Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Secrets of SAFE: A trillion of Treasuries here, a trillion there and pretty soon you are talking about real money …

by Brad Setser Friday, January 30, 2009

China has $1946 billion in reserves. The PBoC had another $185 billion in “other foreign assets” at the end of November. Given the fall in China’s reserve requirement, now likely has maybe $160 billion and perhaps less. The PBoC therefore already manages a portfolio in excess of two trillion dollars. The CIC has around $90 billion (less if it marks to market) – as it spent $67 billion acquiring Huijin (China’s existing bank recapitalization vehicle), $20 billion recapitalizing the CDB, $3 billion of China Everbright and $19 billion on ABC. The state banks have at least another $100 billion in foreign assets. Sum it all up and the foreign portfolio of China’s government is north of $2.3 trillion.

Consequently it should be a surprise that China’s government now has close to a trillion in Treasuries. OK, not quite a trillion. But darn close. $860 billion or so at the end of November and – if current trends continue — over $900 billion at the end of December.

China also has $550 billion or so of Agencies, which are effectively now backstopped by the Treasury. That works out to an enormous bet by China’s government on US government bonds.

These are just a few of the conclusions of a new paper, China’s $1.7 trillion dollar bet, that I co-authored with the CFR’s Arpana Pandey.

This paper presents detailed estimates of the growth of China’s foreign portfolio, taking into consideration the increase in China’s hidden reserves. The story is here is simple: China’s reported reserve growth from mid-2007 to mid-2008 understates its actual reserve growth, as the government forced the banks to hold dollars to meet a portion of their reserve requirement. There isn’t any real doubt about this; the PBoC’s reported an enormous increase in its “other foreign assets.” These hidden reserves are now coming down; China’s reported reserve growth now somewhat overstates the true pace of its reserves growth.

The more innovative portion of the paper presents a detailed portrait of the evolution of China’s portfolio over time.* Our estimates of China’s US portfolio are the result of a lot of detective work. China’s recorded US purchases have – until recently – clearly understated China’s real purchases. The challenge was working out a way to estimate, China’s true purchases using the US data.

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Just how much is $350 billion?

by Brad Setser Friday, January 30, 2009

My colleagues at the Council’s Center for Geoeconomic Studies calculated that it was enough to buy most of the common equity of the US financial system — at least on January 21.

That isn’t the best use of the TARP’s funds, but it does illustrate just how little common equity is now left to help support the financial sector’s large aggregate balance sheet.

Update: The book value of bank equity is of course higher. And the banks have other sources of regulatory capital.

Read Dean, Areddy and Ng on the management of China’s reserves during the crisis

by Brad Setser Thursday, January 29, 2009

Dean, Areddy and Ng key their story off Wen’s criticism of US economic management. But it is really much more about the political fallout inside China from China’s losses on investments that they considered safe.

The story breaks a lot of new ground. It highlights how China’s losses on Reserve Primary, Lehman, Morgan Stanley and WaMu influenced China’s decision-making It also confirms that China was very very nervous about its Agency exposure.

“The alarm for Chinese leaders started ringing loudly in July and August as problems deepened at Fannie and Freddie. Senior Chinese leaders, who hadn’t been apprised in detail of how China’s reserves were being invested, learned for the first time in published reports that the country’s exposure to debt from those two alone totaled nearly $400 billion, say people familiar with the matter. Fearing that the U.S. government might not fully back the companies, China demanded and received regular briefings throughout the peak of the crisis from high-level Treasury Department officials, including Mr. Paulson, on the market for U.S. debt securities — especially those of the mortgage giants.”

It seems like China’s top leaders knew less about China’s portfolio that American reserve watchers; it is not inconceivable (gulp) that I was the source for those published report about China’s Agency holdings. My own work with Arpana Pandey, incidentally, suggests that China’s holdings of Agencies were closer to $600 billion at their peak – though it is possible that China never held more than $400 billion of Fannie and Freddie debt, as there are other kinds of Agency bonds.

The Journal’s story also confirms that there has been a huge swing in the management of China’s reserves. The TIC data, which has shown a huge increase in China’s Treasury holdings, wasn’t off.

It turns out that one of China’s main criticism of US policy is simple: the government didn’t stand by institutions that China expected the US to support. Lehman. Wamu. And the Reserve Primary Fund. Dean, Areddy and Ng:

“Leaders in China, the world’s third-largest economy, have been surprised and upset over how much the problems of the U.S. financial sector have hurt China’s holdings. In response, Beijing is re-examining its U.S. investments, say people familiar with the government’s thinking. …

Chinese leaders have felt burned by a series of bad experiences with U.S. investments they had believed were safe, say people familiar with their thinking, including holdings in Morgan Stanley, the collapsed Reserve Primary Fund and mortgage giants Fannie Mae and Freddie Mac.”

