Brad Setser

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Cross border flows, with a bit of macroeconomics

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Beat Down

by Mark Dow

I have a couple of themes on which I wanted to post, but they will most likely have to wait for later. The market, in the words of the E*Trade commercial, is issuing me a bit of a beat down today, and I have to focus on a little risk management. C’est la vie….

Weekly Federal Reserve balance sheet update

by Mark Dow

This post is by Mark Dow

This just hit my inbox, from the research team at Barclays. Since we’ve talked a fair amount of late about the Fed balance sheet, I thought I’d pass it on.

“Weekly Federal Reserve balance sheet update

Usage of the various Federal Reserve liquidity programs continues to erode as outstanding loan amounts mature and are not replaced with new borrowing. The overall size of the central bank’s balance sheet is now 9% smaller than it was at the start of the year.”

Chinese Handcuffs? No, Chinese trade deficit

by Mark Dow

This is Mark Dow. Brad is away.

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below. Read more »

GCC Sovereigns: A Little Better off

by rziemba

this post is by Rachel Ziemba

Thanks again to Brad for letting me fill in while he’s on vacation. Sorry I’m late catching up with you all but I’ll try to chime in on some of the key releases especially on China in the next week. But let me start out with something from the world of oil wealth.

Timothy Geithner, the U.S. Treasury Secretary, travels to the GCC (Saudi Arabia and the UAE) in a few days to commune with some of the more significant creditors of the U.S. and possibly urge these savings-rich countries to contribute to the IMF, as several emerging market economies have pledged. As a result it seems an apt time to re-estimate how much these governments and their neighbors in Qatar and Kuwait have accumulated.

While the Gulf’s holdings of U.S. assets pale in comparison to China’s, the GCC possesses the largest trove of US stocks among foreign governments. With most of its assets managed by the central bank, Saudi Arabia likely holds the most US treasury bonds. The other GCC countries, most of whom entrusted their oil windfall (and gas in Qatar’s case) to an array of investment funds, tend to have a more diversified portfolio. However, the U.S. dollar still dominates the Gulf’s foreign asset position.

With the rise in the price of oil in Q2, some analysts have again been talking again about the global role of sovereign funds. While some, such as the China Investment Corporation (CIC), for one, seem to have become more active investors again, armed with new advisers, the Gulf funds still seem to be homeward looking for now. The latest –and forthcoming – RGE Monitor Global Outlook suggests that growth in the GCC will be flat in real terms, with a slight contraction possible in 2009. The significant assets of the region have allowed GCC countries to steer their economies to a softer, if still, harsh landing. Much of the region’s output, investment and sentiment remain linked to oil despite various attempts to diversify its economy. Steffen Hertog has a nice new piece on the lessons learned from the 80s by Arab oil producers.

Many GCC sovereign funds have boosted their holdings in domestic banks, domestic equity markets other savings been drawn on to meet fiscal deficits. Meanwhile, some of the few identifiable foreign investments in H1 2009 were made by hybrid funds like the UAE’s Mubadala, which tend to invest in sectors that could help domestic economic development or in sectors they already dominate (such as oil and petrochemicals).

The foreign assets of GCC central banks and sovereign funds are estimated to have fallen to just over $1.1 trillion at the end of June 2009 from about $1.2 trillion at the end of 2008. This estimate draws on a methodology Brad and I created last year, which estimates the inflows to the funds, and assumes similar performance to benchmark indices for each asset class. This estimate though, is somewhat lower than some other prevailing estimates. Recently released analysis by McKinsey Global Institutes suggests that Sovereign investors of the GCC, one of their ‘new power brokers’ managed closer to $2 trillion at the end of 2008.

The national breakdown suggests that Saudi Arabia accounts for over $400 billion of the assets (including the non-reserve assets of the Saudi Arabian monetary Agency and the foreign assets it manages for other parts of the government). The UAE, accounts for the next largest amount, around $350 billion, not including Mubadala and some Dubai funds. Kuwait’s fund managed just under $240 billion and Qatar, over $60 billion. The remainder is managed by the central banks of the region.
The slightly more fiscally-conservative (and richer) countries with more oil reserves per capita, like Abu Dhabi and Kuwait, or gas reserves (Qatar) and their more risk-tolerant funds should have seen the value of their assets reflate along with risky assets. Despite the increase in the oil price, the correction at the end of June 2009, limited the paper gains.image003

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The lunch may be free, but how much is it worth?

by Mark Dow

This is Mark Dow. Brad is still away.

