I tend to be a bit better at spotting risks than opportunities. I have long worried that China might conclude that it is no longer in its interest to continue to buy ever larger quantities of Treasuries, especially as it buys Treasuries terms that likely imply future losses for China’s taxpayers. But that doesn’t mean that I am among those who are worried that China necessarily needs to slow its Treasury purchases (let alone sell its existing holdings) to finance its fiscal stimulus.

Let me see if I can explain why.

The basic argument why China’s fiscal stimulus could put pressure on the Treasury market is fairly straightforward; just read the FT’s Alphaville.

The US has long financed its fiscal deficit by selling debt to China.

Indeed, the scale of China’s purchases over the last twelve months is hard to overstate. Some work that I am doing with the Council on Foreign Relations Arpana Pandey suggests that China’s monthly Treasury purchases over the last year (really the last 12 months of TIC data, so September 2007 to August 2008) have averaged about $15 billion or month – or just under a $1 billion a business day. And that total almost certainly understates China’s recent purchases of Treasuries. During the last year, Arpana Pandey and I estimate that China bought about $15 billion of Agencies in an average month. However over the last few months China has stopped buying Agencies – and increased its Treasury purchases. As a result, China’s recent purchases of Treasuries could easily have exceeded $15 billion a month.

Looking forward, though, the US fiscal deficit is poised to increase – almost certainly significantly. The Treasury also has to sell bonds to finance the revamped TARP. China by contrast plans to run a bigger fiscal deficit and spend (or so it seems) more at home. Combine those two trends and it seems to suggest that China will be providing a lot less financing to the US just when the US is going to be selling more Treasuries than ever before.

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“Give me yield, give me leverage, give me return” perfectly sums up how Wall Street bought itself close to financial ruin. JP Morgan’s William Winters didn’t just create help to create CDOs. He seems to have a way with words.

During the past few years, the Street bet – and bet big – on two theories in its quest for higher returns.

The first was that housing prices never fell. At least not on a nation-wide basis. That meant that lending against a diversified pool of housing collateral wasn’t that risky, no matter how risky the individual borrower might be.

The second was that macroeconomic – and financial – volatility had been vanquished. That, in effect, meant it was OK to try to improve returns through the use of borrowed money.

Neither assumption proved true.

As the crisis has unfolded, the different ways different institutions had bet on a low-volatility-home-prices-only-rise world gradually became clear. Gretchen Morgenson – in her big Sunday New York Times article– delves into how Merrill Lynch in particular got caught up in the excesses of the boom.

Her article — which included the Winters quote — didn’t just look at Merrill though. She noted that Wall Street was a big buyer of mortgages for its “private label” mortgage backed securities at the peak of the housing boom. Morgenson reports that the Street issued $178 billion of mortgage and asset backed CDOS in 2005 – and an incredible $316 billion in 2006. 2006 was when the quest for yield was at its most intense. Short-term interest rates had been raised. That should have squeezed profits. The fact that it didn’t should have been a warning sign.

It turns out that the rapid growth in CDOs stuffed with exposure to risky mortgages — including “synthetic” exposure from writing credit default swaps on bonds backed by subprime debt* — was facilitated by the broker-dealers willingness to hold more credit risk on their own balance sheets. If you have any doubts, read Gillian Tett’s reporting from over a year ago.

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For the US housing sector – and the financial firms that financed the boom – a bigger boom meant a bigger bust. Home prices rose higher than before — and now are falling fast.

Shipping too. The Baltic dry index rose high on the back of Chinese demand. And recently it has fallen even faster than it rose.

The Baltic index tracks the cost of shipping bulk goods. But it is indicative of the broad contraction in global trade that is almost certainly now underway. No wonder that China is now pondering the risk that its export boom could turn into an export bust. Its export boom was comparable in scale to the United States housing boom. Perhaps bigger – as it also drew on demand fueled by Europe’s housing boom (and, until recently, the RMB’s large depreciation v the euro) as well as US demand.

Whatever the cause, China’s exports have grown steadily larger over the past few years. Indeed, as the following chart shows, it is almost impossible for words to do justice to the scale of China’s export boom.

Yes, the pace of nominal export growth has slowed recently. But that is largely the result of a bigger base – not any major slowdown. Real export growth has slowed more than nominal exports. But real export growth – despite the loud complaints of the textile sector – has remained positive so far this year. The basic story of this decade – at least until now — is of an enormous boom. There isn’t even much volatility.

Particularly relative to say the 1990s. Back then the pace of growth was generally slower and – as importantly — periods of rapid export growth were followed by periods of no growth. This shows up clearly in a chart that looks at the 12m change in exports (exports in the most recent 12ms – exports in the preceding 12ms).