….. The Reserve issue “is causing a lot of concern with a lot of financial institutions in China,” said the Chinese official. Some officials expected that the U.S. and its financial institutions would better protect China from loss. “If the U.S. is treating us this way, eventually that will be enough cause for concern in the stability of the [U.S.] system,” the official said

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Central banks were not the big buyers of synthetic triple AAA …

by Brad Setser Wednesday, January 28, 2009

Ricardo Caballero argues that the current crisis stems from (flawed) efforts to construct safe assets out of risky assets in order to meet a surge in investor demand for safe assets.

He is on to something.

There was a surge in demand for safe assets that pushed yields on Treasuries (and Bunds, OATS and Gilts) down at the peak of the boom. And investment banks – with help from the rating agencies — did respond by constructing new kinds of products that combined higher yields than Treasuries (or Agencies) and the appearance of safety.

Caballero thinks the banks constructed these securities to meet demand from central banks and sovereign funds.

Global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash. Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets – the market moved to create synthetic AAA instruments. …. The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields.

I don’t think that is quite right. Central banks and sovereign funds weren’t the main buyers of “structures” that produced a “synthetic” triple AAA credit Central banks generally stuck to instruments with cleaner cash flows and less risk. Many have mandates that require that they invest in fairly short-term instruments that have explicit government backing.

Let’s review the portfolios of the key players:

— Japan (MoF mostly) remains overwhelmingly in Treasuries, with a small number of Agencies. As far as I know, that is about as far as the MoF and BoJ went.
— Brazil’s central bank basically holds Treasuries.
— Russia’s central bank held a lot of short-term Agencies. But it liked the Agencies own debt, not the mortgage backed securities they guaranteed. Russia’s its investment guidelines are quite restrictive. It needed a government guarantee. It wasn’t buying any “private lablel” structured product.
— India has been quite conservative. It doesn’t even hold many securities. Most of its reserves are on deposit at an international institution — likely the BIS. Who knows, maybe the BIS dabbled in structures, but India wasn’t a big source of demand for CDOs.
— Mexico didn’t go further than dabbling with Agencies. Agency MBS were a bid deal. It is mostly in Treasuries.
— Saudi Arabia is a bit of a mystery. I doubt it holds any structures on its own book. But it also likely outsourced the management of a fraction of its fixed income portfolio, and well, maybe the managers had a mandate that allowed them to take a bit of risk. I just don’t know. The Gulf’s sovereign funds liked equities (and private equity) more than they liked complex debt instruments – though they probably invested in hedge funds that made levered bets on complexity. I would be surprised if the Gulf has more than $100 billion of exposure to structured products. the Gulf’s big bet was on the equity market.
— Korea clearly took a few more risks back when it wanted to juice returns to offset the won’s appreciation (how the world has changed). But even if it put a third of its dollar portfolio (say 20% of its total portfolio) in dollar bonds that lacked government banking, it wouldn’t have bought more than $50 billion of “product.”
— Norway also took credit risk with its bond portfolio. But the US only made up about a third of its bond portfolio. Back when bonds were 60% of Norway’s portfolio, Norway could not have have had more than 20% of a $300 billion portfolio in US bonds of all kinds. It thus could not have accounted for more than about $60b of demand for various structures. And it clearly wasn’t just buying structures.

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There is currently a shortfall in Chinese demand for the world’s goods, not Chinese demand for the world’s bonds

by Brad Setser Tuesday, January 27, 2009

The tone of some recent commentary on the Sino-American relationship almost suggests that the US is so reliant on Chinese financing that it should be encouraging China to devalue the RMB to increase China’s current account surplus – and thus its capacity to finance the US deficit. Presumably it should encourage China to limit its fiscal stimulus too, so as to better assure the financing the US needs to sustain the large increase in its fiscal deficit. The last thing the US should want is any policy change that might, well, increase Chinese demand for the world’s goods. The risk that this would reduce China’s demand for America’s bonds is too great.

I disagree.

Right now the global economy is short of demand for goods, not short of demand for government bonds. The expected rise in the US fiscal deficit does not imply a rise in the current account deficit when private demand is contracting. It thus doesn’t imply any increase in the United States need for external financing, at least not in the short-run. The more China does to support global demand, the better – even if thus means a fall in China’s current account surplus and a gradual fall in Chinese demand for foreign assets. If a strong Chinese stimulus ends up supporting the global economy – and net exports help to pull the US out its slump — all the better.

