global and Singapore’s state holding company, Temasek reported their most recent investment returns. In Temasek’s case, these were for the year ending in March 2008 and for Norway from the second quarter of 2008. Both reported lower returns than in 2006/7 – which is not surprising given asset price moves in this period.

Reports from these two model funds, which represent two ends of the sovereign wealth spectrum give us some clues as to how other, less transparent sovereign investors might be faring in the current market. In fact, since many such funds appear to have suffered losses, despite the inflow of capital received by oil funds (Brad and I have been working on a paper that presents some new forecasts) might call into question the expected rate of growth of such funds. Furthermore they raise the question of whether the risk management operations of these funds are up to the challenge. Both funds note that they have been beefing up such operations as they expect the credit crisis to persist for some time to come.

How are they faring?

Temasek, which primarily takes large stakes that it manages actively – still reported a fairly significant profit – asset sales offset equity market declines. Yet, it sees the year(s) ahead as more complicated. Temasek’s report noted that 2007 was the first year in the last five in which its returns failed to clear the cost of capital hurdle. And that may only get more difficult in the rest of 2008 and 2009 given that credit costs remain elevated and profit expectations are being revised down in many markets.

Furthermore, it may have become more exposed to riskier assets – ranging from investments in Merrill to other forays into distressed assets. These may have absorbed much of the new capital injected. By increasing its holdings in the financial sector (which now makes up 40% of its portfolio- up from 38% last year), it may be less diversified. Given large investments in Merrill and Standard Chartered, one might actually be surprised that the exposure to financial institutions is so low. Its new purchases were offset by sales of Chinese and other banks in which it booked profits. And its 19% stake in Standard Chartered, one of the best performing global banks- in part because of its exposure to corporate banking in Asia and the Middle East, has been profitable.

Singapore’s holdings in the OECD actually rose in 2007/8, though it continues to up its allocation to Asia ex Singapore and Japan. In this way, like GCC funds it may have actually increased not decreased exposure to the U.S. in light of the crisis. And it may do so in the future.

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Creditors sometimes do get a vote

by Brad Setser Monday, August 25, 2008

I was on CNBC on Thursday – and the planned segment on the role non-democratic governments play in financing US deficits morphed into a discussion of Chinese and Russian Agency holdings. The segment was hyped as “Do America’s creditors own the US” but the actual discussion swerved the other way: America’s creditors now depend on the US government to bail them out of their bad investment in Agency bonds. The implication seemed to be that the US still held the upper hand.

Count me unconvinced.

No doubt any large debtor does have leverage over its creditors.

Moreover, many countries finance the US not because they like US financial assets but rather because they want to hold their exchange rates down in order to support their export sectors.* They certainly haven’t done so for the returns. That gives the US a bit of room to maneuver: the US was able to attract central bank financing even as it cut US interest rates and the dollar slid.

Finally, the sheer scale of the surpluses in the oil-exporting economies and China limits their options. China and the oil-exporters will combine to run a $1 trillion dollar surplus. That implies a $ 1 trillion deficit elsewhere in the global economy. India’s $1 trillion economy cannot support a $1 trillion deficit. Realistically, that kind of surplus has to be offset by a large deficit in the US and Europe. There is a reason why the Gulf’s purchases of US assets almost certainly rose after Dubai Ports World, and CNOOC/ Unocal didn’t stop China from financing the US. Sovereign wealth funds options are a bit more limited that is sometimes claimed — at least at a macro level.

The alternative to large-scale purchases of US financial assets is even larger scale purchases of European financial assets, or policy changes that reduce the surplus of the oil-exporting economies and China.

But the United States isn’t in a position where it can disregard its creditors either. The US now relies heavily on central bank purchases of Treasury and Agency bonds – what I have called the quiet bailout – to sustain its current account deficit. Without that flow, the US couldn’t run a counter-cyclical fiscal policy – and the Agencies couldn’t step up their purchases of mortgages to offset a collapse in the market for “private” mortgage backed securities. America’s creditors couldn’t stop financing the US without provoking a sharp fall in US demand that would damage their export sectors – but the US also cannot avoid a far large contraction that has happened to date without ongoing central bank financing.

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Faltering central bank demand for agencies …

by Brad Setser Friday, August 22, 2008

Central bank holdings of Agencies at the New York Fed have fallen by $9.4b this month (from $981.7b to 972.3b), while central bank holdings of Treasuries are up by close to $28.4b (from $1394.6b to 1423.0 b)

Most central banks hold the bonds the Agencies themselves issue, not the bonds they guarantee. But there is a big exception: China. And China too seems to be scaling back its purchases. In the course of a (good) article on the Agencies, the Economist notes that China was — until recently — buying $5 billion of Agency MBS a week.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks.