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If oil stays in the 60s — and if China isn’t willing to buy Agencies, let alone riskier assets — sovereign funds are not going to be the kind of force in the global economy that many forecast earlier this year. The investment banks are now busy revising their forecasts for the growth of sovereign funds down.

Nonetheless, sovereign funds are not going to disappear entirely, so understanding their various investment strategies remains important. In my view, the common argument sovereign funds are inherently passive, long-term investors interested mostly in financial returns oversimplifies.

For a recent example of this argument — one that happened to catch my attention — consider a recent column from Bloomberg’s Michael Sesit:

These funds represent the excess reserves of countries with large current-account surpluses and/or major oil exporters. They are overwhelmingly invested outside their domestic markets and so far have been managed passively, without political bias, to achieve enhanced returns.

No doubt some sovereign funds are invested passively and without political bias. Norway’s fund certainly invests passively, and its “political bias” is very transparent. The Abu Dhabi Investment Authority, Singapore’s GIC and the Kuwait Investment Authority all seem to focus primarily on managing a passive external portfolio — though in all three cases a lack of transparency makes it hard to know for sure. The KIA is certainly under pressure to do more to support Kuwait’s own market. The scale of the GIC’s investments in the financial sector also at least raises the question of whether the GIC’s strategic is evolving to include taking strategic states that might help to support Signapore’s own ambitions as a financial hub.

But many other funds invest both at home and abroad. Any many aren’t just passive investors either.

Singapore’s Temasek, for example, originally had some similarities to France’s proposed sovereign fund: it managed the Signapore’s strategic stakes in its large domestic firms. And it clearly takes large strategic stakes when it invests abroad.

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Central bank reserve growth has unquestionably slowed. Indeed, global reserve growth in October was almost certainly negative. But the Fed’s custodial holdings are still rising. That could imply that central banks are moving out of euros and into dollars, reinforcing the dollar’s rise. More likely though it is evidence that central banks are moving out of money market funds and other dollar assets with a bit of credit risk. No central bank wants to be in the same position as the China Investment Corporation. Explaining how you lost money on your safe investments isn’t fun.

The general flight out of risk by central banks is one reason why the Treasury’s bailout of the Agencies has failed to halt the central bank run on Agencies. The flight out of Agencies — and flight into Treasuries — over the past two months has been stunning. Last week continued the trend: central banks added close to $20b to their Treasury portfolio at the New York Fed while cutting their Agency holdings by $7 billion. That helps support the Treasury market amid all the new supply, but hasn’t done wonders for the Agency market.

Just look at a graph — produced by my colleague Paul Swartz of the Center for Geoeconomic Studies — showing the 52 week change in Agency and Treasury holdings.

The world — at least for central bank reserve managers — changed in late July. The rise in their Treasury holdings since then has been nothing short of stunning. Their activities are having an impact on the Agency market too. Agency spreads have stayed wide — despite large purchases of Agencies (at least for while) from PIMCO. Paul Swartz helped me show this graphically but comparing the 3m change in central bank holdings of Agencies at the New York Fed to Agency spreads over Treasuries.

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The US, UK, Eurozone and Japan all look to be in recessions. The US and Europe had been the main drivers of global demand growth – at least for finished goods. That is going to change.

Emerging economies that relied on a commodity windfall to support higher domestic spending and investment may also need to cut back. The windfall isn’t what it once was. That also will cut into demand.

Emerging economies that relied on borrowing from the rest of the world to support high levels of domestic spending and investment also will be cutting back. They have been hit by the credit crunch.

China benefits from lower commodity prices. It has no need to borrow from the rest of the world to support high levels of domestic investment.

The world economy could really use a Chinese locomotive. But it increasingly doesn’t look like it will get one. A recent Credit Suisse report noted that the latest purchasing managers survey suggests that China is about to enter a manufacturing recession. Export orders fell sharply – as one would expect. But import orders fell more. If that proves an accurate guide to China’s demand for the world’s goods and services, China won’t be doing much to support global growth.

There has long been a rather sterile – at least in my view – debate over how much exports contributed to China’s recent growth. It has long been clear that:

a) Most of China’s growth didn’t come from exports. It couldn’t. Net exports almost never generate 10% growth on their own.

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Back when the US Treasury announced the TARP, a common assumption was that the rise in the United States need to borrow need implied that the US would necessarily need to borrow more from the world’s central banks. After all, central banks have been the main purchasers — on net — of Treasuries over the past few years. Now there is a sense that the world’s central banks are necessary to finance not just the Treasury bonds associated with the TARP, but also the large expected fiscal deficit – and indeed concern that central bank demand may not rise as fast as Treasury supply.

Just today the Treasury announced it expected to issue – on net – an additional $500b this quarter. That is a lot by any measure.

I would be surprised, though, if it is all bought by central banks. Or even if most of the new Treasury will be absorbed by central banks. For the first time in a long time, I suspect Americans — not the world’s central banks — will be the main source of new lending to the Treasury.

