Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Relitigating 1998 at the end of 2008

by Brad Setser Wednesday, December 31, 2008

Tyler Cowen argues that the “Committee to Save the World” made a mistake in 1998 by, well, saving the financial world. They thus missed an opportunity to teach the banks a lesson in sound risk-management.

He specifically argues that the Fed (actually the New York Fed) shouldn’t have called the big banks together to recapitalize LTCM. The recapitalization didn’t require any Treasury funds or draw on the Fed as a lender of last resort, so calling it a bailout obscured the meaning of the term bailout – the fed catalyzed a private bailout of LTCM but it didn’t do a true government bailout. You might even say that the Fed catalyzed a bail-in of LTCM’s creditors. But by acting, Cowen argues that the Fed set a precedent that creditors of big financial institutions don’t take losses, and thus encouraged bad bets.

I am not totally sure. The big banks called to the New York Fed were the creditors of LTCM and they were in some sense “bailed-in.” To avoid taking losses on the credit that they had extended to LTCM, they had to pony up and recapitalize LTCM.*

It just so happened that the market recovered and it was possible for LTCM to exit many of its positions without taking large losses, or in some cases any losses. The banks that took control of LTCM when LTCM was on the ropes were able to unwind LTCM’s portfolio in a way that didn’t result in additional losses. But the result Cowen desired — large losses for the banks and broker-dealers who provided credit to LTCM – was quite possible if LTCM’s assets weren’t sufficient to cover all its liabilities. No creditor of LTCM was able to get rid of its exposure as a result of the Fed’s actions.

Lehman’s creditors didn’t get a chance to do a similar deal. There were too many of them — and there was too little time. I suspect, though, that Lehman’s creditors and counter-parties would be far better off if they had all agreed to pony up say 10% of the money they had lent to Lehman and in the process had provided Lehman with enough equity to allow it to be unwound in a more orderly way.** They still would have taken losses, but those losses might well have been smaller – even counting the new money they put in – than the losses that Lehman’s creditors will incur as a result of Lehman’s bankruptcy filing.

Moreover, it seems a bit strange to look at LTCM in isolation.

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China has lost its appetite for risky assets

by Brad Setser Tuesday, December 30, 2008

George Chen of Reuters reports that both the CIC and SAFE are scaling back their investment in risky assets. Word has come down from on high.

China’s foreign exchange watchdog, the State Administration of Foreign Exchange, will cut back on overseas equity buys next year after suffering major losses on the collapse of U.S. lender Washington Mutual, according to sources. ..

The big losses by SAFE in the WaMu deal through its investment in the TPG fund have drawn attention from top government leaders in Beijing, who have urged both CIC and SAFE to be more cautious on its overseas investments next year. CIC has already attracted massive criticism at home over its deals in U.S. firms, which have been battered by the credit crisis, with its stakes in private equity house Blackstone Group (BX.N) and Morgan Stanley (MS.N) diving in value. One of the sources said both CIC and SAFE would focus more on overseas investments in fixed income areas rather than equities deals in 2009.

Right now it actually seems like China isn’t willing to any risks period. That includes buying bonds with some credit risk. Over the past few months, China seems to have bought little other than Treasury bonds — and perhaps some German bunds and other high-quality Euro-denominated bonds.

It is mathematically impossible for China not to account for a very large share of the Fed’s custodial holdings of Agencies — and those holdings continue to fall. They are now down for the year. They were way up in July, so this is a huge swing. And conversely the growth in central banks Treasury holdings is truly incredible. Think of a $450 billion increase in a year — an increase far in excess of the increase in 2004 when it seemed like Japan was buying every Treasury bond it could find.

I would bet that the CIC is privately pleased that SAFE took a loss on its investment through TPG in WaMu. TPG apparently wanted the CIC to participate, and the CIC said no. SAFE didn’t. George Chen again:

Sources said TPG initially approached China Investment Corp, lobbying the country’s official sovereign wealth fund to become a major limited partner of its new private equity fund. CIC, which was set up by the Communist government last year to earn higher returns on a $200 billion portfolio of its foreign exchange reserves, declined the offer mainly due to concerns about investment risks and poor prospects of U.S. markets, the sources said. Instead, TPG’s dealmakers contacted SAFE and the foreign exchange regulator agreed on condition that TPG would also jointly invest some of its own money in the WaMu deal, the sources said.

