Brad Setser

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The flight from risky US assets

by Brad Setser
September 16, 2008

It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right.

It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.*

That would normally make it hard to sustain a large current account deficit. The US still needs roughly $60b a month in net inflows to cover its external deficit. Net sales of foreign assets of $32b provided some financing — but not nearly enough to cover the outflow of short-term funds. $75b in net outflows isn’t exactly a good sign, even if the dollar’s rebound suggest more flows (perhaps from large US sales of foreign assets) in August.

The same basic trend is apparent in the data for the 12ms through July 2008, which can easily be compared to the 12ms through July 2007 — think pre-crisis and post-crisis.

After the crisis, foreigners have bought roughly:

$350b of long-term US treasury bonds, and another $125b of short-term bills — for a total of $475b of US Treasuries. That explains how the US has financed its fiscal growing deficit. Foreigners also bought around $150b in Agency bonds, $210b of corporate bonds and $55b of US equity ($20b excluding the SWF capital injections into the banks and broker dealers).

Before the crisis, foreigners bought roughly:

$205b of long-term Treasury bonds (and reduced their holdings of bills by $10b), $285b of long-term Agencies, $540b of long-term corporate bonds and $210b of US equity.

Notice a trend?

Sovereign wealth fund flows into equities clearly have been trumped by a broader retreat from risk, including a retreat by sovereign investors.

There are a couple of other important swings in the data.

US investors dramatically reduced their net purchases of foreign assets. US net purchases fell from $280b to $95b. That helped. US capital outflows have to be financed by capital inflows.

And US banks dollar liabilities fell by $400b — producing a huge net outflow that offset much of the inflow.

As a result, net “TIC” flows for the last twelve months are only $210b — well below the current account deficit. Some of that gap could be covered by net FDI inflows, but in general FDI inflows and outflows match up pretty well, so it is hard to see that large an inflow from FDI. The remaining gap is an error term — we simply don’t know what all is going on.

That net flow can be broken into a $67.7b net private outflow (counting short-term flows) and a $277.8b net official inflow.

Two points here:

The US data consistently understates official inflows. We know $280b is too low for a host of reasons — not the least the fact that the Fed’s custodial holdings increased by more. The past “survey” revisions have consistently revised official flows up and private flows down. There is no reason to think that this has changed. Indeed, the past revisions would suggest the entire $260b in “private” purchases of Treasuries over the past 12ms in the TIC data are likely official inflows, and that the $90-95b in private purchases of Agencies are too. If those flows are allocated, the net official inflow is over $600b — and the net private outflow is correspondingly larger.

The US data doesn’t seem to be capturing all the flows associated with the unwinding of the shadow banking system. That at least is my perception. I don’t have any other good explanation for the gap between identified flows and the US deficit.

Now to the country data.

I found one country with large reserves that added to its long-term Agency holdings in July: Hong Kong. Everyone else was a net seller. China, Russia, the Gulf (“the Asian oil exporters”), Brazil, Korea, Singapore, and Japan. So was the UK — which likely indicates a further fall in official demand. The TIC data indicates a huge reallocation by official investors from Agencies to Treasuries — and a far larger reallocation than showed up in the FRBNY accounts.

Let’s look at five specific countries where central banks and sovereign funds typically generate a sizable share of the flow.

China added $20.4b to its short-term holdings and Treasury portfolio, while cutting its holdings of long-term agencies by $3.4b. That strikes me as a flight from risk.

China was still buying US corporate debt in July, but in smaller amounts than in previous months. This isn’t a flow I understand well. Chinese purchases of corporate debt have increased recently — and that presumably has driven the rise in overall “official” purchases of corporate debt. But there were also substantial Chinese purchases from mid-2006 to mid-2007. The mystery: these flows weren’t match by a rise in stocks in the survey data. Count me confused.

The Asian oil exporters (i.e. the Gulf) added $7.5b to its short-term holdings, and another $0.8b to its long-term Treasuries — for a “flight to safety” flow of $8.3b.

China and the Gulf account for a large share of the global surplus, so their flows matter.

