Council on Foreign Relations

That at least seems to be the Treasury’s policy.

Krishna Guha of the FT reports that the US believes that dollar pegs can help countries manage commodity price volatility.

Mr McCormick said that oil producers were not in the same position as large manufacturing exporters such as China. “A commodity-driven economy with a lot of volatility in commodity prices could be a beneficiary of a pegged regime,” he said.

So much for the notion that the Treasury is open to a change in the Gulf’s peg.

And so much for any illusion that I might have some influence over US policy.

In my Peterson institute policy brief, I argued that commodity price volatility is a reason not to peg to the dollar. A peg assures that fluctuations in the dollar price of a commodity (say oil) will translate one for one into volatility in countries local currency revenues from commodities. By contrast, a currency that appreciated when commodity prices appreciated and depreciated when commodity prices depreciated would tend to stabilize a country’s local currency revenues.

And I am not quite sure how pegging to a currency that has depreciated in real terms even as oil has appreciated in real terms has helped smooth out macroeconomic volatility in the oil-exporting economies; it seems to have produced high levels of inflation, negative real interest rates and a wildly pro-cyclical macroeconomic policy mix.

It isn’t hard to see why Paulson is intent to signal that the US remains open to foreign investment from sovereign wealth funds — and why he is pushing the Gulf to allow more foreign investment in its oil sector. A sharp fall in financing for the US would be disruptive, US investment banks are keen to do business with sovereign funds and the Bush Administration is keen to spur more investment in oil production in the big oil-exporting economies. The Wall Street Journal reports (in an article that was perhaps buried a bit more than it should have been) that the big oil exporters are exporting less this year than last.

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Peter Fisher (Blackrock, formerly of the Treasury and the New York Federal Reserve) as quoted by the Wall Street Journal’s David Wessel:

“The idea of risk dispersion is nice in theory, but in practice it depends on who risk gets dispersed to. It turns out that we dispersing risk it into strong hands who could hold it through volatility. Rather we were dispersing it to weak hands who couldn’t hold it, and ended up adding to the volatility.”

So true.

Who were those weak hands?

Some credit hedge funds – whose use of leverage left them exposed to volatility.

Broker dealers like Bear.

And stronger – but not quite-as-strong as advertised – hands like UBS..

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This is Brad Setser once again. Thanks to Rachel Ziemba for filling in while I was away. A couple of regular readers have reported some difficulty posting comments at the cfr.org blog. My apologies for any lost comments. We are working on it. In interim, though, please keep commenting — some comments seem to be directed into a “awaiting moderation” file for reasons that have yet to be determined but I can moderate them manually.

Back in 2004, it was considered rather stunning when China added close to $100 billion to its reserves ($95 billion) in a single quarter, bring its total reserves up to around $600 billion.. The dollar’s fall against the euro (and associated rise in the dollar value of China’s euros) explains around $15 billion of the rise. But at the time, $80 billion was considered a very large sum for China to have added to its reserves.

Now China has $1756 billion in reserves, after a $74.5 billion April increase. The dollar rose against the euro in April, so the underlying pace of increase – after adjusting for valuation changes – was more like $82 billion.

In a month.

And not just any month – in a month when oil topped $100 a barrel.

$82 billion a month, sustained over a year, is close to a trillion dollars. A trillion here, a trillion there and pretty soon you are talking about real money. If a large share of China’s reserves is going into dollars, as seems likely, this year’s increase in China’s dollar holdings could be almost as large as the US current account deficit.

The fact that one country’s government – and in effect two institutions (SAFE and the CIC) – are providing such a large share of the financing the US needs to sustain large deficits (particularly in a world where Americans want to invest abroad as well as import far more than they export) is unprecedented.

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This post is by Rachel Ziemba of RGE Monitor, filling in for Brad Setser.

