Council on Foreign Relations

The data on global reserve accumulation is my great white whale.   I suspect I am about the only person who cares that the IMF just released its q3 data on global reserve accumulation.  

What is the story?  Simple: strong reserve growth and not much evidence of diversification, at least among those countries who report data to the IMF.

Countries that report data on the overall composition of their reserves to the IMF added $162.5b to their reserves in q3.  I usually add the non-reserve foreign assets of the Saudi Monetary Agency to that total.  SAMA's non-reserve foreign assets increased by $22.5b or so in q3.   That brings the global total up to $185b, give or take.

Valuation wasn't much of a factor — the dollar rose marginally against the euro in q3, going from 1.2779 to 1.2687 (based on the St. Louis Fed data series).  That reduced the value of the world's existing stock of euros and similar currencies.   My rough cut puts those valuation losses at around $9b — implying a valuation adjusted reserve increase of $194b in q3. 

Back in November (warning: RGE premium subscription required), Christian Menegatti and I esimated a q3 global increase of around $172b (valuation adjusted) based on the countries we track.   We were a bit on the low side. I suspect a lot of the smaller oil exporters added to their reserves at a very rapid clip.

$194b is particularly impressive because Russia made big payments — over $23b in payments — to the Paris Club out of its reserves in q3.  Moreover, Chinese reserve growth was relatively low — about $47b — in q3 for reasons that i don't fully understand.   The $194b global increase came without the two biggest recent sources of reserve growth firing on all cylinders, so to speak.

The q3 total is higher than my estimates for the valuation-adjusted increase in q1 and q2 ($177b in q1, $168b in q2).  $194b is within striking distance of $200b.   Indeed, I would be surprised if the q4 total isn't above $200b after adjusting for valuation.  

I consequently think it is fair to say that reserves increased at a $800b annual pace in the second half of 2006, with emerging economies accounting for the lion's share of the increase. That would be a record pace for a year — though it doesn't quite match the record quarters generated by Japan's heavy intervention at the end of 2003 and in early 2004.

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Or for that matter, sometimes says C3DOs rather than either C3PO or CPDOs.  I used to think that no one loved acronyms more than the US government, but then the structured finance boom came along.  

I'll second Gillian Tett's comment about the accelerating pace of change. 

Another factor driving the trend is broader acceleration of the global financial innovation cycle. Low interest rates have left investors scrambling to find new ways to earn returns – and banks are responding by inventing products at such a furious pace, they barely have time to think up names.

Back around 2002 or 2003 I thought I had a pretty good understanding of how the market managed credit risk, though admittedly one largely derived from studying the market for dollar and euro bonds issued by emerging market sovereign borrowers.   In 2005, I struggled to understand how the market had stopped just betting on credit risk and started to be bet on the correlation between different credits (see this FT retrospective).  And in 2006, I more or less gave up trying to really understand CPDOs (let alone how CPDOs differ from ALDOs or reverse CPPIs). 

Trying to track petrodollars from secretative Gulf states and the latest gizmo dreamed up by the world's best financial engineers was more than I could handle! 

I remain convinced that there is a reason why the growth of emerging market reserves (and resulting low yields on many fixed income assets) and the growth in the stock of CDSs (credit default swaps), CDOs (collateralised debt obligations), LCDSs (loan CDSs), ABCDS (a CDS of an asset-backed securities), CLOs (collateralised loan obligations), ECOs (equity collateralised obligations), CDO2 and CDO3 (Gillian Tett: "CDOs of CDOs of CDOs") and CPDOs (constant proportion debt obligations) has been highly correlated.    

The reasons why central banks in India and Thailand decided to be more “scrooge” than “santa” this December are coming into clearer focus.

Take India.  Before the Reserve Bank of India (RBI) hiked bank reserve requirements (triggering an equity market sell off), Indian foreign currency reserves were rising rapidly.  They were up around $8b in November.    And not all that was valuation gains on India’s large euro and pound holdings – valuation explains maybe $3.5 of the increase, even if 50% of India’s reserves are in euros/ pounds.   The RBI was intervening to the tune of at least $1b a week.   

After the hike in reserve requirements, the Reserve Bank of India has been out of the market, more or less.  Reserves were stable in the first two weeks of December. (Data comes from the RBI’s weekly statistical supplement) 

Take Thailand.  Its central bank imposed inflow controls (triggering flight by investors who already had money in Thailand) after the pace of capital inflows picked up in early December and reportedly approached $1b a week.   That is a phenomenal sum for an economy the size of Thailand  … 

Take Korea.  The FT has reported that dealers believe Korea’s government spent $4b in the first three weeks of December fighting pressure for the won to appreciate, after reportedly spending $2b or so in November.   The Korean government is taking cues from the PBoC and talking tough as well.   Korea's Deputy Finance Minister recently said Korea is willing to buy dollars in near infinite quantities to resist further won appreciation.

