Bretton Woods Two Lives

The Fed has started to tighten, Greenspan said anyone who has not hedged their interest rate risk desires to lose money. Yet higher short-term rates have not led to higher long-term rates. In the jargon of the market, the yield curve has flattened.

Why is the yield on long-term Treasuries still so low?

My tentative answer: a surge in reserve financing in the fourth quarter from emerging economies largely made up for Japan’s absence from the Treasury market. As central banks intervene in the foreign currency market to defend a fixed exchange rate or to prevent their currency from appreciating, they buy dollars -- dollars that are then invested in the US fixed income market, whether in Treasuries, Agencies or something else. That is the Bretton Woods two hypothesis: foreign central banks will finance the US trade deficit in order to keep their exchange rate from appreciating.

What is the evidence?

China. China’s reserves jumped $28 billion in October (This was confirmed in Friday’s Wall Street Journal, but I have yet to find a free link). Maybe $5 billion of that can be attributed to changes in the euro/dollar, the rest came from People’s Bank of China intervention to support the renminbi-dollar peg. Suppose that China’s reserves increased by another $25 billion in both November and December -- $5 billion from valuation gains and $20 billion in new intervention. That would imply that China’s total reserves jumped by more than $75 billion in q4, and China’s overall reserves now stand at roughly $595 billion. Its dollar reserves -- what matters for the financing of the US deficits -- could well have increased by $60 billion ($20 billion a month) in the fourth quarter.

Don’t like my inferences? Look at what Andy Xie of Morgan Stanley has been saying. He expects hot money inflow of $100 billion into emerging Asian economies in q4, with most of that going to China. Since emerging Asia is running current account surpluses and does not need extenral financing, all these inflows generally get captured in reserves.

Russia. Russia’s reserves are up $25.7 billion in q4, to nearly $121 billion. Some of that increase is from the euro’s rise v. the dollar, but not all.

India. India’s reserves are now $131 billion, up $12 billion in q4.

Brazil. Its reserves are up $3.3 billion this quarter, to nearly $53 billion. Brazil, though, differs from all the other countries on this list: it still has fewer reserves than it needs. Its reserves, net of what it owes the IMF, are only about $25 billion -- not a lot for an economy of Brazil’s size.

Korea. Its reserves really surged this quarter. They are expected to reach $200 billion at the end of the year, up $25 billion from the end of September.

Taiwan. The Central Bank of China -- Taiwan’s central bank -- saw its reserves increase by $9 billion between the beginning of October and the end of November, so Taiwan’s reserves probably increased by at least $12 billion in q4. For the year through November, Taiwan’s reserves are up $32.5 billion.

Sum up the estimated reserve accumulation of these six countries in the fourth quarter -- call my little grouping the BRICs plus the non-city state NICs -- and you get a total of $156 billion. Assume 75% of that increases, $117 billion, comes from an increase in their dollar assets, not valuation gains on their euros, yen and gold. The US current account deficit in q4 is likely to be around $175 billion. In other words, to find two-thirds of the financing the US needed in q4, you only really need to look at the balance sheets of six big financial institutions.

Six emerging economy central banks are probably providing the US with, on average, a bit over than $1 billion a day in financing.

Pretty amazing when you think about it. That is lots of market concentration, not to mention a rather extreme dependence on the political and economic decisions of a few countries.

Not all of this dollar reserve buildup went into the Treasury market, but with roughly $117 billion going into US assets, enough presumably did make its way into Treasuries to have some impact on Treasury prices ...

The overall amount of official financing the US received in q4, of course, is even greater. The smaller Latin American and Asian economies are intervening as well. With oil high, the Gulf states are making plenty of money too -- though it is a bit harder to estimate the pace at which they are adding to their external assets.

Let’s try anyway. The New York Times just reported that the assets of its oil fund increased by $33 billion this year. Norway produces about 3.3 mbd of oil, and the revenue from the oil oil no doubt contributed to fund’s increase, along with the appreciation of the oil fund’s existing assets. If the Saudis, the Qataris, the Kuwaitis, and Emirates saw their external assets grow at a similar rate relative to their oil production -- a huge assumption -- their 15 mbd of oil would translate into a $150 billion or so increase in their assets this year. Of course, in the gulf, more of this increase would show up in the private funds of the oil sheiks and less in the accounts of a transparent Norwegian-stlye petroleum fund.

However, my round-about way of estimating the increse in oil sheik assets feels a bit too high, particularly since I am interested in the new assets the sheiks are buying with their oil windfall, not the valuation gains on their existing assets. The Gulf oil states are getting about $100 billion more for their oil this year than in 2002. If most of that windfall is being saved, they added maybe $75 billion to their assets this year -- a number consistent with the IMF’s forecast for an overall $110 billion current account surplus in the Middle East. Since oil was particularly high in q4, $25 billion in new external assets this quarter would not be an unreasonable estimate -- particularly given what happened to Russia’s reserves.

The Gulf states are presumably even less interested in dollar assets than the Russians, but their money still has to go somewhere. And given the United States’ enormous need for financing, some of it has to trickle back into the US.

Bill Gross has warned that a burst of intervention could bring the price of the ten year down: I have a sneaky suspicion that is what happened this quarter. We were looking for intervention from Japan --and missed accelerated reserve accumulation by emerging Asia and the oil states. Some oil exporters no doubt have been diversifying out of the dollar, but there modest first steps seem to have been overwhelmed by the scale of Asia’s q4 reserve accumulation.

Does the surge in q4 reserve financing mean that the Bretton Woods two system is stable and sustainable, that rising reserve accumulation in the emerging world will finance a rising US current account deficit? Or is it evidence that the system is being stretched to its breaking point, and the People’s Bank of China and the Bank of Korea are being asked to do too much, and to take on too large a share of financing the US deficit?

The scale of the financing these countries are providing the US is truly staggering. If my reserve accumulation numbers are correct, the central banks of six emerging economies added reserves at a $600 billion annual pace in q4, and added dollar reserves at annual pace of between $450 and $500 billion. That pace of reserve accumulation, should it continue, is enough to finance a large chunk of the United States’ 2005 current account deficit, which is likely to be in the $750-800 billion range.

Europe complains that it alone bears the burden of currency adjustment v. the dollar. Emerging Asian central banks could just as well complain that they alone are stuck with the burden of financing the United States.