Norges Bank Investment Management, which manages Norway’s $380 billion Government Pension Fund-Global announced Q1 returns last Friday (A more detailed profile from which this piece draws heavily is available at RGE Monitor). Norway’s results tend to be watched quite closely as it is the most transparent sovereign fund, it thus provides a benchmark for measuring other funds. Furthermore, it gives some indication of how funds might have fared in the tumultuous last few quarters – allowing us to start testing how far these funds are stabilizing investors. Stabilizing they might be, but the evidence suggests that many of these funds have sustained significant losses in recent months, highlighting the importance of selecting managers.

In Q1, the GPF-G reported its worst ever quarter, with the fund posting a negative return of 5.6% on its portfolio as calculated in a basket of currencies in which the fund holds assets. Its equity portfolio reported a -12% return (again in international currency). More interestingly and concerningly perhaps, the results show that Norway’s internal managers performed even worse than its benchmark portfolio. As in Q4, excess return from the portfolio managed in house underperformed the benchmark portfolio – this time by about 1%.

Similarly, the investment portfolio of Norwegian reserves reported negative returns in Q1 and underperformed the benchmark portfolio. Despite transfers of almost $18 billion (88b NOK) from oil revenues, the fund was worth less (in a basket of currencies and in Norwegian Krone) in March 2008 than in December 2007. Dollar weakness boosted the value of its large euro and pound holdings (about 60% of the portfolio) meaning that the fund did gain somewhat in dollar terms (though not if one strips out transfers)

Now, given some of the losses sustained in Q1 by a broad range of investors, such results are perhaps not surprising. In fact, any fund that held the equity index would have reported losses. A good thing they have long investment horizons.

Should funds like ADIA and KIA have primarily tracked the index, they too would have reported losses. We imagine that they didn’t though. The results do highlight the importance of picking managers well. Something to think about now that many commentators are suggesting that sovereign funds pick professional managers. But one or two quarters does not a track record make or break (given the long-term nature).

There are a few reasons not to extrapolate too far from Norway’s results. 1) Norway’s asset allocation is different from an ‘average’ sovereign wealth fund portfolio, being more exposed to fixed income than most funds and with no exposure to alternative assets. It also has less exposure to emerging markets and invests only in a narrower group of EMs. 2) Norway tends to take small stakes, with the average stake size less than 1% of the equity in question. Its different management style means it might be less exposed to individual stocks. 3) Finally, Norway has an official policy of rebalancing its portfolio, that is new inflows will be targeted towards the weakest sectors and regions. This policy had the net result of directing most of Norway’s inflows to fixed income during the equity boom and likely means most of the $18 billion in Q1 transfers accrued to the equity allocation. It also means that transfers from oil revenues not capital gains accounted for much of the Norwegian funds growth in 2005-7.

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This post is by Rachel Ziemba, filling in for Brad Setser. I want to thank Brad for giving me the chance to guest blog again.

With oil futures staying above $130 a barrel – the links between dollar and oil are under the microscope. Overall, some recent evidence seems to indicate that despite protests to the contrary, oil exporters are still buying dollar assets and that dollar weakness may have delayed ongoing diversification away from the dollar. But a number of oil exporters including QIA and ADIA might have a dollar share of less than 40%. All of which makes some speculation about Libya’s dollar assets rather interesting. Libya alone is a relatively small oil producer – it is among a group of countries producing between 1.5-2 million barrels of oil a day but its investment decisions are indicative of broader trends.

Note: The latter part of this post was truncated – it has now been replaced.

Collectively four African countries (Algeria, Libya, Nigeria and Angola) produce under 8 million barrels a day of oil – somewhat less than Russia or a bit more than that produced by GCC countries aside from Saudi Arabia.

So far African oil exporters have had amongst the most conservative asset allocations. For the most part this was of necessity, Nigeria and Algeria had a lot of debt to pay off. And sanctioned Libya kept most of its wealth in very short-term bank deposits though it had some equity stakes, mostly in Europe. So far only Libya has made the move to higher yielding assets, creating the Libya’s Investment Authority (profile here), grouping together six pre-existing funds. The legacy funds had assets totaling around $16 billion including the Libyan Africa fund, Although its asset allocation was never disclosed, it likely takes equity stakes and otherwise invests in higher yielding assets than the deposits that dominate the holdings of the Central Bank.