$5 billion a month is a large sum: $60 billion annualized. But it seems a bit low to me. The Treasury survey indicates that China bought nearly $100b of Agency MBS between June 2006 and June 2007 (bringing total Chinese holdings of Agency MBS above $200 billion), and Chinese reserve growth has picked up substantially since last June. (Edited from the initial post, see the note below)

Over the last year (think the period after the subprime crisis), central bank holdings of Agencies and Treasuries have increased by $419.5 billion — with a clear shift toward Treasuries recently after a long period where Agency holdings were growing faster than Treasuries. This quiet bailout far exceeds the roughly $35 billion that sovereign funds have invested in US banks. The US TIC captured most of these investments, and its shows $34.2 in official purchases of US equities over the last 12ms, with almost all the increase coming right after the big recapitalizations. The total would be higher if UBS and Barclays are added in — but also remember that many central banks don’t use the New York Fed’s facilities, and some rely on outside managers for even a Treasury and Agency portfolio. Central banks likely added more than $420 billion to their total holdings of Treasuries and Agencies over the last year.*

Americans have long criticized other countries for financial systems that direct credit to sectors favored by the government. Many argued that such directed credit contributed to the Asian crisis. It was inefficient. Countries would be far better off if they let the market pick winners. Or so the argument went.

Yet I think you can argue that the US right now isthe recipient of the largest government directed credit program in the world.

On one end, a private Chinese saver adds to their RMB account at a Chinese state bank. That state bank in turn buys the short-term bills the central bank issues to sterilize its reserve growth, or, put differently, the central bank finances its growing external portfolio by borrowing money rather than printing money. The central bank, having bought dollars in the foreign exchange market using the RMB it borrowed from the state banks, then buys US agency bonds — in effect, directing credit to the US housing market.

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2008 isn’t 1998

by Brad Setser Friday, August 22, 2008

Russia’s reserves fell by $16.4 billion last week.

Data released by Russia’s central bank showed a drop in foreign currency reserves of just over $16.4bn in the week beginning August 8. This was one of the largest absolute weekly drops in 10 years, according to Ivan Tchakarov at Lehman Brothers.

Some of that reflects the fall in the dollar value of Russia’s existing rubles, but Russia’s central bank still likely sold close to $10 billion of foreign exchange to limit the rubles slide.

No one though is that worried that Russia is going to default — or run out of cash. It still has well over $550 billion left in the bank. And with oil trading between $115 and $120 a barrel, Russia should be able to replenish its coffers quickly.

To be sure, capital outflows have put some pressure on Russia’s domestic market, and domestic borrowing costs are up. That may constrain the Kremlin a bit. Charles Clover of the FT writes:

global market sentiment … could end up being an important check on Kremlin decision-making. “The million-headed hydra of the bourgeoisie has sent a signal: ‘change your course, comrades!’” wrote the popular internet columnist Dmitry Oreshkin on in a joking reference to the communist background of Russia’s leadership.

But it isn’t anything like 1998.

At the end of June 1998, Russia only had around $11 billion in the bank — almost all borrowed from the IMF. The United States decision not to support the disbursement of a $5 billion installment on Russia’s IMF loan was enough to leave Russia effectively bust, and to force a default.

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The dollar and the world’s central banks (once again)

by Brad Setser Thursday, August 21, 2008

Macro Man is back from vacation, and I have little to add to his explanation for the dollar’s rebound.

The gap between the United States economic performance and the rest of the world’s economic performance looks set to narrow — which makes the dollar a bit less unattractive and other countries’ assets a bit less desirable. The gap between US rates and other large countries interest rates may fall, as other G-10 central banks start to ease. Finally, I have long been convinced — in part because of a good Goldman Sachs paper on the topic — that high oil prices are bad for the dollar. A weak dollar may also be good for oil, though I am less convinced on that point. I would put it differently: the Fed’s easing was bad for the dollar and it was good for oil, in part because a host of rapidly growing countries with subsidized oil prices followed the Fed and adopted extremely easy monetary policies that helped (for a while) spur oil demand.

UPDATE: Things look a bit different on Thursday than on Wednesday, with oil back up ..

That said, the US external deficit remains far larger than the deficit private investors abroad want to finance at current US interest rates. The June TIC data (released last Friday) was rather weak. Indeed, right now the US is having trouble consistently producing assets the rest of the world wants to buy. But CDOs composed of tranches of mortgage backed securities based on subprime loans practically have to be given away. The stock of US banks and broker dealers hasn’t seemed like such a good deal recently. Foreign demand for US stocks has dipped recently.

Of course, the US doesn’t rely exclusively (or even heavily) on private demand for its debt and equity for financing. In some sense, it cannot. Not when a set of surplus countries’ still have undervalued currencies. The FT leader notes: “global imbalances between the US and currencies pegged to the dollar are not yet fully resolved. A faster appreciation of Asian currencies still makes a lot of sense, as does a re-peg of oil exporters’ exchange rates to a basket of currencies.” The big surplus countries right now — China and the oil exporters — channel almost all of their surplus into their central banks and sovereign funds. The growth in China’s government assets exceeds its (still large) current account surplus. The same was true of Russia in the second quarter (the third quarter may be different). And almost all of the Gulf’s oil surplus is channeled through SAMA and the Gulf’s three big sovereign funds (ADIA, KIA and QIA). The concentration of Chinese and Gulf foreign assets in state hands implies that the buildup of official claims from the surplus countries will play a large role financing the deficits in the deficit countries.