Let’s go through several key points in more detail:

The core problem in the global economy is a shortage of demand for goods, not a shortfall in demand for safe government bonds

The collapse in global trade recently has been absolutely stunning. Exports are down over 20% in a host of Asian economies. China is actually doing comparatively well. Its exports so far have fallen less than Korea’s exports, Taiwan’s exports and Japan’s exports. Global output is falling.

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A truly global slump. Do not look to the emerging economies for good news …

by Brad Setser Monday, January 26, 2009

Only a few months ago it was common to argue that growth in the emerging world would prevent a global recession. That forecast looks increasingly wide of the mark. The slowdown in the emerging world now looks to be as severe – and potentially more severe – than the slowdown in the advanced economies.

Morgan Stanley’s currency team recently observed that “Brazil’s growth collapsed in 4Q08, with several activity indicators displaying the worst decline on record.” Earlier this year Brazil was growing strongly on the back of both strong domestic demand and strong global demand for its commodities. The domestic growth dynamic (and the improved state of the balance sheet of Brazil’s government) made me think it might be able to ride out this crisis relatively well. Guess not.

Russia is in even worse shape. Output is poised to fall sharply. Danske Bank expects a 3% fall. That might be optimistic. Moving from a budget that balances at $70 oil to a budget based on $41 a barrel isn’t fun even if Russia uses its fiscal reserve to adjust gradually. Eastern European economies that relied on large capital inflows rather than high commodity prices to support their growth aren’t doing any better.

The Gulf is in better shape than Russia, but that isn’t saying all that much. $40 a barrel oil requires the Gulf to dip into its foreign assets, but most countries still have plenty of spare cash (though not as much as before). Still, all of the Gulf is slowing. And the most exuberant bits of the Gulf – Dubai in particular – are in real trouble. Most of the Gulf’s sovereign funds under-estimated their countries need for emergency liquidity. They aren’t quite in the same position as Dubai’s Istithmar (looking to sell Barneys for cash as demand for luxury goods falls), but they presumably do wish that they had more liquid assets — and more assets that weren’t correlated with oil.

The commodity-importing BRICs aren’t doing much better. India is slowing. And China is really slowing. Stephen Green of Standard Chartered has constructed an indicator of Chinese economic activity that isn’t based on the government’s reported GDP data. It suggests a far bigger fall in Chinese output than in 1998.*

Chinese output shrank in the fourth quarter. The first quarter isn’t going to be any better.

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The US placed about $1.3 trillion of Treasuries with non-Chinese investors in 2008

by Brad Setser Saturday, January 24, 2009

Yes, China probably bought close to $400 billion of Treasuries too. My top secret model says China bought exactly $374.571 billion of Treasuries in 2008, a record. China certainly bought far more Treasuries in 2008 than in 2007. My model, which accounts for flows through London, suggests that China added $120.3 billion to its Treasury portfolio in 2007.

But the big surge in demand for Treasuries in 2008 didn’t come from China. Other investors increased their holdings of marketable Treasuries by $1310 billion. That is a huge increase from the (estimated) $127 billion increase in their holdings of marketable Treasuries in 2007.

It stands to reason that investors should be debating whether this surge in non-Chinese demand can continue, not whether China will keep on buying Treasuries.

Relatively speaking, the big change in 2008 was the emergence of non-Chinese demand for Treasuries. And not all of that demand came from central banks either.

My best guess is that central banks bought about $650 billion of Treasuries in 2008, up from about $290 billion in 2007. $650 billion is a record by the way. It is also far more than the TIC data indicates, as I am adjusting the TIC data upwards to reflect the fact that the TIC flow data tends to understate official purchases.* It is also a bit more than the roughly $500 billion increase in central banks custodial holdings at the New York Fed. I am not trying to understate the impact of central banks on the market.

But given the scale of new issuance by the Treasury (The Treasury issued $1257 billion in marketable Treasuries) and the scale of the fall in the Fed’s holdings of Treasuries (down $427 billion, counting the securities the Fed has lent out to the market), private investors added over a trillion dollars to their Treasury holdings in 2008 — more than the world’s central banks.

That is a huge change from 2007. In 2007, best I can tell, private investors were net sellers of Treasuries, as central bank purchases exceeded the net issuance of marketable Treasuries ($194 billion) and the Treasuries the Fed sold into the market ($54 billion).