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The collapse of financial globalization …

by Brad Setser Monday, December 29, 2008

The last six months — if not the last year — logged what felt like a decade’s worth of financial news. So perhaps it isn’t surprising that swings that normally would attract an enormous amount of attention have gone almost unnoticed. Like the near-total collapse of private capital flows.

Both private capital inflows to the US and private capital outflows from the US have fallen sharply. They have gone from a peak of around 15% of US GDP to around zero in a remarkably short period of time …

The fall in private flows over the last four quarters has been much sharper than the fall in the US current account deficit. The current account deficit continues to hover around $700 billion (5% of US GDP). Financial globalization — the growth in private cross-border flows, and associated rise in private inflows and private outflows — doesn’t seem to have been as central to the ability of the United States to sustain large current account deficits as some thought back in 2004 and 2005.

The preceding graph is based on the BEA’s balance of payments data, scaled to US GDP (the quarterly data was transformed into an annual series by calculating a rolling 4q sum and the sign on private outflows was reversed). I did adjust the latest BEA data in one way. From q2 2007 on I subtracted “private” purchases of Treasuries from the “private’ total. The last survey of foreign portfolio holdings — which revised the data from mid-2006 to mid-2007 — basically re-attributed all private purchases of Treasuries from private investors in the UK to the world’s central banks. My adjustment thus anticipates the revisions that are likely to follow from the next survey.*

But even if “private” Treasury purchases since mid-2007 are counted there still would have been a stunning fall in private capital flows. Direct investment flows have continued. Other financial flows though have largely gone in reverse, with investors selling what they previously bought. In the third quarter foreign investors sold about $90b of US securities (excluding Treasuries) and Americans sold about $85 billion of foreign securities. And the reversal in bank flows on both sides (as past loans have been called) has been absolutely brutal.

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Better late than never …

by Brad Setser Tuesday, December 23, 2008

A lot happened this year. And an awful lot happened in the last few months, even setting the US Presidential election aside.

— The US experienced its worst financial crisis since the Depression. The Fed dramatically expanded its balance sheet, becoming the world’s lender of last resort and the United States’ lender of almost every resort.
— Capital flows to the emerging world reversed. Inflows turned to outflows.
— High carry currencies tumbled. So did the pound. The dollar rallied even as the US financial system teetered on the edge of collapse, then slid as the Fed cut rates to zero.
— Global trade, and I would guess global economic activity, started to contract. Just look at fall in Japan’s exports in November …
— Oil prices fell. A lot. Several oil-exporters that were on top of the world with oil at $145 are now looking at serious financial trouble.

It consequently isn’t a surprise that America started to think about the holiday festivities a bit later than usual. That isn’t just a conjecture either. My colleagues at the CFR’s Geoeconomics Center compared Google searches for “Santa” to Google searches for “foreclosures.” It turns out that Santa overlook foreclosures a bit later than normal. And it took even longer for Santa to overtake foreclosures in those parts of the country where home prices have gone down the most. Do look at the chart.

Never fear. The housing grinch didn’t quite steal Christmas. Santa eventually won out, even in those parts of the US with the biggest fall in home prices.

To celebrate, I’ll be taking a few days off.

Happy Holidays to all. And, if it fits, Merry Christmas.

What is going on with China’s reserves?

by Brad Setser Tuesday, December 23, 2008

Are they up? That is what one Chinese source suggested in late November. Logan Wright of Stone and McCarthy took a peak at the PBoC’s balance sheet and it indicated that reserves (measured in RMB) were up in October, in part because the central bank reduced the dollar reserves that the state banks were required to hold.

Or are they down, as a set of leaks over the weekend suggest?

As Michael Pettis notes, it is an important question — and there isn’t yet any hard data points.

