Brad Setser

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Not necessarily always stabilizing …

by Brad Setser
July 23, 2009

One common argument — at least prior to the crisis — was that sovereign investors, because of their long-term focus, were generally a stabilizing presence in the market. Sovereign wealth funds in particular. And presumably central bank reserve managers as well. After all, in many cases, the line between a sovereign wealth fund and an aggressively managed central bank reserve portfolio is rather thin.*

These arguments were always a bit hard to assess. There isn’t enough data on the actual actions of sovereign funds to evaluate their true impact on the market. Did sovereign funds step up their purchases of equities when the markets went down? Or were they sellers then?

The available data does suggest that reserve managers have generally acted to stabilize the currency market. Central bank demand for dollars tends to rise when the dollar is going down. But the available evidence also suggests that reserve managers added to the instability in the credit markets during the recent crisis.

Central banks rather suddenly stopped buying Agency bonds, pushing Agency spreads up — at least until the Fed stepped in.

And, as the latest BIS bank data makes clear, they also withdrew large sums from the international banking system. The following chart comes table 5c in the BIS locational banking data; it shows the annual change in the deposits that the world’s reserve managers hold in the banking system.**


To be sure, central bank reserve managers weren’t the only ones pulling money out of big international banks. Money market funds were too. But the loss of $400 billion in deposits — $220 billion in q4, another $170 billion in q1 — from the world’s reserve managers added to the pressure a lot of banks faced. Including, I would guess, some European banks with large dollar balance sheets; that is one reason why there was “extraordinarily high demand for dollars from foreign financial institutions” during the crisis.

A central bank that is intervening to support its currency during a crisis will, of course, need to run down its foreign assets. Some of the fall in central banks’ deposits in the international banking system during the past crisis consequently is just a reflection of the fall in reserves.

But some of it also reflects a flight to safety. Remember the surge in central bank purchases of short-term T-bills during the crisis?


Central banks were, in aggregate, big buyers of Treasuries during the crisis even as their total assets fell. In fact, central bank demand for Treasuries was — for a while — going up even as the world’s dollar were were, best I can tell, going down.


The Fed — helped by the US Treasury, which sold a lot of T-bills during the crisis and put the funds on deposit at the Fed so the Fed could act as dollar lender of last resort to the global banking system — was able to offset these shifts. The US government in effect lent dollars to the banks that were losing dollar deposits as the world’s reserve managers shifted into Treasury bills. It all sort of worked.

The crisis was contained.

The flight to safety on the part of the world’s reserve managers during the crisis was understandable — and individually rational. No reserve manager wanted to have funds (uninsured funds) in a bank that failed. But it also wasn’t stabilizing.

My conclusion: reserve managers need to be cautious as they seek yield in good times, as they are fundamentally loss-adverse. That aversion to losses can, in some circumstances, prove to be a destabilizing force in the market. And, of course, the regulators of the major international banks also need to do a better job …

* Some reserve managers took more market risk than some sovereign wealth funds.
** The BIS data is adjusted for valuation effects


  • Posted by Too Much Fed

    “The Fed — helped by the US Treasury, which sold a lot of T-bills during the crisis and put the funds on deposit at the Fed so the Fed could act as dollar lender of last resort to the global banking system — was able to offset these shifts. The US government in effect lent dollars to the banks that were losing dollar deposits as the world’s reserve managers shifted into Treasury bills. It all sort of worked.”

    So were the losses socialized/securitized onto those taxpayers who did NOT buy into there is not too much debt out there from the fed and others.

  • Posted by Too Much Fed

    How about the next time the fed needs help from the treasury (really the taxpayers), we (the taxpayers) tell them to forget it?

    You (the fed) created this problem; you fix it without help or better yet go bankrupt.

  • Posted by Cedric Regula

    Wonderful. So central banks can extol the virtues of lack of banking regulation in good times, and if anything goes wrong with the ideology, short the banking system out of business during a crisis?

    Did the Basel Accord have a clause in it to that effect?

  • Posted by jonathan

    Is it me or is BIS data a pain to read? (I’m referring to their publication, not your chart.)

  • Posted by Cedric Regula

    Let’s blame Europe for a change.

    At first blush, the global crisis began with CDOs going bust once some signs starting occurring that housing prices can go down, and that made Wall Street’s math jockey’s math look bad. CDS didn’t help, if it was AIG selling them.