Why? The last few months have been marked by three trends:

– The scale of Treasury issuance picked up. A bigger deficit, the TARP and above all the Supplementary Financing Facility led to a nearly $780b increase in outstanding stock of public debt between the end of August and the end of October.

– The pace of central bank reserve growth slowed. I don’t yet have full data for October, but reserve growth unquestionably slowed dramatically last month as capital flows to emerging economies reversed. Most central banks are running down their reserves, not adding to them. See Korea. Or Russia. And unlike in q3 – when around $150b in Chinese reserve growth and $50b in Saudi reserve growth more than offset the fall in other countries reserves – I suspect that on net central banks reduced their total reserves in the month of October. That also is a big change.

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The Gulf states are thought to have built up their cash reserves in q2 and q3 – though the supporting evidence was always circumstantial (the TIC data implied that no one was buying US equities) and anecdotal.

Now there is a bit of hard evidence. We know that the Saudi Arabian Monetary Agency (SAMA) added $40.9b to its foreign deposits in q3 2008 – and only $13.6b to its foreign securities portfolio.

We also now know that the Saudis added $144.3b to SAMA’s foreign portfolio between the end of q3 2007 and the end of q3 2008. Not a bad year. A little over $50b of that went into deposits; a little over $90b went into securities. In other words, the shift toward deposits is recent phenomenon.

SAMA’s non-reserve foreign assets now total $405.2b and it manages another $63b in foreign assets for Saudi government pension funds as well as $31.7b in foreign currency reserves. That works out to close to $500b in total assets — enough to potentially make SAMA the largest sovereign fund manager in the Gulf. Rachel Ziemba and I never were convinced ADIA was nearly as large as some claimed – and both the big slide in global equities this year and the creation of new Abu Dhabi sovereign funds reduced the size of its portfolio.

Of course, looking only at the size of formal sovereign funds – and institutions like SAMA – misses the large “private” assets of some of the Gulf’s key families. Notably the region’s royal families.

Those private fortunes are coming out in the open — in part because a new generation of princes (and royal advisers) seems less adverse to advertising their wealth than the older generation.

Abu Dhabi’s Sheik Mansour bin Zayed al-Nahyan seems set to buy 16% of Barclay’s for his private portfolio (fits nicely with ManCity). Sheik Sheikh Hamad bin Jassim bin Jabor Al Thani (Qatar’s prime minister) is investing in Barclay’s through his private fund as well. And the QIA is adding to its stake too. If Qatar keeps adding to its stake in Barclays I guess it figures it will eventually make money …

One of the investors in UBS last December also is thought to be a member of one of the region’s royal families.

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The Fed’s balance sheet just surpassed 2 trillion dollars. It has grown by a trillion dollars over the course of the year. Literally. See “total factors supplying reserve balances” at the close of business on October 29. That growth was financed by Treasury bill issuance ($560b from the supplementary financing facility) and a large rise in banks deposits at the Fed ($405b).

The stated foreign reserves of China’s central bank reached $1.9 trillion at the end of September. That though understates the total assets managed by the PBoC by around $200 billion. It is now clear – I think – that the PBoC manages about $200 billion in foreign currency that the state banks have placed at PBoC. This isn’t a secret: the PBoC reports over $200 billion in “other foreign assets.” That means the PBoC already has a foreign currency balance sheet of over $2 trillion.

The pace of growth in that balance sheet slowed a bit in q3 – and may slow more in q4. But between q3 07 and q3 08, the PBoC added about $600 billion to its foreign portfolio (and another $100b or so was handed over to the CIC). The CEQ summary of my article for them covers this — though it only goes through q2 2008.

It consequently is natural to compare the balance sheet of the Fed with the external balance sheet of the People’s Bank of China — a balance sheet that is managed by the State Administration of Foreign Exchange (SAFE).

The Fed has a somewhat under $500 billion in Treasuries on its balance sheet. But it has lent about $220 billion of those securities to liquidity starved broker-dealers. It consequently has fewer Treasuries on hand than it reports. Its “uncommitted” Treasury portfolio is around $270b.

SAFE has – if it is safe to assume that SAFE accounts for the majority of China’s reported holdings of Treasuries – about $540 billion of Treasuries. But this total understates China’s real holdings; China probably accounts for about ½ (maybe more) of the Treasuries sold to investors in the UK (look at the pattern of past revisions). It consequently has more Treasuries on hand than reported in the US data – probably about $700 billion.

The Fed has provided about $1 trillion in credit — ok, $920 billion — to the US financial system – whether repos ($80b), term credit ($300b), other loans ($370b), purchases of commercial paper ($145b), or its holdings of the Bear assets JP Morgan didn’t want ($27b now).

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