 The FT again:

“To stabilise the economy, it is essential to maintain the currency at a certain level and the government will make its best efforts to achieve that,” Kim Sung-jin, a deputy finance minister, told KBS radio. “If the government consults with the central bank and intervenes in the currency market, our resources are unlimited,” Mr Kim said.

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This is the time of year when I stop being a New York-based international economist/ blogger and return, briefly, to being a full-time Kansan.   

Concretely, that means I won’t be foraging for food on the streets of New York.  Instead, I will be pampered by my mother’s amazing talent with flour, sugar, butter (lots of butter, alas) and nuts.   I am not entirely cut off from modern electronic communication but this blog won’t be my top priority …

I expect to start posting regularly again toward the end of next week.  I trust China won’t release its November reserve data – a data point I am eagerly awaiting, for a host of reasons – the day after Christmas.

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Tis the season to be compassionate.

And I guess that also applies to those who are allowed to grace the Wall Street Journal’s oped page –

The opinions there rarely come as much of a surprise.  One standard critique of the blogosphere is that it brings together people who already agree to reinforce their pre-existing convictions.  

That hardly seems to be feature unique to blogland: the Wall Street Journal oped page has long served a similar function.  But I was still surprised by the Malpass WSJ oped — an oped that strongly suggests that the US trade deficit reflects surging business investment in the US, financed by aging, slow growing Europe and Japan. 

Malpass writes:

“the trade deficit and related capital inflow reflect U.S. growth, not weakness — they link the younger, faster-growing U.S. with aging, slower-growing economies abroad …

The trade deficit is the mechanism allowing consumption and investment in the U.S.to grow faster than in Europe and Japan.  The issue for the U.S. is whether it's worth the interest costs. It's the same question facing a small business: Should it borrow money to expand the payroll, train employees, buy land and machines, conduct R&D, build inventory? Profit and credit-worthiness help make the decision.”  (Emphasis added)

Malpass is careful not to attribute the rise in the US current account deficit entirely to  a surge in business investment.  He talks of the increase in "consumption and investment" not of the increase in investment alone.  But the analogy between a small business looking for external financing and the US isn't an accident either.  Malpass very explicitly argues that the US external deficit doesn't reflect US profligacy.  In his view, it is a sign of the strength of the US economy.

Maybe.

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I was not all that impressed by the “day after” coverage of  Thailand’s capital controls in the financial press.    

Everyone initially looked for parallels to 1997 – and signs that the most recent bout of turmoil in Thailand could lead to a cascade of trouble in other emerging economies. 

Most stories quite rightly noted that the risk of contagion much smaller this time around.  However, the overall tone of the coverage still often struck me as off.   The focus  was on the impact of  a new round of Asian contagion could have on American and European investment in emerging economies.   But parallels to 1997 were played up a bit too much without noting the enormous changes that have taken place since 1997. 

The coverage today – particularly the Wall Street Journal’s reporting on the thinking of the Thais and the New York Times’ reporting on the pressures facing all Asian economies — has been much better.

But I still want to put forward my list of the key differences are between 1997 and today — and note a couple of parallels that in my view haven't gotten enough attention.

1/  Emerging Asia doesn’t need capital from the US, Europe or Japan.   That is a bit of an over-generalization, as there are some economies in emerging Asia that are running current account deficits.   But in aggregate, emerging Asian economies save more than they invest – and are net lenders to the rest of the world.    Thailand itself ran a current account deficit in 2005, but is on track for a significant surplus in 2006.  In aggregate, all the private capital that flows into emerging Asia is effectively lent back to the industrial world, whether by private investors, or, more often by central banks.   That is a key change from 1997.

2/  Private investors betting on a rise in the baht or won or renminbi are effectively betting against the central banks of these countries every bit as much as those who bet against the baht or won or rupiah did in 1997.    

In 1997, central banks were intervening to keep their currencies from falling.    Speculators would say borrow baht, and then sell the baht to the Bank of Thailand for dollars – a bet that pays if the baht falls.     In 2006, Asian central banks are intervening to keep their currencies from rising.    Foreign investors have dollars and want baht.   And there is more demand for baht than demand for dollars in the private market.   That normally would lead the value of the baht to rise.   But right now the central bank often steps in, selling the baht foreign investors want and buying the dollars foreign investors don’t want.   

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The Economist did a big feature on petrodollars.   Breaking views and a host of financial columnists have hinted that Hank Paulson should have paid a visit to Riyahd as well as Beijing.  The BIS attracted a bit of attention with an article indicating the dollar share of some oil exporters bank deposits was heading down.  And a fairly recent FT Lex column revealed one of the financial world’s worst kept secrets:  a bunch of London hedge fund managers (and equity fund managers) would like to get their hands on a larger fraction of the world’s petrodollars.

2% of $500 billion (or some small share of it) is kind of interesting.   No matter if some hedge funds aren’t delivering the kind of performance needed to justify their fees.  There are plenty of ways of betting on the dollar that don’t involve giving Goldman’s Global Alpha fund 2% of your money and 20% of the (not always present) upside. 

