from Follow the Money

Bretton Woods 2 lives

October 3, 2006

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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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The IMF released its data on global reserve growth on Friday.   And – to no one’s real surprise – the IMF data indicated that there is one key reason why capital flows uphill in today’s global economy.   Central bank policies.

The world’s central banks added $225b to their reserves in the second quarter – a bit more than the $181b they added in the first quarter.   That is a lot.    Back in the pre-Bretton Woods 2 era, $225b in reserve growth would be a lot for an entire year.  Now is, more or less, only a slightly above average quarter. 

I like to look at a slightly broader measure of reserves that picks up funds shifted (nominally) to China’s state banks and the Saudi Monetary Agency’s non-reserve foreign assets.   China didn’t shift any funds to the state banks in first half of the year, to my knowledge, but the Saudi’s non-reserve foreign assets increased significantly in the first quarter.

Consequently, my measure shows an increase in central bank reserves of $234b in the second quarter – a bit more than the $206b increase in q2.     Changes in the dollar/ euro and dollar/ pound, though, contributed to the strong increase in the world’s reported reserves in q2.   I estimate that valuation gains explain $63b of the q2 increase, and $28b of the q1 increase.   If the effect of valuation changes is removed from the global data, q2 reserve growth – by my estimates -- was actually a bit lower than in q1: $171b v. $178b ... 

The fall-off in reserve growth largely stems from the fact that Saudis didn’t add as much to their foreign assets in the second quarter as they did in the first quarter.  It seems to be a seasonal thing (Warning: the link is to RGE prop content).   It certainly didn’t reflect a fall in oil prices.

If the $348.3b in (valuation adjusted) reserve growth from the first half of 2006 is repeated in the second half of the year, the world is on track to add about $700b to its reserves in 2006.  That would be a bit more than in 2004 or 2005.  

 

The available data suggests that the pace of reserve growth slowed a bit in the third quarter.   That though is entirely because Russia and Mexico used their reserves to make large payments on their external debt in the third quarter.  There doesn’t seem to be any real drop-off in the underlying pace of reserve growth.  More importantly, we don’t (yet) know how much China added to its reserves in August or have any hints about September.  Personally, I suspect both numbers will be big  -- China’s trade surplus is large and I suspect hot money inflows picked up as well.   The RMB sure looks like a one way bet to me.

I would consequently be surprised if there was a major slowdown in global reserve growth in the second half of the year.   Generally speaking, I expect Chinese reserve growth to pick up and oil exporters reserve growth to slow a bit.  Oil isn’t quite as high as it was, while China’s trade surplus is likely to be very large in the second half of the year. 

Sustained global reserve growth is consistent with what Michael Dooley, Peter Garber and David Folkerts-Landau predicted back in 2003.  They argued that not only was global reserve growth high, but that there was no reason to think that global reserve accumulation would fall back.  So far, they have been right.   

Data on the overall increase in global reserve growth doesn’t tell us how much financing central banks provided to the US.      That requires estimating what fraction of the central bank’s reserve growth was invested in dollars – and what fraction of those dollars were lent, directly or indirectly, to the US.

I rarely agree with Stephen Jen.   I certainly don’t think current imbalances are a natural byproduct of global integration, rather than a natural consequence of unprecedented reserve growth in emerging economies.  Global integration didn’t start with the Asian financial crisis – or with the post-2002 surge in reserve growth and the US current account deficit. 

But Stephen Jen is right on one point.  Best we can tell – central banks have not been diversifying their reserves.  Rather than selling dollars when the dollar is under pressure, central banks have tended to buy more dollars when the dollar is falling – helping to stabilize the market.

 

That trend seems to have continued in the first half of 2006.   In 2005, central banks reduced the share of their reserves going into dollars, and picked up their euro/ pound purchases.  Think of it as taking advantage of the dollar’s 2005 strength to pull back a bit on central banks’ massive “overweight” dollar position.   In 2006, by contrast, central banks have resumed their 2003/2004 practice of investing most of their new reserves in dollars.

 

Estimated dollar share of (valuation-adjusted) reserve growth

 

2003

2004

2005

Q1 2006

Q2 2006

Global (estimate)

84%

79%

60%

80%

77%

Countries that report data to the IMF

79%

82%

57%

75%

68%

Industrial countries

105%

92%

28%

n/a

50%

Emerging economies

61%

63%

49%

63%

71%

Emerging economies that do not report data to the IMF (estimate)

86%

79%

69%

82%

89%

The data shows that the overall share of new reserve growth invested in dollars fell a bit in q2 – relative to q1 – even though the dollar slumped more in q2.  

