Ok, my title is a more-than-a-bit unfair.

But sovereign wealth funds are fundamentally vehicles for investing central bank reserves — or Treasury reserves from surplus oil revenue — in equities and real estate rather than in classic reserve assets. And this year classic reserve assets have done rather well. Equities and real estate have not.

The likely result has been large losses. Most sovereign funds remain, despite the efforts of Ted Truman, the US Treasury and the IMF, remain rather secretive, so we don’t know for sure. But it is hard to see how a large sovereign fund could have done well this year.

Take a large fund oil fund, one that started 2007 with maybe $500 billion.

– Say 60% of the fund was invested in equities. The fund started the year with $300 billion in equities, and probably ended the year with $150-$180 billion. Equities globally are down between 40% and 50% in dollar terms.
– Say 20% of the fund was invested in real estate, hedge funds and private equities. The fund started the year with $100 billion in “alternatives” and probably ended the year with between $60 and $80 billion. It is hard to tell exactly, as many “alternative” assets aren’t traded in liquid markets, though the fact that some endowments are trying to sell their limited parnerships in private equity funds at large discounts suggests that if these assets were marked to market, they would be down.
– Say 20% of the fund was invested in government bonds. Setting aside exchange rate moves, they held their value. For simplicity’s stake, let’s say $100 billion remained $100 billion (say mark to market gains on long-term treasuries offset any slide the dollar value of euro-denominated bonds).

The fund would have ended the year with between $310 billion and $360 billion.

Even if the fund received $50 billion from high oil prices (and kept the entire $50 billion in cash, avoiding any losses over the course of the year), it would end the year with between $360 and $410 billion.

This fund, of course, is fictional. But it is meant to capture the dynamics of a fund like the Abu Dhabi Investment Authority.

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For much of the most recent phase of the rolling global crisis, the dollar and the yen rose against the euro, the pound and most emerging market currencies.

Some of that was a reaction to the euro’s extreme strength going in to the crisis; a $1.55 euro amid a European recession would have made life very uncomfortable for many European manufacturers.

But some of the dollar’s rise also reflected a global scramble for dollar liquidity, whether as a safe have (compared say to the ruble, the dollar looks good .. ) or to repay dollar-denominated debts. John Authers of the FT:

On a trade-weighted basis, the dollar rose 22.7 per cent from July until its peak last month. This was not, evidently, due to any great strength in the US economy. Instead it was largely a perverse phenomenon – as traders sold assets to pay down debts (deleveraging), they often had to buy dollars. So as the crisis intensified, so the dollar strengthened. The only exception to this was the yen, which does even better than the dollar when investors are anxious.

Over the past two days, though, the dollar has fallen against both the euro and the yen.

The US trade data surprised on the downside — and while it is far too soon for the dollar’s recent rise to really have an impact on the trade data, the rise in the deficit perhaps did remind the market that over time a rising dollar would tend to maintain the still large trade deficit not bring it down. Macro man was far more surprised by the rise in the non-oil deficit than I was; it was always going to be race down between imports and exports. And last month exports fell by more …

The collapse of Madoff’s investment fund presumably hasn’t done wonders for the United States image as a financial safe haven either. His stable, predictable returns turned proved too good to be true. See Cassandra (hat tip Naked Capitalism).

And the apparent collapse of Detroit’s bailout hasn’t helped.

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A key reason the US October trade deficit went up not down is a rise in the volume of US oil imports.

Oil imports were down 14% in volume terms in September and were up a bit over 2% in October. That is noise. The 3m rolling average for oil import volumes is still down 6% y/y — and the y/y fall is around 5%. But the rise in volume offset the fall in price (the average price of imported oil fell from over $107 a barrel to $92 a barrel), so the petrol deficit rose by $0.8b to $32.7 billion in October.

The good news is that the average price of imported oil still has a lot further to fall. I would guess that the 2008 petrol deficit (netting exports out) will be close to $400 billion. It could fall to $200-250 billion in 2009.

The bad news is that October exports were down $3b from September — and down $16b from their July peak. They almost certainly will fall more. The constellation that supported strong US export growth — strong global growth and a weak dollar — has disappeared. The really bad news is that real export growth is slowing faster than real import growth.

A longer time series shows the recent downturn in “real” exports and imports clearly.

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It is hard to put lipstick on a pig.

China’s November trade data (a 2.2% year over year fall in exports; a 17.9% year over year fall in imports — see Andrew Batson of the Wall Street Journal) suggests that global trade is contracting quite rapidly. And since trade accounts for a rising share of global activity, it suggests that the global economy has stalled — and perhaps is contracting.

The fall in China’s exports suggests global demand is falling. And the fall in China’s imports on first blush seems larger than can be explained just by the fall in demand for imported components for China’s exports and sliding commodity prices: it suggests that Chinese domestic demand is quite weak …

The November data from Korea and Taiwan tells a similar story. All experienced far larger falls in year over year falls in their exports than China did.

Sometimes the y/y change for China paints a misleading picture — as the timing of China’s New Year can have a big impact on the data. Not in this case. The 3 month moving average is heading down too — and it almost certainly has further to fall.

