from Follow the Money

2007 all over again? The dollar, central bank reserves and US bonds

May 26, 2009

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Lower interest rates in the US than in much of Europe and most emerging economies

Slower expected growth in the US than in the emerging world

Rising oil prices

Falling dollar.

That describes the past week.

But it also describes most of 2007 and the first part of 2008.

In the last WEO (Box 1.4), the IMF argued that the world’s imbalances weren’t at the heart of the recent crisis, as the trigger for the crisis wasn’t a withdrawal of foreign financing to the US. The credit crisis, in other words, wasn’t a dollar crisis.

That argument was a bit overstated. The Bretton Woods 2 system was central to the ability of the United States to sustain a large deficit in the household sector – just as the expansion of the US household deficit was central to the ability of many emerging economies to grow their exports. Absent central bank demand for dollars, the natural circuit breakers would have kicked in earlier, before so much risk accumulated in the financial sector.

Moreover, it ignores the fact that there was something of a dollar crisis from the end of 2006 to early 2008.

When the US slowed and the global economy (and the European economy) didn’t, private money moved from the slow growing US to the fast growing emerging world in a big way. The IMF’s data suggests that capital flows to the emerging world more than doubled in 2007 – and 2006 wasn’t a shabby year. Net private inflows to emerging economies went from around $200b in 2006* to $600b in 2007. Private investors wanted to finance deficits in the emerging world, not the US – especially when US rates were below rates globally. Normally, that would force the US to adjust – i.e. reduce its (large) current account deficit. That didn’t really happen. Why?

Simple: The money flooding the emerging world was recycled back into the US by emerging market central banks. European countries generally let their currencies float against the dollar. But many emerging economies didn’t let their currencies float freely. A rise in demand for their currency leads to a rise in reserves, not a rise in price. As a result, there has been a strong correlation between a rise in the euro (i.e. a fall in the dollar) and a rise in the reserves of the world’s emerging economies. Consider this chart – which plots emerging market dollar reserve growth from the IMF’s quarterly COFER data against the euro … **


If the rise in reserve growth in the emerging world is a sign of the amount of pressure on the dollar, then the dollar was under tremendous pressure from late 2006 on. It central banks had broke – and lost their willingness to add to their dollar holdings then – there likely would have been a dollar crisis. A fall in inflows would have forced the US to adjust well before September 2008.

The chart, incidentally, was prepared for a CFR contingency planning memo I did on the foreign policy implications of a potential dollar crisis. By crisis, though, I had something rather more dramatic than the slide of last week in mind. Especially as it seems that the dollar has stabilized a bit this week.

Why is all this relevant?

Last week felt a more like the fourth quarter of 2007 than the fourth quarter of 2008. For whatever reason -- an end to deleveraging and a rise in the world’s appetite for emerging market risk or concern that the Fed’s desire to avoid deflation would, in the context of a large fiscal deficit, would lead to a rise in inflation and future dollar weakness – demand for US assets fell.

In some sense, the dollar’s fall shouldn’t be a surprise. Low interest rates typically help to stimulate an economy is by bringing the value of the currency down and thus helping exports. Moreover, as Broda, Ghezzi and Levy-Yeyati of Barcap argue, it is reasonable to think that financial deglobalization will generally make it harder for any country, the US included, to sustain large deficits. A weaker dollar helps to limit the spillover of the US stimulus into external demand – and pushes other countries to rely less on exports for growth. It thus pushes them to do more to stimulate domestic demand (as in say Japan). And by lowering the US trade deficit, it reduces the amount of financing the US needs to attract from the erst of the world.

A declining dollar, though, forces a host of emerging economies are to decide how much to intervene to try to limit their currencies’ appreciation. And in some cases, they have to decide whether or not it makes sense to (still) peg to the dollar.

Don’t forget, China’s currency depreciated alongside the dollar last week. China’s exporter are thrilled. But if China is serious about reducing its exposure to the dollar, it cannot allow dollar weakness to turn into RMB weakness. We know how that story plays out.

Reading Bloomberg on Friday -- and the Wall Street Journal this morning -- left little doubt that many central banks were once again intervening heavily in the foreign exchange market. Russia’s central bank bought over $5 billion last week. A surge in intervention would explain the strong rise in the Fed’s custodial accounts over the last two weeks. They rose by over $50 billion in the last two weeks of data – a $100b monthly/ $1200b annual pace.

That pace of reserve growth would allow the US to sustain it current account deficit – and add to their foreign portfolio. So long as Americans want to buy the financial assets of fast growing emerging economies, Americans actually need to borrow even more than is required to cover the trade deficit from the rest of the world.

The data then suggests not all that much has changed – despite all the talk about China’s desire to find an alternative to the dollar. China still buying dollars to keep its currency from appreciating. Words and actions haven’t matched.