1) The rise in China’s trade in surplus in q4 (we have data from October and November) certainly suggests that there is an underlying basis for ongoing reserve growth. And the fact that the Fed’s custodial holdings have been constant even as other countries’ reserves have been falling suggests that someone has been adding to their reserves — or that some central banks have been shifting money into the Fed for safekeeping because they no longer trust private custodians. For that matter some of the money that China shifted to the state banks might have come back to the PBoC — and as a result, the PBoC would have additional money to buy US bonds.

2) Exchange rate moves — notably the dollar’s rise against the euro — would have cut into the dollar value of China’s reserves in October and November. October in particular. I estimate that the valuation losses on China’s foreign exchange reserves in October and November were in the $65-70 billion range. That could explain a portion of the fall — and it is consistent with an ongoing rise 9or at least stability) in China’s US holdings. But one would expect that the bulk of the valuation losses to come in October, not November.* And if the dollar’s recent slide is sustained for another week, valuation gains on China’s euros and the like should add around $50 billion to China’s reported December reserves.

3) If — as is widely believed — SAFE put about 5% of its portfolio into equities in 2007 and early 2008 and if SAFE marks its equity portfolio to market, it should have additional valuation losses in October and November. On the other hand, this also should have an impact on the q3 data — especially the data for September. I simply don’t yet know how SAFE is accounting for fluctuations in its equity portfolio. But so long as China put no more than 5% of its reserves into equities, it is hard to see how q4 losses could top $25 billion …

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The central bank flight to safety

by Brad Setser Sunday, December 21, 2008

Floyd Norris of the New York Times highlights a theme that I have touched on many times: foreign demand for US assets with any hint of credit risk has disappeared. Foreign demand for US corporate bonds — a category that includes “private-label” asset-backed securities like repackaged subprime mortgages — fell sharply in 2007 and hasn’t recovered. * And more recently foreign demand for US “Agency” bonds — the debt issued or guaranteed by Freddie Mac, Fannie Mae, Ginnie Mae and the like — has fallen sharply.

Norris highlights this shift effectively. But he didn’t quite go as far as he could have.

I would add three additional points:

1) Foreign central banks — not private investors — have led the shift out of Agencies toward Treasuries. We know this because of the data in the Fed’s custodial accounts, which show a clear shift at the end of July. From the end of 2004 to the mid 2008, central banks were only slowly adding to their holdings of Treasuries while their holdings of Agencies the the New York Fed ballooned from something like $250b at end of 2004 to close to $1 trillion at the end of June 2008. And since mid 2008, central banks have been selling Agencies and buying Treasuries in big way. The following chart plots central banks’ custodial holdings at the Fed against my best guess of central banks true holdings of Treasuries and Agencies. That guess comes from a model that I have been working on with Arpana Pandey of the Council that reattributes purchases through London to the official sector in real time, and thus avoids the jumps associated with the survey revisions.** Think of it was anticipating the outcome of the next couple of surveys of foreign portfolio investment (The survey data consistently revises central bank holdings of Treasuries and Agencies up and the UK’s holdings down).

2) The shift from Agencies to Treasuries continued in November and December. There isn’t any “TIC” for those months, but the New York Fed’s data shows a $43 billion fall in central bank holdings of Agencies in November and another $38 billion fall in the first three weeks of December. Since the end of September, central bank holdings of Treasuries are up by over $210b and central bank holdings of Agencies are down by close to $130 billion — as the following chart illustrates.

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by Brad Setser Friday, December 19, 2008

The thesis that China and America should be viewed as a single economy – or at least as a single currency area – is due for a comeback.

After flirting with change, the RMB is once again pegged tightly to the dollar. 6.85 is the new 8.27. I would not be surprised if China’s external surplus and the United States deficit prove to be roughly equal in size in 2009 The obvious argument is that while the US runs a big deficit, Chimerica doesn’t. East Chimerica’s surplus offsets West Chimerica’s deficit. No worries. At least so long as China’s government is willing to finance the US.

The fact that the Chimerican currency union required unprecedented growth in China’s reserves was always my main objection to the Chimerica thesis. A currency union in theory shouldn’t require that kind of government intervention to keep in balance.