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Estimates of the break-even oil price in Saudi Arabia’s budget vary, ranging from under $40 a barrel to around $50 a barrel.

Sometimes that is because of different assumptions about Saudi Arabia’s actual production — the more the Saudis cut back production, the higher the oil price they need to balance their budget.

Sometimes that reflects different assumptions about the relevant oil price: the price Saudi Arabia gets on its actual production blend is a bit lower than the benchmark price for sweet light oil.

And sometimes it just reflects a failure to adjust for the games the Saudis play with their budget.

Formally, the Saudis plan to spend 410 billion Saudi Riyal — or $109 billion — in 2008 (more here). That incidentally is less that the 443 SAR ($118 billion) the Saudis actually spent in 2007, as spending ran a bit over the 380 billion SAR ($101b) in the formal budget. I don’t believe for a second that the Saudis are really going to spend less in 2008 than in 2007. Rachel Ziemba — who watches the local press closely for RGE — thinks the Saudis actual 2008 spending will come in around 532b SAR ($142 billion).

That works out to a break-even price for the Saudis’ blend — using the IMF’s assumption of 7.5 mbd of exports — of around 51 or 52 dollars a barrel.

My calculation ignored the Saudis non-oil revenue. But it also ignored the Saudis production costs. Neither amounts to all that much though, so I doubt my rough math is too far off. The IMF estimated the Saudis 2008 break-even price at $50 a barrel.

Moreover, Saudi spending has been growing at something like 15% a year, if not a bit more — remember, the Saudis had to increase their budget substantially just to assure that salaries kept up with inflation. And the Saudis probably aren’t going to scale back spending immediately. They don’t want the Saudi economy to come to a sudden halt. Projecting existing spending patterns out, I wouldn’t be surprised if the Saudis spent 585 SAR ($156) in 2009 — a spending level that produces a crude estimated break-even price of the Saudi blend of around $57. For sweet light, that works out to an oil price of $60 or more ..

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The great moderation – a theory that become quite popular once the big financial party of this decade really got going after 2004 (see the New York Times graphic on LBOs) – had two components.

One: Macroeconomic volatility was a historical relic. Downturns were not going to be as severe as in the past – in part because of the success of counter-cyclical monetary policy.

Two: Financial volatility also was a thing of the past. The combination of reduced macroeconomic policy and the credibility of monetary policy meant that financial markets weren’t as subject to wild gyrations.

The implication of course was that leverage was safe. Financial firms could enhance their returns by borrowing more and taking bigger bets. And everyone else could increase take on more debt too – whether firms or households.

I guess it is now time to go back to the drawing boards.

Financial volatility has come back, with vengeance. And not just in the equity markets. After a period of (relative) stability, there have been a series of sharp moves in the foreign exchange market. The yield on the thirty year bond has swung wildly. The pros are amazed at some of the strange permutations that derivatives markets have churned up under stress.

And Friday’s employment data leaves little doubt that macroeconomic volatility is back with a vengeance. The pace of contraction in economic activity in the US – and probably globally – this quarter is likely to be brutal. Wall Street economists are increasingly starting to sound like Dr. Doom.

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Tracy Alloway of the Financial Times’ Alphaville blog — echoing Robert Sinche of the Bank of America — thinks that spending reserves to defend your own currency and support your own banks is a form of economic nationalism.

Funnily enough, I always thought that building up reserves through thick and thin — and accumulating more reserves than a country ever needed for its own financial stability — was a far more egregious example of economic nationalism. A country that only adds to its reserves is presumably pursuing a policy of intentionally holding its currency below its equilibrium value in order to support its export sector. A country like China isn’t just accumulating reserves because it enjoys financing the US, UK and many European governments at low rates ….

The tone of the the FT’s excerpts of the Bank of America report suggest that a country that sells its reserves to support its own economy hurts the global economy. Not true. It may drain liquidity from some parts of the financial market, but the sale of reserve assets finances policies that add liquidity (so to speak) to parts of the goods market.

Reserves are meant to provide a buffer against external shocks. And right now a host of emerging economies are facing a major shock. Remember, a country that is selling its reserves is trying to keep its currency from falling. That means it is trying to keep the price of the world’s goods in its market from rising — and in so doing, it is keeping demand for the world’s exports up.

And a country that draws on its reserves to make up for shortfall in export revenue is substituting the sale of foreign assets for a fiscal contraction — a contraction that would subtract from global demand growth.

Suppose for example Russia stopped intervening, let the ruble depreciate, didn’t bailout its banks (so they defaulted on their foreign debt and couldn’t finance domestic firms) and budgeted for $40 a barrel oil next year. Russian imports would collapse. That would have a big impact on Europe’s exports. The UK doesn’t make all that much these days, so this shift would hurt Germany more than the UK. But just because it helps some countries (and sectors) more than others doesn’t meant that the world doesn’t gain when a country draws on its own reserves to avoid a major contraction in demand.