I have spent a lot of time trying to track down data on petrodollars recently.   I am well aware of the gaps in the data – gaps that make it hard to know exactly what the big oil funds are doing.     We don’t know a lot of things.  But I think we still know a few things.  And while Lex got some things right, I also suspect Lex may have missed a few nuances. 

That is telling: if the leading financial column in the leading financial paper of the financial world’s capital for petrodollar recycling isn't picking up on these nuances, it is probably fair to say that knowledge about petrodollars now significantly lags interest in petrodollars  … 

Lex argued that Russia’s oil stabilization funds' dollars are overwhelmingly in Treasuries.   The London Times reports something similar. 

“The Government has stowed $83 billion in petrodollars in its Stabilisation Fund, which the central bank manages and is invested entirely in AAA-rated US Treasury bills.”

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Bernanke's comment didn't rub me the wrong way (more on that later), but it certainly hit a nerve elsewhere.   I suspect the Treasury — which wants China to appreciate as much as anyone — was among those who were not thrilled by Bernanke's choice of words. 

Not because they disagree intellectually.  But because Bernanke's comment will be contrasted with the language in Treasury's foreign currency report. 

Still, I don't think anyone will be surprised to see that the Treasury declined to find that China meets the technical requirements for being charged with currency manipulation.   The language in the law about "intent" gives the Treasury a lot of wiggle room.

Paulson telegraphed this pretty much from the day he arrived at the Treasury.  

Plus, I doubt the Chinese would have hosted a Strategic Economic Dialogue if they thought they were going to be hit over the head to a "manipulation" charge.  "Manipulation" would turn the "dialogue" into a "negotiation" real fast.

Max Baucus is probably right:

The semiannual Treasury report “is no longer a relevant tool to deal with currency issues,'' Senator Max Baucus said in a statement today. The Montana Democrat will be Chairman of the Senate Finance Committee, which oversees U.S. trade policy, when Democrats take control of the Senate in January.

“It's time for a new approach and new tools,'' said Baucus, who promised to work toward legislation that better addresses what he deems unfair currency policies of U.S. trading partners.

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The title of his December 15^th column was “Asian central banks may spook investors in 2007.”

He mentioned China, India and South Korea.    Thailand seems to have beat them all to the punch.

Mukherjee noted that both the RBI (India’s central bank) and the Bank of Korea raised reserve requirements earlier this month – India on local currency deposits, Korea on both won demand deposits and foreign currency borrowing.   Higher reserve requirements on foreign currency borrowing are a kind of covert capital control – the Bank of Korea wanted to make it harder for Korean banks to borrow yen or dollars, yen or dollars that the banks then converted to won.

Mukherjee didn’t relate this story to the broader global pattern of capital flows and currency moves – a story discussed exceptionally well by Menzie Chinn and Kash Mansori their Wall Street Journal econoblog.   But I will.

I don’t think it is an accident that India, Korea and Thailand have all taken actions to lock up domestic liquidity in the banking system (through higher reserve requirements) and in some cases to try to limit capital flowing into their economies in the month of December.

There was a significant shift in global capital flows in November.  Look either at the euro/ dollar — or the increase in the reserves of Asian central banks. Money that previously flowed to the US – or perhaps Europe – started to flow into Indian markets (especially the equity market), Korean markets and Thai markets.

All faced upward pressure on their currencies.  The won and the baht had already appreciated more than other countries in the region – so their exporters in particular worried about further intervention.

And all started to intervene in the foreign currency market in a big way.   And intervention isn't –despite what some say — costless.   So called sterilization can be difficult.

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In 1998, oil collapsed.  In 2006, oil soars. 

In 1998,  Russia defaulted after Treasury Secretary Robert Rubin refused to throw good money after bad, and blocked NSC pressure to continue disburse more than $5b of the IMF's $15b credit line to Russia.  In 2006, Russia added over $100b to its reserves even as it repaid almost $25b of debt to Germany and a host of other official creditors.

In 1998, credit spreads blew out.  Volatility went crazy too.    In 2006, credit spreads collapsed.  Volatility fell to record low — some would say crazy low — levels. 

In 1998, private capital flowed out of emerging economies in a big way.   In 2006, private capital flowed into emerging economies in an even bigger way.    Into emerging market funds.   But also into emerging economies — and specifically into the coffers of emerging market central banks.

In 1998, an Asian emerging economy facing responded to pressure on its currency by imposing draconian capital controls.   Well, that hasn't changed.  In 2006, another Asian emerging economy responded to pressure on its currency by imposing draconian capital controls.

Back in 1998, Malaysia was worried that speculative pressure was driving the ringgit down too far and too fast.    Thailand, by contrast, is currently worried that speculative pressure is driving the baht up too far and too fast.    

A sign of the times.