    Then our IBs began imploding. So banks began mistrusting banks and we got the Libor rate spikes.

    Ben goes into action and turns on the liquidity spigot, and since foreign banks seem to do a hell of a lot of dollar lending, but Ben doesn’t know where our eurodollars are, he feels obligated to provide dollar liquidity to the ROW. Ergo the CB currency swaps.

    OK, we did it and we need to fix it.

    But then we start to hear maybe it wasn’t that simple.

    Enter the Iceland story. The population of Iceland can fit in Yankee Stadium, so that is the taxpayer base that could potentially backstop a crisis with Icelandic banks. Iceland has grown a proportionally huge international banking system relative to their taxpayer base.

    Supersize the same story and you get Switzerland.

    Then there is German and Austrian banking, with the integrated banking model, but 30:1 leverage similar to our IBs.

    Maybe they all bought some CDOs, but it sounds like loans to Eastern Europe were by far the bigger problem.

    Sweden’s nationalized banks seemed to have made the same mistake. So much for the government looking out for their taxpayers! I find that very disappointing.

    And of course the naughty London banks that caused Britain’s debt/GDP ratio to jump from 35% to 100% in a week. A large part of what they did wrong had to do with British real estate.

    So now we find out from the BIS that some central banks were draining liquidity during all this? The system really is insane.

  • Posted by JenH

    Indulge me in a quick round of devil’s advocate, since you know I’m puzzling through this myself….

    True, the CB dollar-hoarding effect wasn’t stabilizing on the banking system, but given the resulting boon to the dollar at a time when a stronger dollar was perhaps a useful thing for the stability of the system as a whole (and for the viability of a US stimulus package), perhaps the net effect was marginally positive?

    that is, given the choice of instability in a sector that is somewhat quarantinable, and weaker dollar reducing levers all around for US policymakers during what had by then become an all crisis in both the financial and real economy, maybe I’d go for the former???

  • Posted by Don the libertarian Democrat

    Couldn’t the Flight to Safety have been part of the trigger for our Debt-Deflationary Situation? The lesson of this Crisis is that we barely missed having a Debt-Deflationary Spiral. I doubt that we’re sure exactly how yet. But one lesson is surely that, if you reach the point of Debt-Deflation through, among other things, a Flight to Safety, you need a Lender of Last Resort to, more or less, Guarantee the solvency of the system. The Fed and Treasury might have done that this time, but I doubt that we’d like to
    chance it again.

    If you’re not for a system anchored by Narrow Banking, for example, then you need to come up with a LOLR for future crises. Good luck.

  • Posted by Yoda

    quarter trillion debt next week, 10yrs yiedl still below 4%? how many trillion is need for 10yrs yield to move above 4%? 2, 3, 4, 5 trillions?

  • Posted by Yoda

    “$235 BILLION!!! That’s nearly a quarter trillion in just one week of DEBT issuance. Annualized, that’s over $12 trillion”

  • Posted by Cedric Regula


    Funny little guy you are.

    In accordance with my personal editorial policy of starting at least one totally believable, but totally unsubstantiated rumor, a week, I heard thru the grapevine(it wasn’t CNBC) that the Treasury is working on a new, innovative financial product.


    That stands for Quarterly Treasury Inflation Protected Security.

    This way they can sell them at an annualized rate of 5%, but not talk about the inflation adjustment at the end of the 3 month maturity.

    No one will ever know what nominal interest rates are.

  • Posted by Rien Huizer


    It is difficult to evaluate this table. First, locations are deceptive. For instance, UK is not only the home of RBS e a, but a major investment banking centre with hundreds of foreign branches. And the GBP is hardly the dominant currency there, either. Then there is FX swaps that confuse the currency composition.

    However the intuition is compelling that there has ben a flight out of credit and market risk by CBs, especially ones with a dollarized external sector (like Greater China, Latin America and most oil exporters). That means a reduction in currency risk (I guess that especially GBP has been victim of that), less interest risk and no bank risk unless that bank’s liabilities are government guaranteed. And that also means that SWFs get less money from their parent gvts.

    For a long time I thought that there was a third* “legitimate” (from a national interest perspective) motive for putting money in SWFs, since that money reduces the transparency of reserve management and thus the opportunity for nosey foreigners (and locals) to find facts that can be criticized (like Chin’s extensive negative window dressing in association with its CNY undervaluation policy). But when trade is a little more balanced, there is less need for that.