Russia cut its long-term agency holdings by $0.4b while adding $3.1b to its long-term Treasury portfolio. It also added $5.7b to its short-term Treasury holdings while cutting its holdings of other short-term securities (think Agencies) by $4.4b. One great irony in the data is that in the month before the conflict with Georgia broke out, Russia provided $8.8b in net financing to the US Treasury. Recent pressure on Russia’s reserves at least has eliminated that bizarre flow.

Korea — which many claimed might be running out of liquid assets — seems to have reduced its Agency holdings far more rapidly than its Treasury holdings: its long-term Treasury portfolio fell by $1.1b, its long-term Agency portfolio fell by $3.6b and its holdings of corporate debt fell by $1.4b. That strikes me as sound liquidity management; it didn’t sell off its most liquid asset first.

Finally Singapore. Singapore cut its long-term Agency holdings by a modest $0.2b while adding $1.1b to its long-term Treasury holdings. But the big story in the data is that it sold $5.2b of US equity. There is no way to know for sure that these sales came from the GIC or Temasek, but it is certainly possible that they did.

All in all, I saw a lot of evidence of a sovereign flight from risk at a time when the market for risk assets was under stress. At the global level. And at the national level.

I’ll try to flesh this out with a few charts later.

* One data point. The detailed data for Agency purchases here doesn’t seem to match the summary data. I used the detailed data. Agency data should be adjusted for ABS repayment, but that adjustment is complex and it doesn’t affect the basic trend, so I reported the unadjusted number.


  • Posted by euro

    Nice summary, Brad:

    But what about that:

    Ring Fences, Rustlers and a global bank insolvency
    In this week which has seen so much speculation on the fate of Lehman Brothers, it seems only sensible to review how an international insolvency of a major bank works and what it might mean for international creditors. The insolvency treatment of international banks has remained one of the stubbornly difficult areas of law to harmonise and huge uncertainty and complexity remains. For excellent background, see Cross-border bank insolvency by Rosa Maria Lastra of Queen Mary, University of London.

    Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local. The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest. Europe has managed to harmonise cross-border insolvency for banks under directives and local law to embody principles of universality and unity within the EU, but that only works equitably if enough assets are in the EU when the bank fails, and local insolvency law still applies in all its divergent complexity.

    Claims against a bank are deemed located wherever the contract creating the claim is undertaken. If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery. If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.

    The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own. As the US dollar is the reserve currency of banking and US Treasuries, Agencies and other assets are the highest preferred asset class, the US is almost always in a good position in an international bank failure.

    The principle of using local assets for local recovery is known as the “ring fence” – the idea being that insolvency drops an invisible “ring fence” around any valuable assets at the borders to meet claims arising within the borders. No country is more assiduous in weaving the ring fence than the United States of America. It is a very successful strategy for US creditors. US creditors of failed international banks tend to recover disproportionately relative to creditors anywhere else. The ring fence contains all these choicest assets for US creditors, and all the international creditors are forced to pick among the dross of foreign assets to eke out a recovery, only receiving any residual US assets remaining after US creditors get 100 percent recovery.

    Lehman has been deeply troubled and subject to speculation since the early spring. That was just about the time that we started to see a marked sell off in foreign markets where Lehman has long been a major player. Recently, along with intensification of that sell off, we have seen a strengthening of the US dollar and US asset markets.

    If one were cynical, and one believed that Lehman was going to be allowed to fail pour encouragement les autres one might wonder if Lehman was quietly bidden – or even explicitly ordered – to sell off its foreign holdings and repatriate the proceeds to asset classes within the US ring fence. This would ensure that US creditors of Lehman received a satisfactory recovery at the expense of foreign creditors. It would also contribute to a nice pre-election illusion of a “flight to quality” as US dollar and assets strengthened on the direction of flow.

    If one were really cynical, one might even think that a wily bank supervisor might arrange to ensure 100 percent recovery for its creditors with a bit of creative misappropriation thrown in the mix. Broker dealers normally hold securities and other assets in nominee name on behalf of their investor clients. Under modern market regulation, these nominee assets are supposed to be held separately from a firm’s own assets so that they can be protected in an insolvency and restored to the clients with minimal loss and inconvenience. Liberalisations and financial innovations have undermined the segregation principle by promoting much more intensive use of client assets for leverage (prime brokerage and margin lending) and alternative income streams (securities lending). As a result, it is often very difficult to discern in a failed broker who has the better claim to assets which were held to a client account but reused for finance and/or trading purposes. The main source of evidence is the books of the failed broker.