About a week ago, an article by Jay Solomon in the Wall Street Journal suggested that Libya was cutting trade in US dollars, preferring the Euro or yen. If that’s the case, this would make it the second country after Iran to ask its trading partners to reduce dollar use in oil transactions (for now at least Libya’s non-hydrocarbon exports are pretty minimal). But its the currency where oil wealth is saved that is more significant that what currency is used for invoicing. Solomon also suggested that Libya’s investment fund (AUM ~ $50 billion) was halting investments in the U.S.

But its not clear that Libya ever really started investing in the U.S. (it did have some indirect stakes even in 2000/01 and a lot of its bank deposits may be in dollars). Like many sovereign funds, Libya’s investment plans have been relatively opaque. While initial statements suggested Libya might choose its foreign investments with an eye to Libyan economic development – that is, investing in companies (especially U.S. ones) that might invest in Libya, there haven’t been any noticeable stakes – to my knowledge.

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There has been a lot of speculation this week about the role speculation has played in the recent run-up in oil prices.

There is little doubt, though, about the short-term economic impact of higher oil prices: an enormous transfer of wealth from the oil-importing economies to the oil-exporting economies.

Back in November, I calculated that a $10 a barrel increase in the price of oil would, absent any increase in domestic spending or domestic investment in the oil-exporting economies:

Increase the US trade deficit by about $50b over the course of the year.

Lead to a $46b (euro 31b) deterioration in the EU-25 trade balance. The EU-25 imports a bit less oil than the US (12.6 mbd v 13.7 mbd) even though it produces less oil than the US and has a somewhat larger economy.

And conversely, each $10 increase in the barrel of oil means:

An additional $57b for the GCC states (Saudi Arabia, Abu Dhabi, Dubai and the other emirates, Kuwait, Qatar, Bahrain and Oman).

An additional $25-26b for Russia.

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That more or less is the conclusion of this week’s Economist.

I agree.

Back in 2003 when the dollar started to depreciate, many emerging economies opted to maintain dollar pegs and follow the dollar down. The resulting increase in their reserves — and holdings of US Treasuries — altered the monetary transmission mechanisms in the US. The dollar was stronger than it otherwise would have been, notably against the Asian currencies. And US rates were lower than they otherwise would have been.

Moreover, long-term rates didn’t rise when the Fed started raising rates, keeping financial conditions looser than they otherwise would have been. And as the revised data from mid-2004 to mid-2006 comes out, it is increasingly clear that ongoing central bank purchases of Treasuries and Agency bonds are part of the explanation for the persistence of low long-term rates. The Economist:

“Emerging economies shared some responsibility for America’s housing and credit bubble. As Asian economies and Middle East oil exporters ran large current-account surpluses, they piled up foreign reserves (mostly in American Treasury securities) in order to prevent their currencies from rising. This pushed down bond yields. At the same time, cheap imports from China and elsewhere helped central banks in rich economies hold down inflation while keeping short-term interest rates lower than in the past. Cheap money fueled America’s bubble.”

The housing bubble and residential construction boom obviously have ended. The US economy has slowed sharply. And the US has cut rates.

The result is that a host of emerging economies are now importing both a weak currency and loose monetary policy from the US. Countries that peg to the dollar can easily have a looser monetary policy than the US — higher rates of inflation and the same nominal interest rate can produce lower real interest rates — but have difficulty maintaining a tighter policy. Raising rates while maintaining a de facto dollar peg would tend to attract speculative capital inflows. Ask China.

Loose monetary policy globally has helped to offset the US slowdown. Much of the emerging world is booming on the back of negative real interest rates. But it also has pushed up inflation globally. The Economist reports that the average global real interest rates is negative (“global monetary policy is now at its loosest since the 1970s: the average world real interest rate is negative”) largely because of very high rates of inflation in the emerging world.