    * The three legitimate reasons are 1. investment returns (universally legitimate) 2. strategic investment (possibly protectionist and discriminatory, certainly nationalistically legitimate and 3. massaging figures, creating opacity. A fourth, but not legitimate reason could be that SWFs tend to engage in transactions that offer greater scope for opportunistic behavior by officials.As far as I know, there have been no reports of examples of reason #4..

  • Posted by Cedric Regula

    Just came across a blog at Debtor’s Prison on the state of Euro securitization. Looks like they went as hog wild as Wall Street, with similar results.

    Have to scroll down a bit to get to the post.

  • Posted by Judy Yeo

    Not an apologist but could u offer a look at matters from the view of these SWFs? After all, presumably those who did take on market risk via high profile investments did lose significant amounts of money and the public (particularly in the case of China) aren’t likely to forget that any time soon. Besides, is there really a choice between long term stabilizing investments and short term profitability, the way some SWF’s management are behaving, they seem to want the best of both worlds , however in conflict that may seem. Ultimately their investments did help finance those rescue packages in some way, however convoluted? perhaps some credit is due for that?

  • Posted by bsetser

    rien — historically, three and four have tended to overlap heavily. one solution has been transpency/ strict rules. russia’s stabilization fund is a good example. and on the other extreme, some gulf funds have investment styles and strategies that seem to reflect the personal tastes of the ruling sheik (or princes) as much as anything else. the proliferation of abu dhabi funds — are reduced use of adia — is a case in point (FT did some good articles on this).

    judy — i think there are a couple of issues here.

    First, SWFs oversold themselves. They claimed to be stabilizing global markets (indeed, so stabilizing that they didn’t need to reveal any information about themselves). That set up a high bar, one that they couldn’t (in my view) meet. They should have argued that they were a way of stabilizing their own economies, not the global economy. That claim though would raise questions about their investment strategies, especially their risky investments designed to collect liquidity premia and the like. if you need to perform a stabilizing function, you need assets that hold value/ are liquid in a shock — which wasn’t where most funds were going in the boom.

    and then there are a couple of very meta issues. Most SWFs arose from policies that sustained imbalances (reserve growth, not distributing the oil windfall broadly but instead saving it centrally, etc). If imbalances are ultimately destabilizing, how can funds that arose to invest the surpluses associated with the imbalances be stabilizing? and are oil flows into equities intrinsically pro-cyclical, as oil prices tend to rise with global growth — and equity prices tend to rise with global growth. that implies more Oil SWF demand for equities when oil prices and equity prices are both high. there are a set of hard questions that were shunted aside by the assertion by the big swfs that they were stabilizing, which generally was used to foreclose debate.

    finally, the most destabilizing actions in the crisis came not from swfs, but from plain old central bank reserve managers — who pulled large sums out of the banks/ stopped buying agencies and thus contributed to the funding difficulties facing a host of intermediaries. this wouldn’t matter in a world where central banks were small, but in the current world it mattered — and frankly, it would have contributed to an even bigger crisis if not for the offsetting actions of the fed.

  • Posted by yoda

    exchanging 14Trillion dollars (trash) for toxic waste (trash) matters? may be stupid Chinese will buy toxic waste (trash), get more dollar (trash) or more t-bill (trash), or long-date treasury (trash). See all those stupid Chinese collecting trash on street like is treasure, it is like is in their DNA?

  • Posted by Rien Huizer


    “Not an apologist but could u offer a look at matters from the view of these SWFs? After all, presumably those who did take on market risk via high profile investments did lose significant amounts of money and the public (particularly in the case of China) aren’t likely to forget that any time soon.”

    Do you think that the public in, for instance, Singapore, will be more tolerant of “high profile investments losing significant..” than the public in China?

  • Posted by Judy Yeo


    is it really fair to expand your analysis of SWFs to include reserve managers, to conflate the 2 might seem tempting in certain cases ( which will not be elaborated on here but most people know what is referred to right?) but in all cases?

    to state that these funds arise out of imbalances (which are seen as destabilizing) makes these institutions which run them inherently destabilizing is clever sophistry but sophistry nonetheless. No economy can ever be perfectly balanced , equilibrium is a theoretical concept. Imbalances will always exist in the here and now- in the long run, we are all not quite part of the equation as keynes put it – the negative connotations associated with imbalances really depend on whose perspective you are adopting.