But Chimerica never was really financially integrated. Back when the RMB was (correctly) considered a one way bet, China erected capital controls to keep American (and other) capital from speculating on its currency. And for most of this decade, the net outflow from China to America came not from a desire on the part of Chinese savers to hold dollars but rather from a desire of China’s government to hold the Chinese currency down against the dollar. That policy required that China buy dollars in the foreign exchange market, and in the process finance the US deficit.

However, another objection may be more important. The argument that Chinese and America formed a perfect union – with US spending generating demand to offset Chinese savings, and Chinese savings financing the borrowing associated with US spending – hasn’t quite worked for the past couple of years. It leaves out Europe. And Europe, not the US, was the big spender in the world economy in 2006, 2007 and the first part of 2008.

My colleague at the Council’s Center for Geoeconomic Studies, Paul Swartz, has produced a clever graph (available on the CGS website) showing that the growth in Asian exports hinges on the growth in US and European imports. Makes sense. Paul also plotted Asian export growth against American import growth and European import growth separately — and the chart of European import growth against Asian export growth highlights just how large Europe’s contribution to Asian export growth has been recently.

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That was fast ….

by Brad Setser Thursday, December 18, 2008

Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK had housing and finance centric economies. Both have significant external deficits. And both are inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now. Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies. In practice things rarely work out as neatly.

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation.

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

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Today’s Fed statement speaks for itself

by Brad Setser Wednesday, December 17, 2008

The Fed cut policy interest rates to zero, more or less. And it signaled that it hasn’t run out of ammunition even if it cannot cut rates further.

Not so long as there are still financial assets that it is willing to purchase. The Fed:

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity. (emphasis added)

Over the last few months, the Fed has more or less taken over a slew of functions previously performed by the private financial system.

Banks with spare cash (more deposits than loans) used to lend to banks that were short of cash (more loans than deposits). Now they lend to the Fed, and the Fed lends to the banks that are short on cash. That way no bank risks taking losses lending to a bad bank ….

Money market funds used to lend both to the financial sector and to firms with short-term financing needs. Now they (to simplify a bit) just buy Treasuries. The Treasury met this demand by increasing its issuance, and (to simplify a bit) putting the cash it raised on deposit with the Fed. That in turn allowed the Fed to lend to institutions in the US and abroad that previously relied on money market funds for financing.

Foreign central banks used to buy rather significant sums of Agency bonds, and in the process finance (indirectly) the extension of credit to American households. Now foreign central banks just want Treasuries. The Fed now plans to purchase rather significant quantities of Agencies, in effect making up for the fall off in demand from other central banks.

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This is what a crisis looks like in the balance of payments data

by Brad Setser Monday, December 15, 2008

At least a crisis marked by a run out of risky US assets and into safe US assets. Right now Agency bonds — think Freddie and Fannie — are considered risky assets while Treasuries are not.

A run out of all US assets and the dollar would look very different.

The October TIC data tells a striking story — one marked by a massive surge in demand by both private and official investors for “safe” assets. Foreign investors bought $182 billion of Treasuries — including $147.4 billion of short-term Treasury bills. There is no real mystery why bill yields dropped so low even as the supply of bills surged. And foreigners added $207 billion to dollar bank accounts.

Sum that up and it works out to close to $400 billion in demand for safe dollar denominated assets. If that kind of monthly inflow is annualized it is a shockingly large number.

It isn’t hard to figure out why the dollar rallied.

$400 billion in a month is far more than the US needs to cover its trade deficit. It allowed foreigners to reduce their holdings of Agencies by close to $75 billion (including a $25 billion fall in short-term Agencies), their holdings of long-term corporate bonds by $13 billion and their holdings of US equities by $6 billion without causing any strain on the dollar.

Indeed, the fall in foreign holdings of US corporate bonds and US equities (though not the outflow from the Agencies) could have been financed by the sale of $36 billion of foreign assets by US residents …

Usually I argue that the TIC data understates official flows. And this month’s data may well do so.

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