    On the wholesale side, margin and collateralisation in connection with derivatives and securities finance arrangements mean that creditors under these arrangements should have good delivery and secure legal claims to assets provided under market standard agreements. As a result, preferred wholesale creditors could have been streamed the choicest assets under arrangements that will look above suspicion on review as being consistent with market best practice.

    If Lehman were to go into insolvency, I will be interested to discover whether US creditors achieve a much higher proportion of recovery than their global peers in other locations where Lehman did business. If so, it will likely be because of the US ring fence and the months of repatriation of assets and funds back into the confines of the ring fence before the failure was finally orchestrated. It will also be because the choicest assets were preferentially delivered to preferred US creditors under market standard margin and collateral arrangements.

    Unfortunately, the pace of an international insolvency means that any retrospective evaluation will be so far down the road that I will likely be almost alone in looking backwards to see what the final distribution effects are and what they mean for equitable principles of international banking practice.

  • Posted by euro

    Or that:

    Russia authorities halted trading on the country’s stock exchange on Tuesday after it plunged 17 per cent in a broad-based sell-off.

    At 1700 local time, the rouble-denominated Micex index had fallen 17.5 per cent to 881.17 and the RTS index dropped 12 per cent to 1,131.120 as the falling oil price, margin calls on local investors and a broader sell-off in emerging markets stocks drove shares down.

  • Posted by euro

    Or just oil price!

    No words!

    It’s not just Team 1250 working hard, it’s just USA’s corruption, in your face!

  • Posted by euro

    Could you explain that:

    US Considering AIG “Conservatorship”

    The U.S. Treasury is considering taking over American International Group Inc. under a conservatorship as one option to address the insurer’s crisis, according to two people briefed on the discussions.

    Executives from AIG, bankers and Treasury and Federal Reserve officials are meeting today on the company’s situation at the New York Fed. A number of options are under being discussed to fill a shortfall of $75 billion to $100 billion in funding, one of the people said. The talks are continuing, he said.

    Goldman Sachs Group Inc. and JPMorgan Chase & Co., which have been leading efforts to find a private-sector solution, informed the Fed that such an effort would be difficult, the person said. Under another option, the Fed would extend a loan to New York-based AIG, according to a person informed of the matter.

    Explain it out of printing, if you dare!

  • Posted by Cedric Regula

    Aye Ca rumba, Happy Hank is going to have to sell lots and lots of treasuries.

    We all know Uncle Pedro doesn’t raise taxes and doesn’t print money.

  • Posted by Cedric Regula

    Here’s a brief take from a Forex analyst on the post LEH & AIG & whomever else impact on the currency markets. Raises the issue again if it will be good selling for tresureals if everyone can figure out that the currency has to devalue.

  • Posted by Rachel

    the only sub-part I can’t quite figure out is Kazakhstan – they dropped over $4b in short-term claims and added a small amount of treasuries.
    But if I recall, there might have been more capital injections into the Kazakh banking system back in July.

  • Posted by koteli

    Dear Brad,

    About a couple of years ago, I started to paste links to leap2020 in your and Nouriel’s posts of RGE.

    At the time, Nouriel’s readers were making jokes about millions of foreclosed american households…

    Not now.

    Now a days, things are changing so fast fast that nobody has a clear north. Everything goes south!

    Here’s today leap 2020 post:

    I also posted some links to Jerome a Paris. Here goes a clever one:

    “”Dutch Disease” was a term coined in the 1970s by the magazine The Economist to describe the syndrome suffered by the Netherlands after the discovery of the massive Groningen field propelled natural gas into the driving seat of the economy. The extractive sector became so profitable that it attracted the lion’s share of new investment, and the resulting gas export boom altered the trade balance and boosted the currency, causing difficulties for the rest of an export-oriented economy. And, as with the “oil curse” that has struck other countries, depletion of the resource has since proved to be extremely painful.
    On a larger scale, but of similar nature, is the high-profitability disorder that has, until recently, characterised the financial sector. The biggest single sector in the 2007 S&P 500 market capitalisation index, weighing 7%-8% of US GDP, its share in total corporate profits stood last year at over 40% from below 20% in the 1970s. Net total income growth in recent years has predominantly benefited a relatively small number of people either working directly in the sector or owners of financial assets. In the UK, where the sector’s share of GDP rose to 9.4% in 2006, from 5.5% in 2001, City-dominated London received 50% of total foreign investment. Per capita Gross Valued Added rose by between 8% and 9% over the last decade in London while, in all other regions of the UK, it stagnated or fell. In fact, the phenomenon is so firmly based in the money centers of New York and especially London, that the label “Anglo Disease”, by allusion to “Dutch Disease”, might appear to be no unfair moniker.
    How to describe the pathology of this ailment? Financiers, now unchecked by regulation or restrictions on leverage, can monetize many kinds of future revenue streams today, generating instant profits they and their clients can capture. That capacity to create apparent wealth out of thin air without limit cannot be matched by any other sector in the economy. Unsurprisingly, it sucks in talent, resources and skills that are not available for infrastructure investment or other economic activities.
    Meanwhile, the investors who have made those immediate profits possible still want to ensure that the future flows that underpin them do in fact materialize–and so they will impose their rules and discipline on the underlying economic activity. The result is an unrelenting focus on profits and shareholder value. Struggling to meet “return on capital” criteria, many non-financial activities experience yet further reductions in capital allocation, and relative decline. Meanwhile, public debate is dominated by financial analysts, as “net present value” becomes the standard prism through which to view any human activity.
    Public policy attempts to provide balance are hamstrung by the fact that, from the financial viewpoint, regulations and tax are restrictions on entrepreneurship and profit to be opposed and if possible eliminated. As for labor, return on capital is improved if its cost can be reduced. Outsourcing, offshoring, and labor market flexibility have helped keep wages in check. Hence a major symptom of the Anglo Disease is long-term stagnation of the majority of incomes.
    Flat incomes might constrain domestic demand, but easy credit (to the further benefit of the financial industry that channels it) has buttressed household spending. Expansionist monetary policies in the West have combined with Chinese mercantilism to offer rapid asset price increases with no consumer goods or wage inflation, generating high corporate profits. Global trade imbalances and what was a massive asset bubble created an economy blessed with the appearance of strong, inflation-free growth–an illusion that helped validate the underlying policies, despite rising inequality and ballooning, unsustainable, debt burdens. Starting with subprime lending, but now extending to other financial activities, market players have suddenly become scared by their collective imprudence and have engaged in a brutal process of deleveraging. While the credit crunch devastates bank balance sheets, the wider economy is also suffering. Credit available to businesses is shrinking, and the spigot of house equity withdrawals is turned off for consumers. The reality of declining or stagnant incomes for the majority can no longer be camouflaged. Prospects are dire, and further damage to the banking sector and the overall economy is likely.
    The imbalances will only be unwound, ultimately, if incomes match spending more closely. That can, of course, happen through a consumer spending slump and an inevitably painful recession. The financial wagers and high-priced assets that surfed on a nicely growing economy will, at some point, have to be marked down as losses, as is happening already. The Anglo Disease will face treatment by the kind of drastic purge that threatens the patient’s very life.
    There remains another way: higher wages across the board, and a more modest financial sector restrained by regulators and unable to impose the artificially high return-on-capital requirements made possible only by excessive leverage. Making banking boring again is, compared to the alternative, a fairly gentle cure for the Anglo Disease.””

    Nouriel and you knew where all that was cominh from, too.

    It’s China’s hand the monster’s head, or Japan’s 0 interest rate, or just US of A greed and imperialism, under a fake democracy?

    Best wishes


  • Posted by fatbrick

    Great job Brad.

    I am more interested in 2 things:

    1) US’s net sell of foreign assets. In July there is 32b net sell. Wonder which market is affected most by these selling.

    2) China’s pruchase on corporate bonds. Is there a detailed break down of corporate bonds market? Where can I find the information?

  • Posted by bsetser

    fatbrick — there is no detail at all in the us data on china’s holdings of corp bonds. the detail is all in the survey, and chinese holdings disappear there