from Follow the Money

Two two-trillionaires

November 01, 2008

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Monetary Policy


Financial Markets

The Fed’s balance sheet just surpassed 2 trillion dollars. It has grown by a trillion dollars over the course of the year. Literally. See "total factors supplying reserve balances" at the close of business on October 29. That growth was financed by Treasury bill issuance ($560b from the supplementary financing facility) and a large rise in banks deposits at the Fed ($405b).

The stated foreign reserves of China’s central bank reached $1.9 trillion at the end of September. That though understates the total assets managed by the PBoC by around $200 billion. It is now clear – I think – that the PBoC manages about $200 billion in foreign currency that the state banks have placed at PBoC. This isn’t a secret: the PBoC reports over $200 billion in “other foreign assets.” That means the PBoC already has a foreign currency balance sheet of over $2 trillion.

The pace of growth in that balance sheet slowed a bit in q3 – and may slow more in q4. But between q3 07 and q3 08, the PBoC added about $600 billion to its foreign portfolio (and another $100b or so was handed over to the CIC). The CEQ summary of my article for them covers this -- though it only goes through q2 2008.

It consequently is natural to compare the balance sheet of the Fed with the external balance sheet of the People’s Bank of China -- a balance sheet that is managed by the State Administration of Foreign Exchange (SAFE).

The Fed has a somewhat under $500 billion in Treasuries on its balance sheet. But it has lent about $220 billion of those securities to liquidity starved broker-dealers. It consequently has fewer Treasuries on hand than it reports. Its “uncommitted” Treasury portfolio is around $270b.

SAFE has – if it is safe to assume that SAFE accounts for the majority of China’s reported holdings of Treasuries – about $540 billion of Treasuries. But this total understates China’s real holdings; China probably accounts for about ½ (maybe more) of the Treasuries sold to investors in the UK (look at the pattern of past revisions). It consequently has more Treasuries on hand than reported in the US data – probably about $700 billion.

The Fed has provided about $1 trillion in credit -- ok, $920 billion -- to the US financial system – whether repos ($80b), term credit ($300b), other loans ($370b), purchases of commercial paper ($145b), or its holdings of the Bear assets JP Morgan didn’t want ($27b now).

Basically, the Fed is currently "funding" an awful lot of the US financial sector –

So too is SAFE.

Adding China’s purchases of Agencies since last June to its reported total in the last survey implies that China now has about $450b in Agencies – down a bit from its peak. No doubt it will come down more (the Fed’s custodial data indicates an ongoing shift out of Agencies by central banks, and the still-high spreads on long-term Agencies are widely attributed to a lack of Asian demand). On the other hand, China’s total Agency portfolio is underreported in the US data – based on the pattern of past revisions, Arpana Pandey of the CFR and I estimate that China’s Agency holdings peaked at around $575b – and have now fallen to around $550-540b.

The Agencies, lest we forget, are financial intermediaries. But they generally have a higher quality mortgage portfolio than private financial institutions, so the underlying risk here arguably isn’t as high as the risk on the Fed’s balance sheet. In some sense though it doesn’t really matter now that the Treasury has indicated it won’t allow systemically important financial institutions to fail: in both cases though the ultimate guarantor against losses is the US Treasury.

SAFE likely has extended some credit to US financial institutions as well – whether by buying their bonds or investing in short-term money market funds that hold some of their paper. I would estimate this exposure is in the $50-100b range – but this is very much a guess.

The Fed now has a foreign portfolio of around $540b – as it has accepted foreign currencies (mostly euros and pounds) as collateral for the dollars it lent to foreign central banks through its swap lines. The structure of these swaps though implies that the Fed has little foreign currency risk; other central banks will eventually pay the Fed back in dollars, and the Fed will hand the foreign currency back.

I suspect that somewhere between 30% and 40% of SAFE’s portfolio is also in reserve currencies other than the dollar (mostly euros, yen and pounds). That works out to a total of between $630b and $840b. SAFE’s non-dollar reserve portfolio would be the world’s second largest reserve portfolio if managed on a stand alone basis. Unlike the Fed, SAFE has the currency risk, for better (2002-q1 2008) or worse (q3 2008, October …)*

All in all though their respective balance sheets look fairly similar. It is almost scary.

They even each likely have a somewhat toxic portion of their portfolio. SAFE is widely thought to have been given permission to put around 5% of its portfolio in equities at some point in 2007. That implies that it likely bought close to $100b of global equities before equity markets started to slide. Its losses here likely exceed the CIC’s losses on Blackstone and Morgan Stanely – at least in dollar terms. It had the bigger absolute exposure to equity markets.

The Fed is the proud owner of nearly 80% of AIG. And its holdings of Bear debt may have some equity like properties …

There are two key differences between the Fed and SAFE though.

One, the Fed has been increasing its exposure to risky assets while SAFE has been reducing its (relative) exposure to risky assets. The Fed’s Treasury holdings are going down; SAFE’s are going up fast – largely because it seems to have stopped adding to its Agency portfolio.

Two, the PBoC’s liabilities are in RMB, while the Fed’s liabilities are in dollars. That means that the PBoC has an underlying currency mismatch -- and all the associated risks.

You could argue that SAFE and the Fed have combined forces to keep the US economy afloat over the past year. SAFE financed the lion’s share of the United States external deficit – and did most of the heavy lifting earlier in the year when private investors didn’t like the dollar. The Fed’s financing has kept the US financial sector afloat. That incidentally is something that financial sector executives might want to consider as they award bonuses; many financial firms would have failed and not been able to pay anything absent taxpayer support –

On the other hand I would argue that the US shouldn’t give to much credit to SAFE for helping to stabilize the dollar earlier in the year – and for providing the US subsidized financing that has helped keep US borrowing rates fairly low. Why – because a lot of the vulnerabilities that built up in the US economy between 2003 and 2007 can be linked – in part – to large purchases of dollars by SAFE during that period. Holding the RMB down discouraged investment in tradables, and encouraged investment in non-tradeables (think homes). And the rise in China’s surplus even as the oil exporters surplus was growing implied large offsetting deficits in the US and Europe – deficits that were found in the US household sector.

The global implications of misaligned exchange rates is something that I hope will be on the agenda on November 15th. But I am not holding my breath …

There is more consensus globally on the need to reform financial regulation in the US and Europe (and to expand the IMF’s lending capacity) than on the need to reform exchange rates …

*In some sense this is deceptive though, as SAFE really should focus on the value of its foreign portfolio in RMB, as its liabilities are in RMB. Or alternatively – given that it is compelled to hold foreign exchange by China’s exchange rate – a measure of global purchasing power.