Central banks aren’t quite as keen on Agencies as they used to be. But central banks still are buying a lot of Treasuries.

Macro Man’s notes one additional reason for the dollar’s rally: central banks are not selling dollars for euros quite as rapidly as they once did. He calls this “addition by subtraction.”

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Good news

by Brad Setser Wednesday, August 20, 2008

The IMF seems to be having a bit of a row over how to do exchange rate surveillance.

Why is that good news?

Because it suggests that the IMF actually is trying to do exchange rate surveillance.

That is something of a change. A good one, too.

For too long, the IMF generally took the view that all exchange rate regimes, and all exchange rates, were above average. Or at least above criticism from the IMF.

Any exchange rate regime, or any exchange rate, could be made to work with appropriate supporting policies.

If Argentina wanted to peg — back in the 1998 to 2001 period — to an appreciating dollar even as commodity prices fell and Brazil allowed the real to depreciate, no problem. Tight fiscal policy could produce the real depreciation needed to bring Argentina’s real exchange rate back into balance, or at least restore investor confidence in Argentine bonds, allowing Argentina to finance the deficits associated with its appreciated real exchange rate. If Saudi Arabia wants to peg to a depreciating dollar and have low rates of inflation, it can — so long as it tightens fiscal policy. No matter that fiscal tightening would push up Saudi Arabia’s surplus, and thus impede global adjustment. And no matter that fiscal tightening would have significant implications for the distribution of the gains from higher oil prices internally, as it cuts off a key channel for broadly sharing the oil windfall. Those with fixed riyal salaries have seen their real external, and in some cases domestic, purchasing power fall.* But raising salaries with a deeply depreciated exchange rate would be inflationary.

So long as the IMF focused on the policies — usually fiscal tightening — the IMF thought necessary to make a country’s chosen exchange rate work, it could avoid getting into a fight over whether a country’s chosen regime was appropriate for its circumstances or, perhaps more importantly, an impediment to global adjustment. That left the IMF in its comfort zone (making recommendations about fiscal policy). But it also meant that the IMF more or less stood on the sidelines as a set of countries pegged to a depreciating dollar despite large and often growing external surpluses.

The IMF is now looking more closely at exchange rates. That makes some uncomfortable. And — as is often the case — matters of great importance get reduced to matters of process. In this case, the IMF’s process for doing exchange rate surveillance.

After spending a bit of time trying to read between the lines of the IMF’s latest report on exchange rate surveillance, I would bet that there is disagreement on at least four points.

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by Brad Setser Monday, August 18, 2008

Agency spreads have widened. See John Jansen for all the gory details.

The New York Fed’s custodial holdings of Agencies haven’t grown at anything like their typical pace over the past few weeks. In the first two weeks of August, custodial holdings of Agencies fell by $6.7b while custodial holdings of Treasuries rose by $24.7b.

And — via Yves Smith — comes word that foreign central banks have been a bit more reluctant than usual to buy the debt the Agencies issue to refinance their retained mortgage portfolio. Lynn Adler of Reuters writes:

Overseas investors took an atypical back seat in Fannie Mae’s three-year note sale this week.

Central banks bought just 37 percent of the $3.5 billion issue, down from 56 percent in May’s $4 billion offering of the same maturity. Asia accounts took just 22 percent of the notes, down from 42 percent in May. “Most fixed income investors to whom we have spoken believe that a capital infusion by the government into Freddie and Fannie is a prerequisite for turning sentiment around in mortgage-backed securities and, by extension, in the broader fixed income markets,” Barclays Capital analysts Rajiv Setia and Philip Ling wrote in a report The longer the debate drags on, the more tentative foreign interest in the sector is likely to become. Even though the GSEs are adequately capitalized, investor confidence has been shaken,” the analysts wrote. “A slowdown in international investor interest remains the major risk factor for agency spreads, in our view.”

No wonder there is a lot of interest in Asian (read “central bank”) demand for Tueday’s Freddie Mac auction.

The Treasury’s bailout plan for Agencies sought to retain the Agencies current “hybrid” structure, one where the Agencies continued to be privately owned even as they borrow in the market at (relatively) low spreads based more on the expectation that they are too big, too important and too Chinese to fail than on the strength of their balance sheets. Larry Summers noted: “almost every outside observer agrees that pre-crisis, the GSEs could only borrow because of their implicit government guarantees. Since the crisis their position has sharply deteriorated, and will deteriorate further.” The Treasury’s plan hinged in the first instance on strengthening the perception that the US government stood behind the Agencies rather than strengthening the Agencies actual balance sheets. And with ongoing deterioration in the housing market — and rising losses on Alt-A mortgages, it seems like the world’s central banks aren’t buying it.

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