Diversification is the only free lunch in investing. But the way many investment managers sing its praises, one can’t help but wonder if its value is overstated (much the way all portfolio managers are programed to say in interviews that “it’s a stock picker’s market”, no matter what the underlying market conditions). Here’s a graph below that speaks a thousand words.

Brazilian Real vs Turkish Lira, over the past year

This is a chart of the Brazialian Real (BRL, in white) vs. the Turkish Lira (TRY, red), over the last year. They have been nomalized to facilitate comparison. Brazil is well known as a commodity exporter, and Turkey as a commodity importer (oil is a huge component of Turkey’s import bill). Keep in mind that over this same period, the front contract on West Texas crude oil fell from USD 136 per barrel to today’s price of 60, and other commodities–both soft and hard–fell by similar amounts.

You will note the one period of divergence in the performance of these two fundamentally distinct countries came in December of last year. This is due to the unwinding of TARKO (Target Knock-Out) contracts that were sold to Brazilian companies ostensibly as pre-hedging vehicles for future dollar export proceeds. However, once they started “working”, these contracts proliferated and quickly became vehicles for specualtion, often by companies that lacked the necessary sophistication in complex derivatives. And had it not been for the coordination of the hedging of these contracts by the Brazilian Central Bank, the December divergence would have been greater. Once this demand for dollars cleared, however, BRL returned to correlate very closely to TRY.

This notwithstanding, the overall similarity of performance over the period would, I think, come as a surprise to most people–given the fundamental backdrop. I know it took the veteran traders I work with by surprise. And while it is true that all correlations “go to one” when markets are under stress, one would still expect to have seen a greater degree of differentiation over the period shown.

A lot of it has to do with fund flows. Funds flows tend to be trendy, with investors getting into and out of strategies–such as emerging market currencies–roughly at the same time. This makes it tough for investors who do their homework and are counting on markets to be rational and efficient. It also makes risk management at least as important as the investment theses themselves.

Once the fund flows come in, the stories that justify the investment follow. Turkey was a great example. Investors at first expressed reluctance to buy TRY with oil going up through USD 100 per bbl. But the story soon followed that made it okay. Strategists and traders started whispering “with oil at these levels there will be large investment outflows from oil producing states, many of which are Muslim. Muslims will feel more comfortable investing their windfalls in other Muslim states, from which Turkey will be a main beneficiary. This will be good for the country and lead to appreciation of TRY”. And thus it was so. An investment thesis was born. Later, after markets crashed and oil had fallen to $40 per bbl., TRY started appreciating again. The story then reverted to the old one we all know and love: lower oil is good for Turkey and for TRY. The Muslim investment thesis had disappeared. In short, when prices go up, a good story will follow.

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The Monkey Multiplier

by Mark Dow

This is Mark Dow. Brad is still away.

There has been a lot of response to the assertion I made the other day that base money has not been growing since December, and that the money multiplier is not passing much of anything on to the broader economy or markets. The story that the Fed is printing money is just too strong to kill with a few facts. But, let me try again with a picture.

Here’s a chart I stumbled onto. It was Bloomberg’s chart of the day a couple of weeks ago. I do not know the research analyst from Westpac, an Austrialian bank, who put it together, and though I can verify his base money numbers, I cannot verify his M2 numbers. Nonetheless, the data fit what I know. Here’s the chart:

The M2 Money Multiplier vs Base Money, last 16 months

Muito Forte

by Mark Dow

This is Mark Dow here. Brad’s still on vacation.

Here’s a quick chart  for anyone questioning the conditional convergence growth hypothesis in emerging markets. In English, the hypothesis loosely posits that you can’t commit suicide jumping out of the basement window (ie. those who start from a much lower base will tend to grow faster until thier growth rate converges with that of more developed countries.)

This chart was brought to my attention by Marcio Ferreira, one of my colleagues at Pharo.

The red line is Brazilian vehicle sales going back to 2001. The white line is the vehicle sales in the US. The two time series are normalized to Dec 2001 so we can see the contrast in growth rates. It paints a powerful picture.