  • Posted by Judy Yeo


    The public in singapore, I can’t speak for, but there will be discontent obviously – how apparent that discontent is depends on whether the elections take place later this year or next; people are too busy worrying over their jobs to really care intensely about the billions they are unlikely to see in their lifetimes. Besides, the high drama of management shifts are enough to drive the gossip mills for some time? How’s the situation in China?

  • Posted by bsetser

    “these funds arise out of imbalances (which are seen as destabilizing) makes these institutions which run them inherently destabilizing is clever sophistry but sophistry nonetheless.”

    I think the main shortcoming of the market/ political debate over sovereign funds was the failure to connect that debate with the debate over imbalances. the connection is real — read a (good) bank of spain paper that argues that we should talk about sovereign investors, not sov. wealth funds or central bank reserves. In both cases, governments built up foreign assets and in the process financed a US deficit that otherwise wouldn’t have been financed. Take China. If the CIC raises $100b by selling RMB and using the proceeds not to invest at home but to buy fx from SAFE, the net result is still a $100b rise in the foreign assets of China – and Chinese government demand for US assets when there isn’t private Chinese demand. if the buildup of foreign assets in central banks’ formal reserves contributed to the maintenance of imbalances, so did the buildup of f. assets in the hands of sov. funds.

    I am curious why you would think otherwise. In a BoP sense, both are capital outflows, both came from govermennts, both offset current account surpluses and both finance current account deficit elsewhere.

    I accept that national surpluses and deficits are a normal part of the world economy. But I also have argued that the size and persistance of the US deficit (and offsetting surpluses in asia/ the oil exporters) was dangerous — and that it wasn’t a market outcome, but rather the result of government policies that maintained net inflows to the us when private investors wanted to finance the fast growing emerging world, not the slow growing (former?) hegemon.

  • Posted by Cedric Regula

    Brad: “but rather the result of government policies that maintained net inflows to the us when private investors wanted to finance the fast growing emerging world, not the slow growing (former?) hegemon.”

    Let’s remember that happened because the powers-to-be are mucking around with our investment returns, and Uncle Sam liked it that way!

    Course it’s true that interest rates will not attract equity investors, if there is an equity boom going on somewhere, but still we are told that some percentage of our national portfolio s/b in fixed income.

  • Posted by yoda

    $WTIC, crude oil too cheap. Saudi and Russia not charging enough for their precious oil in toilet paper denominated trade. they need to cut down production/export their oil when oil price is this low.

  • Posted by Rien Huizer


    “How’s the situation in China?”

    Re investment losses? I guess no one knows, except people with access to polling data (or a similar process of surveying popular sentiment). But you suggested that the PRC public might be particularly sensitive to this. My above question to you was then ( taking into account the various calculations of the high cost [per Singapore capita (dependent on citizenship etc status) of Temasek’s altruistic investment strategy) why a similar question might not be asked wrt , for instance Singapore (and taking into account that Singapore has, a democratic political process, albeit with a traditionally dominant party that has not yet seen gvt rotation. Your following comment is appreciated and informative. If you do not mind, a little more about the recent developments re Singapore’s Sovereign wealth:

    What I find paradoxical is that apparently Temasek (according to Spore NOT a SWF) has sold (at a loss) its Merrill/BoA, Barclays investments, whilst GIC (THE Spore SWF) kept its UBS and Citigroup, at least, that is what I believe has happened. When all these investments were made, I thought that this was maybe more than an opportunistic gamble, that it would be supportive (and thus strategic) of Singapore’s financial services development strategy. All these are very important players in the private banking and FX markets. Buying these stakes would be unorthodo
    x, but not necessarily without vision. In addition some of these investments were structured in a rather defensive way.

    But the questions are (a) how did those investments comply with the Temasek Charter
    (b) why did some investments end up in GIC and others in Temasek
    (c) why did Temasek take losses and not GIC?

    I have a strong feeling that the investments in question blurred the SWF/non SWF line and in addition the Temasek ones conflicted with the Temasek Charter, whilst the GIC ones if indeed strategic did not quite comply with a purely “return-oriented” SWF, as GIC purports to be…

    It looks like we are going to have an interesting political year in Asia, with controversy in China, a possible “democratic transition” in Japan, Unresolved succession questions in Thailand and Singapore, precarious equilibrium in Malaysia. The only bright spot is Indonesia -and there terrorism erupts again (or not). I have not seen anything like this since the early/middle 1990s