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Is the US now more, or less, reliant on China’s government for financing?

by Brad Setser Friday, January 23, 2009

Rarely do nominees — or even Treasury Secretaries — make news in their written response to questions posed by Senators. But Tim Geithner’s comments on China yesterday tcertainly made news. I more or less agree with Dr. Drezner . Geithner essentially restated Obama’s campaign position — and Obama has long been more concerned about China’s pattern of sustained intervention in the currency market than the Bush Administration has been. Manipulation sounds harsh, but it more or less is a different way of stating something that Dr. Bernanke noted a couple of years ago: China’s exchange rate regime has served as a de facto subsidy for China’s exports.

But Geithner also preserved his options. Above all he signaled that the US hopes that China will respond favorably to US calls for it too more to support domestic Chinese demand (China’s current stimulus is — measured correctly — smaller than the US stimulus: Keith Bradsher reports that “China’s stimulus program is likely to add 1 to 3 percent to its economic growth this year, said Dong Tao, a China economist at Credit Suisse. The American program is likely to add close to 3 percent to the United States’ growth, he predicted” ) and to reconsider its peg. Michael Phillips of the Wall Street Journal reports:

Mr. Geithner stressed Mr. Obama’s promise to “use aggressively all diplomatic avenues open to him to seek change in China’s currency practices.”

More interesting, at least to me, is how hard it seems to be to report on the complexities of the US economic and financial relationship with China right now, when so much is changing. China is buying more Treasuries even as the pace of its reserve growth slows. But the increase in China’s demand has been dwarfed by the increase in Treasury issuance.

One point in the Times story was clearly off. The Times, citing Edward Yardeni, claims that China’s trade surplus is shrinking dramatically:

““Things have changed quite a bit since Hank Paulson made an issue of this,” said one, Edward Yardeni, an independent analyst, referring to Henry M. Paulson Jr., the just-departed Treasury secretary. “The Chinese trade surplus is shrinking dramatically and China’s economy is falling into recession. I think it really wasn’t necessary. It doesn’t accomplish anything.”

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Trouble in Tokyo … and in London.

by Brad Setser Thursday, January 22, 2009

Japanese exports are down. Way down. The 35% y/y fall in December is consistent with a brutal collapse in intra-Asian and global trade.

The yen, though, is up. Way up against some currencies. It recently approached a record high against the slumping pound.

The yen’s rise amid Japan’s slump is no doubt a source of concern at the Bank of Japan — and the Ministry of Finance. No one right now really wants an appreciating currency.

It also has to be a bit of a concern to a few other central banks as well. At least to their reserve managers. Over the past several years, the pound has been a popular diversification play, taking a rising share of the world’s rapidly growing reserve pie.

In 2000, the IMF indicates that central banks that report detailed data to the IMF held a little less 4% of their reserves in pounds and around 6% in yen. By the end of 2007, the pound’s share topped 7% while the yen’s share had slipped to under 3%. Central banks didn’t like low yen rates, and the pound offered a bit of carry.

Some industrial counties (like the US) have long held a lot of yen, but the data from those emerging economies that report the currency composition of their reserves to the IMF is consistent with the global trend. If those emerging economies that do not report detailed data to the IMF acted like those that did, annual central bank purchases of pounds over the past several years have been in the $40 to $70 billion range. That is real money for an economy of the UK’s size.

The pounds share of the total slid a bit in q3 as the dollar and yen rallied, but that doesn’t mean that central banks were selling pounds. Those emerging markets that report data to the IMF bought $9 billion of pounds and sold $9 billion of yen in q3.

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Should the US worry about the drop in foreign demand for US long-term assets?

by Brad Setser Wednesday, January 21, 2009

The latest TIC data provides yet more evidence that financial globalization — the rise in cross-border flows — has peaked. At least temporarily. Foreigners are buying far fewer long-term US bonds than they used too.

Look at a plot of gross foreign purchases of US long-term bonds and gross foreign purchases of US equities. Both are heading down. Net long-term bond flows are heading down too. Net equities aren’t heading down, but (see below) that is largely because Americans are now selling their foreign equity portfolio faster than foreigners are selling their US equities.

It is also striking, at least to me, that bond inflows have been so much larger than equity inflows over the past few years. Popular coverage of the “markets” in the US focuses on the equity market. But the capacity of the US to sustain its low savings rate hinged not on foreign demand for US equity but rather foreign demand for US bonds. Apart from a brief period around the .com craze, the US never financed its external deficit by selling equity to the world.

What is driving the fall in demand for long-term US bonds? Number one, a fall in demand for corporate bonds. Remember that all “private” mortgage backed securities are considered corporate bonds in the balance of payments data. Private US demand for foreign bonds is also falling.

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