from Follow the Money

Borrowing more, but borrowing proportionately less from the world’s central banks

November 4, 2008

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Back when the US Treasury announced the TARP, a common assumption was that the rise in the United States need to borrow need implied that the US would necessarily need to borrow more from the world’s central banks. After all, central banks have been the main purchasers -- on net -- of Treasuries over the past few years. Now there is a sense that the world’s central banks are necessary to finance not just the Treasury bonds associated with the TARP, but also the large expected fiscal deficit – and indeed concern that central bank demand may not rise as fast as Treasury supply.

Just today the Treasury announced it expected to issue – on net – an additional $500b this quarter. That is a lot by any measure.

I would be surprised, though, if it is all bought by central banks. Or even if most of the new Treasury will be absorbed by central banks. For the first time in a long time, I suspect Americans -- not the world’s central banks -- will be the main source of new lending to the Treasury.

Why? The last few months have been marked by three trends:

-- The scale of Treasury issuance picked up. A bigger deficit, the TARP and above all the Supplementary Financing Facility led to a nearly $780b increase in outstanding stock of public debt between the end of August and the end of October.

-- The pace of central bank reserve growth slowed. I don’t yet have full data for October, but reserve growth unquestionably slowed dramatically last month as capital flows to emerging economies reversed. Most central banks are running down their reserves, not adding to them. See Korea. Or Russia. And unlike in q3 – when around $150b in Chinese reserve growth and $50b in Saudi reserve growth more than offset the fall in other countries reserves – I suspect that on net central banks reduced their total reserves in the month of October. That also is a big change.

-- At the margins central banks shifted from Agencies to Treasuries. That shows up clearly in the Fed’s custodial accounts. Treasury holdings for foreign central banks rose by almost $135b from the end of August to the end of October – a very strong pace. Agency holdings fell by almost $60b over that period. That is one key reason why Agency spreads remain wide.

The net result, best I can tell, is that over the past two months Treasury supply grew faster than foreign central bank demand – so the share of Treasury bonds held by foreign central banks fell. I expect that trend to continue for a while.

I should actually add a fourth trend -- one that mattered more in the year to August 2008 than in the last two months: The Fed has also been running down its own holdings of Treasuries, increasing the effective supply of Treasuries on the private market. A year ago it held about $800b in Treasury bonds. Now it has a little under $500b – but it has lent out about $200b of those through its securities lending facilities. This has had a similar effect to new Treasury issuance: it added to the supply of Treasuries circulating in the private market.

Indeed, the total increase in Treasuries in the market between August 2007 and August 2008 -- i.e. before Lehman’s default triggered the current crisis and the huge surge in Treasury borrowing -- has been quite large. Think $425b from the Fed’s balance sheet (an outright fall of $305b, and another $115b increase in securities lent out over that time frame) and roughly $400b of new Treasury issuance (see the monthly statements of the public debt).

The TIC data implies -- if one assumes, as one should, that most private demand abroad really comes from central banks -- that around $500b of this increase in supply was snapped up by the world’s central banks. But $300b was not.

And that was before the crisis led Treasury issuance to soar and central bank reserve growth to slow. There is no way central banks will buy most of the $500 billion in Treasury issuance in the third quarter. Not when so many are running down their reserves.

Two other points –

One. The estimates of central bank Treasury holdings – and China’s holdings – that I provided the Wall Street Journal’s Bob Davis are higher than those reported on the Treasury’s web site. That is intentional. The Treasury’s numbers will be revised when the next survey data comes in. I estimated the size of the likely revisions to provide a better sense of what China currently holds. The last revised data is point is now from June 2007 -- a long time ago.

Two. Central banks hold relatively few short-term bills, relatively few bonds with a maturity over ten years and relatively few TIPS. That means the central banks hold a very large share of the interest paying notes with a maturity of between one and ten years.

What about next year. That is a bit harder to forecast.

We know that the Treasury will be issuing a lot of debt.

We also know that central banks cannot buy many Treasuries if they are selling off their reserves rather than adding to them. Sure, they can shift from riskier assets to Treasuries – as they have been. But if global reserve slows dramatically, central banks purchases of Treasuries also will slow.

I am fairly confident that if oil remains in the 60s, the central banks of oil exporting countries won’t be big buyers of Treasuries. The domestic demands on the oil exporters are too high. That isn’t a bad thing. It means more demand from the oil exporters for American, European and Chinese goods. Toyota now plans to export American made SUVs to the Gulf.

I am also fairly confident China will continue to buy Treasuries. China’s dollar peg has gotten tighter. And China is still running a large trade surplus -- something that is unlikely to change all that much in the near term. Yes, Chinese export growth will slow -- perhaps dramatically. But China’s "processing" imports and more importantly its commodity import bill will also fall sharply, limiting the fall in China’s trade surplus. A reduction in capital inflows should bring China’s reserve growth down. But absent a surge in hot money outflows, Chinese reserve growth will remain strong -- over $100b a quarter. And if China isn’t willing to buy Agencies let alone riskier assets, it will continue to buy a lot of Treasuries.

Other emerging Asian economies are currently selling dollars to keep their currencies from falling. But if the market turns and pressure for appreciation reemerges, I wouldn’t be surprised to see some countries start intervening to keep their currencies from rising. Some countries -- notably Korea -- may need to rebuild reserves. And many Asian exporters probably also wouldn’t mind helping their exporters a bit with a weak currency either.

Nonetheless, central banks are unlikely to match the extraordinary pace of reserve growth that characterized much of 2007 and 2008. That though doesn’t necessarily imply that US Treasury rates will have to rise dramatically to induce private investors to absorb the increase in Treasury supply. Not so long as economic climate remains so bad. Yesterday’s data was awful. And the recent fall in consumption suggests that Americans will soon start saving a bit. Their appetite for risky assets has already fallen. That means more demand for safe assets. Investors who reached for yield in the boom times got burned; many may play it safe.

Consequently, whileCalculated Risk worries about fall in Chinese demand for Treasuries, I worry more that China’s steps to stimulate its economy won’t be vigorous enough. Right now, demand for the world’s goods seems to be falling fast . Demand for safe financial assets is not. And Treasuries -- judging from their yields -- are still considered safe. At the margin, I would rather see China step up its imports of goods and services than continue its current pace of Treasury purchases.

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