Indeed, if — and it is a huge if (see below) — private savings and investment do not change as a result of the government’s decision to run a bigger fiscal deficit, selling foreign assets to make up for a shortfall in say oil export revenue and to finance a budget deficit leads directly to a larger current account deficit and more demand for the world’s goods. It isn’t a beggar-thy-neighbor policy.

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Most creditors believe that the debtor needs to take the lead in addressing their own problems. China is, apparently, no different. Geoff Dyer of the Financial Times reports:

Wang Qishan, a vice premier and leader of the Chinese delegation at the two-day talks, called on the US to take swift action to address the crisis and said the two countries needed to work together. “We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China’s assets and investments in the US,” Mr Wang said.

Zhou Xiaochuan, governor of the Chinese central bank, urged the US to rebalance its economy. “Over-consumption and a high reliance on credit is the cause of the US financial crisis,” Mr Zhou said. “As the largest and most important economy in the world, the US should take the initiative to adjust its policies, raise its savings ratio appropriately and reduce its trade and fiscal deficits.”

Jim Fallows’ interview with Gao Xiqing has a similar tone: the US should treat its creditors rather more nicely. Fair enough. China now almost certainly has well over $1 trillion in US Treasury and Agency bonds, and probably close to $1.5 trillion in total dollar exposure (more on that next week). That is a lot by any measure — more than really makes sense.

On the other hand, I hope that Chinese policy makers recognize:

a) They, not the US, decided to intervene heavily and in sustained way to hold their exchange rate down, a policy that necessarily implies financial losses for China. China is effectively overpaying for financial assets (dollar reserves) that it doesn’t need in order to support its export sector. There is no way the US can guarantee China against losses on its holdings of dollars.

b) Investors in highly leveraged financial institutions risk large losses. China’s discomfort with its current losses suggests it never should have bought large stakes in major financial institutions. One of the concerns Larry Summers raised about sovereign wealth fund investments in large financial institutions is such investments would turn the always difficult decision to wipe out the equity of a failed financial institution into a foreign policy decision. That rings true.

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On Monday China apparently decided to allow the renminbi to depreciate against the dollar.

Let’s be clear: China generally still has to intervene in the market to keep its currency from appreciating. There is no other way reserves could have risen from $1.9 trillion at the end of September to “over $2 trillion” now.* Traders in China bet on where they believe the government wants the exchange rate to go, not its market-clearing rate. Private Chinese demand for dollar assets still isn’t comparable in scale to China’s $400 billion current account surplus.**

Neil Mellor of the Bank of New York believes that the renminbi’s recent depreciation is a very conscious policy choice:

Since the start of this week, however, there appears to have been a further palpable shift in policy. Following a clear shift in the wording in the latest quarterly monetary policy report and a speech over the weekend by President Hu Jintao (warning that China’s competitiveness and trade strength were being threatened), the PBOC on Monday set the central parity rate of USD/CNY aggressively higher. After four and a half months of sideward trading, the market reacted strongly to this apparent change in attitude by pushing USD/CNY to the top end of its band. The reaction in the NDF market was even more dramatic with the one-year NDF jumping 3.16% (its largest ever one day move in either direction). This upward pressure has continued over the last two days to leave the NDF now forecasting a 6% y/y rise (spurred on today by comments from Vice premier Wang Qishan that China will do all it can to stabilise exports).

If other Asian currencies fall along with China’s currency, the net result would be a broad depreciation of emerging Asian currencies against the dollar more than an improvement in China’s relative position in Asia. And right now Asia is the region of the world economy with the largest current account surplus – and the surplus region that stands to benefit the most from the fall in oil prices.

A global shortfall in demand (and contraction in trade) implies that almost everyone is struggling to maintain (or expand) their market share. China’s exports have stood up well to date (in nominal terms, monthly exports are running about $20b a month above their total in 2007). Monthly exports in 2008 are nearly two times as high as monthly exports in 2005. The scale of China’s recent export boom is hard to exaggerate. But there is little doubt that China’s exports – all of them, not just textile exports – are poised to slow rapidly. Korean exports fell sharply in November. It is hard to believe that China’s exports won’t also soon slow if not start to fall; the latest data on new export orders suggest additional weakness ahead.

That slowdown comes at a time when China’s domestic economy is also slowing – and consequently is extremely unwelcome. China’s latest purchasing managers index (PMI) was as almost bad as the United States’ latest PMI index.

Moreover, China — like the US – is feeling squeezed by the dollar’s recent appreciation. In real terms, the renminbi has appreciated by far more after it stopped moving up against the dollar that it ever did when it was moving against the dollar. Allowing the renminbi to depreciate against the dollar as the dollar rises would limit China’s real appreciation. It would be consistent with how a basket peg would work.

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Tanta proved that deep knowledge and passion could give life to any topic, even one that might seem dry. No one made the details of mortgage origination and securitization more compelling. The obvious relevance of her work helped. So did the fact that she could really write — no one was better at sustaining a complex (and lengthy) argument over multiple blog posts. But what always stood out to me was her deep sense that we all had a stake in making sure that mortgage securitization was done well, and we all lost when it wasn’t. She cared enough to try to make the part of the world she knew best work a bit better. Her voice will be missed.