At the same time, May 2009 isn’t quite May 2008 – or November 2007.

Three things have changed:

a) First, the US trade deficit is about half as big as it was in 2008 – or early 2008. The amount the US needs to borrow from the world has gone way down. If American households desired level of savings has gone up – and thus their desired level of consumption has gone down – the size of the dollar depreciation needed to get rid of the trade deficit and America’s need to be a net borrower from the world has also gone down. Expenditure reduction (spending less on all goods, including imports, no matter what the level of the dollar) has substituted for expenditure switching (shifting from foreign to domestic production as the price of imports rises)

b) Second, “strong” economic performance in the current context consists of shrinking less rapidly than the rest of the world, not growing more rapidly than the rest of the world. The US in that sense is doing better than Europe. And it isn’t clear that the gap between say US and Chinese growth is actually any larger now than it was a year ago.

c) Third, the rise in central bank reserves isn’t translating into a rise in demand for longer-term US bonds. Central banks are just buying short-term bills. That presumably is one of the reasons why long-term rates are rising now – while they remained (surprisingly) low back in 2006, 2007 and 2008. Central banks weren’t willing to buy long-term notes at 2% -- or even at 3%. Maybe they just didn’t want to lock in low rates. Maybe they feared a mark-to-market capital loss if rates rose. Or maybe they fear that inflation will rise, eroding the real value of longer-term claims. In some sense, it doesn’t matter. The dynamics of the market changed …

One of the “stabilizers” that artificially dampened volatility in the pre-crisis world – the tendency for a fall in the dollar to be associated with a rise in intervention and a rise in central bank demand for longer-term US treasuries (and agencies) --- seems to have gone away. Or at least it is operating a bit differently. Central banks are still intervening to prop the dollar up. But they aren’t currently willing to buy longer-term US bonds. And the US doesn’t really want to finance its fiscal deficit just by selling bills.


* Private inflows to the emerging world were a bit lower in 2006 than in 2005. This though is somewhat misleading. In 2006, there was a surge in private outflows from China – but that surge was entirely due to a policy decision to use swaps to shift the management of some of China’s reserves to the state banks and other state-run financial institutions. Those outflows weren’t really private. True inflows consequently were almost certainly around $300b in 2006.

**The dollar’s value against the euro is an input for the model estimating dollar reserve growth among those countries that do not report detailed data to the IMF. It isn’t the key input though – the total rise in reserves matters more. Note though the correlation also holds among the countries that do report detailed data to the IMF – and here the data series are truly independent.

Some additional supporting analytics illustrating how central bank demand for dollars has tended to go up when the dollar goes down (v the euro):

With the help of Paul Swartz, I used a bit of math (or magic) to turn the IMF’s quarterly COFER series into a monthly series. The COFER series has been adjusted to include Saudi and Chinese non-reserve foreign assets reported by their respective central banks. The correlation between estimated dollar reserve growth on a rolling 12m basis and the dollar is uncanny.


To be sure, I am using a portfolio balance model to estimate the increase in the dollar reserves of countries that do not report data to the IMF, and thus a slide in the dollar automatically increases dollar reserve growth for any given level of overall reserve growth. This though doesn’t really drive the results -- and it strikes me as a reasonable assumption. The IMF data for countries that don’t report the currency composition of their reserves is dominated by China -- and I have used the TIC data to get a decent sense of the dollar composition of China’s reserves. The Saudis are the second biggest component of the data, and I think it is safe to assume that they haven’t shifted away from the dollar in mass. Moreover, I am in effect assuming that the countries that do not report detailed data to the IMF are acting like the countries that do -- a chart that just used the data for reporting countries would show the same trend.

I added the 12m change in the Fed’s custodial holdings as a stress test. The Fed’s custodial holdings generally moved together with overall dollar reserves until mid 2007. That isn’t hard to explain. Asian countries also tend to use the Fed’s custodial facilities more than the oil exporters; that helps explain the gap from mid 2007 to mid 2008. Moreover, we know that China was buying equities from q2 2007 on, and in general central banks were taking more risks with their portfolio. The result was less use of the Fed’s custodial facilities.

More recently, the Fed’s custodial holdigns have increased by more than dollar reserves, as countries shifted back into safe assets.

I also looked at a a plot showing the 3m change in the Fed’s custodial holdings and the dollar’s value v the euro. In most cases, a rise in the euro’s value v the dollar is tied to faster growth in the Fed’s custodial holdings. That is what one would expect if other central banks are resisting pressure for their currencues to rise along with the euro against the dollar.


There is an important exception though: q3 2007, just after the subprime crisis? Reserve growth was still pretty strong then, so the fall off in inflows to the Fed’s custodial accounts isn’t explained by a fall in reserve growth. My guess is that central banks shifted funds to the BIS, but I am not sure -- it is a bit of a mystery.

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