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Calculated Risk is worried that China — and other countries with lots of reserves — may start to spend more domestically, leaving less to park in US Treasuries. This concern is sometimes tied more specifically to last week’s tragic earthquake. Funds that China spends rebuilding won’t be available to lend to the US. It would be hard to float a new bond to investment the CIC’s investment in US banks when there are very clear pressing needs in China. Calculated Risk writes:

“What happens if these countries use these accumulated surpluses to stimulate their domestic economies to offset weaker exports to the U.S.? Wouldn’t they have to sell U.S. assets? And wouldn’t that push up interest rates in the U.S. – further weakening the U.S. economy – and further weakening exports for these same countries?”

I worry about a lot of things, but I would put the risk that China will spend too much domestically far down on my list of concerns.

The most likely impact of more domestic spending in China isn’t the sale of US assets. It is a somewhat reduced amount of new buying. And if China’s foreign assets rose by something like $200 billion (counting funds shifted to the CIC and the rise in the foreign assets of the state banks) in the first quarter, China has a lot of scope to reduce its purchases without selling anything.

And the way is oil is rising right now, any fall off in Chinese purchases will be offset by rising demand for US financial assets from cash rich oil exporters. There is an enormous difference between a world where oil trades at $70 a barrel (and the oil-exporters can cover their budgets and pay for their imports with $50 a barrel oil) and a world where oil trades at $130 a barrel (and the oil-exporters can cover their budgets and pay for their imports with $55 a barrel oil). Spending would have to go WAY up before the Gulf would need to start selling off some its foreign assets right now.

Official portfolios are set to increase by well over a trillion dollars this year. There is lots of scope to buy less without selling anything.

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Back in 2005, the rise in the ratio between home price and rents, the unusual rise in real home prices and the rise in household debt relative to income seemed, at least according to some, to be an example of things that couldn’t go on forever.

Looking at those graphs reminds me of two other things that sure seems like they cannot go on forever but as of now show few signs of slowing: the increase in China’s (worldwide) exports, and the growth of its reserves.*

*reserves here is defined to include funds now managed by the CIC and funds that have been shifted to the state banks. In both cases, the government retains the currency risk.

Is there any sign either export growth or reserve growth is slowing? Not really. Export growth is slowing in percentage terms. But that largely is the result of a larger base. In dollar terms, Chinese export growth has just leveled off.

To be sure, the fact that Chinese export is no longer accelerating in dollar terms is something of a change. But Chinese exports are still expanding by about $250b a year. For reference, total Chinese exports in 2000 were only about $250b a year. $250b is a big number.

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Michael Phillips in Monday’s Wall Street Journal:

If there’s one message the Bush administration has been trying to hammer home to Chinese leaders, it is this: A major country with a huge trade surplus and rising prices should let its currency strengthen with market forces. So why is the administration nearly silent about the fixed exchange rates of Saudi Arabia and other Persian Gulf oil fiefdoms? After all, like China, the big powers in the Gulf — Saudi Arabia and the United Arab Emirates — link their currencies to the U.S. dollar, export far more than they buy abroad, and now face inflation imported from overseas.

The US policy right now is that China shouldn’t peg to the dollar but the Gulf should. In reality, neither should. Kristin Forbes — who I briefly worked for — has this right.

“Given the huge current-account surpluses and reserve accumulation in the Gulf states, it’s getting harder and harder for the U.S. Treasury to justify putting pressure on China, but not the Gulf states, to have more exchange-rate flexibility,” says Kristin Forbes, an economist at the Massachusetts Institute of Technology and former adviser to President Bush.

Dollars pegs are both inflationary and an impediment to effective balance of payments adjustment. The currencies of the countries with huge surpluses need to appreciate; the currency of a country with huge deficit not so much. And it is hard for say Chinese renminbi — let alone the Saudi riyal — to appreciate if it is tied to the US dollar.