That data point, however, is a bit misleading.  In q1, the world’s industrial countries, in aggregate, both:

  • reduced their overall reserve holdings; and
  • sold euros and other reserve currencies to buy dollars.  

That pushed up the overall share going into dollars.  But in some sense, we don’t care so much about the world’s industrial countries.   At least not right now.   Almost all global reserve growth is in the emerging world.

Many emerging economies – notably China – do not report data on the currency composition of their reserves to the IMF.   Right now, these countries account for about ½ of the overall increase in reserves. That limits the value of the COFER data.    And requires that I make some rather Herculean assumptions to fill in the gaps in the data. 

But  the emerging economies do report data on the currency composition of their reserves added $92b to their reserves in q1, and $111b in q2.   Once valuation changes are stripped out, though, the basically intervened at the same pace in q1 and in q2 – with around $80b in valuation adjusted reserve growth in both quarters.

What did they do with those funds? 

In q1, They bought about $50b of dollars and $30b of other currencies. 

And in q2, when the dollar came under increased pressure, the share going into dollars increased.  About $57.5b of their $81b in valuation-adjusted reserve growth went into dollars, and about $23.5b went into euros, pounds and yen.   The dollar’s share of their (valuation adjusted) reserve growth rose from 63% to 71%.

The 71% share is significant -- it above the 60% overall dollar share of their portfolios.  Once again, key central banks upped their dollar purchases when the dollar came under pressure.

Obviously, I don’t know what the countries that don’t report data to the IMF did.   They account for $106b of the valuation adjusted increase in reserves in q1, and $75b of the q2 increase.  The data in the table is a guess.  It could be way off. 

It is based on the assumption that the central banks that do not report data are targeting a dollar portfolio share of around 75% -- a somewhat higher share the dollar portfolio share of those emerging economies that do report to the IMF.  Why the higher dollar share?   Simple: most of the countries that I suspect do not report their reserves to the IMF seem to peg to the dollar. 

It also assumes that the central banks who do not report acted like their colleagues who did report, i.e. they buy more dollars when the dollar is under pressure.  

What then is my bottom line? 

I estimate that the world’s central banks added $141.5b to their dollar reserves in q1, and $131.6b in q2.    $273b of dollar reserve growth in the first half of 06 isn’t shabby.  It implies a $546b pace for the year – well above the 05 total (now estimated at $400b).  

Estimated dollar reserves growth

 

Q1

Q2

H1

Estimated $ reserves increase

141.5

131.6

273.1

 

 

 

 

Recorded US inflows

75.7

74.9

150.6

o/w Treasuries

42.1

-8.9

33.4

o/w Agencies

24.1

30.5

54.6

o/w bank deposits

-0.8

41.7

40.9

o/w other

10.3

11.6

21.9

International bank deposits (BIS 5c)

51.1

25?

76.1

Total

126.8

99.9

226.7

 

 

 

 

Gap

14.7

31.7

46

 
And, for what it is worth, the gap between my estimate of dollar reserve growth and the increase in dollar reserves that emerges from combining the US data and the BIS data seems to have shrunk a bit.    That likely implies one of two things:  I either over-estimated dollar reserve growth in 2005 or central banks scaled back their purchases of US securities through London based custodians.

I am biased, but I vote for the later.    My sense is that a lot of central banks parked a lot of dollars in bank accounts.  The increase in the BIS data in q1 was quite high, and in q2, the US data shows a large increase in central bank dollar deposits in the US banking system.   They were waiting for US interest rates to peak.  

Their purchases of Treasuries were way, way down. 

And my sense is that a lot of central banks resumed their Treasury purchases in a big way in August and September.   They wanted to lock in higher rates …. And perhaps they also sensed that the tide was turning, and wanted to make some trading gains.   

I may though be overanalyzing the data.  Best I can tell, the ratio between Chinese reserve growth and recorded inflows to the US rose a bit in 2006.  And, after dipping in 2005, the ratio between the Middle East’s current account surplus and recorded Middle East purchases also rose.   It still though, is quite low – far too low to account for all the dollars most folks think the Gulf states are parking away. 

Remember, the global reserves data doesn’t account for the growth in the assets of the world’s oil investment funds, with the exception of Russia’s oil stabilization funds (it is managed by the central bank).   And they world’s oil exporters had lots of money to play with.    The US data still almost certainly understates US dependence on official inflows.

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