Brazilian vehicle sales vs US vehicle sales, 2001-2009, normalized

The Dollar: It’s an Overhang, not a Hangover

by Mark Dow

Few things are more confounding to economists and traders as forecasting currencies. However, as I have come to realize, the approach each group takes is very different. Economists are never wrong, only early; traders are often wrong, but never in doubt. Economists look at interest rate differentials, growth differentials, current account positions, and other fundamental factors. It doesn’t always help much, but it is a defensible place to start. Traders, on the other hand, cognizant or not, focus not on the fundamentals, but on the “fundamental story”. These stories typically emerge to fit recent price action and are then coupled with what economists refer to as stylized facts. Unlike facts, stylized facts are not stubborn things. Some stories turn out to be true, others false, but whether they are true or not the most powerful ones share two characteristics: they are easy to explain and intuitively appealing. And once a good story takes root it can be very difficult to dislodge it—irrespective of how untrue it may be.

“Stories” that drive the dollar abound. They are usually easy to explain and intuitively appealing. Most of them turn out to be wrong. Excessively low interest rates in 2003, the Fed “printing money” today, large current account deficits, increasing budget deficits, Chinese concerns, all of these are given ample airtime. In short, the core story we have been hearing is that the dollar is now suffering a hangover from the fiscal, monetary and external account binge it has been on in recent years.

How well does this hangover story hold up? Not well.

First, dollar weakness has not been as dramatic as the story that has accompanied it. The only big decline came in 2007 (red arrow in the chart below) when the world was in massive risk seeking mode, loading up on carry, reaching for yield, constructing CDOs and CDO-squareds, and using the dollar as a funding currency. Much of this decline was unwound over the past year as the world began to deleverage. In fact, the dollar is right about at the same level as it was when Lehman went bankrupt.

Dollar Index 2004 -2009

Second, much of the story centers on the Fed’s expansion of base money. This is wrong on many counts. To begin with, the Fed is not printing as much as you might be led to think from listening to financial commentators on TV. Base money (here) has been flat lining since early this year (total liabilities are in the leftmost column). Moreover, the money multiplier has continued to decline, as credit is destroyed and the private sector delevers. (I think many commentators end up confusing base money with the broader money supply, but there is no need to get into this now). In addition, when the expansion of base money was truly rapid, from September to December of last year, the dollar was getting stronger. Why? Because that’s when the demand for dollars was strongest. Memories of Econ 101 and quotes from Milton Friedman have encouraged an excessive focus on the supply of money, when the real driver has been the sharp changes in demand. As funding pressures in the financial system eased, the dollar started to decline again. It is not a coincidence that the DXY (dollar index) made a high in early March when the S&P made its lows. Lastly, there is an article in this week’s Economist, pointing out how the ECB has been as expansionary as the Fed, but have been lower profile about it. But I haven’t heard any talk about the debasing of the Euro. In sum, sexy though the story might be, I don’t think the “Fed-is-printing-money-like-Zimbabwe” theme is really driving anything but the psycology of a few.

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The central bank panic of 2008

by Brad Setser

Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion.

Central bank sales of Agencies in 2008: close to $100 billion.

That is a one-year swing was close to $400 billion.

It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market.

Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

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Sign of strength or evidence of weakness? China’s dollar reserves

by Brad Setser

On Friday, Paul Krugman interpreted China’s call for a new reserve currency as a sign of weakness:

“But Mr. Zhou’s speech was actually an admission of weakness. In effect, he was saying that China had driven itself into a dollar trap, and that it can neither get itself out nor change the policies that put it in that trap in the first place.”

China is, according to Krugman, hoping for a magical solution that will “rescue China from the consequences of its own investment mistakes.” I agree.

Krugman rather provocatively argues that “China acquired its $2 trillion stash — turning the People’s Republic into the T-bills Republic — the same way Britain acquired its empire: in a fit of absence of mind.”

I agree, at least in part.

I would be surprised if the State Council received a memo from the PBoC back in 2004 saying “$500 billion in reserves isn’t enough for a country with a closed capital account; let’s aim for $2 trillion by the middle of 2008.”

At the same time, China’s leaders made a series of choices that resulted in the accumulation of huge quantities of reserves. Even if China’s leaders didn’t plan to hold so many dollars, they weren’t willing to make the policy changes needed to avoid accumulating their current stash.

No doubt the Asian crisis led most Asian countries to conclude that they wanted more not fewer reserves. At the same time, it is hard to attribute the buildup of China’s reserves simply to the Asian crisis. China — like other emerging Asian economies — actually didn’t build up its reserves immediately after the Asian crisis. If China’s only priority was building up its reserves, it should have devalued the RMB in 1998 – not maintained its peg to an appreciating dollar.

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