from Follow the Money

A couple of (mental) light bulbs …

August 8, 2006

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I spend a lot of time thinking about reserves.  And I have long been puzzled by the modest April increase in China's reserves.   China’s trade surplus was solid.  There is no particular reason to think that FDI inflows into China slowed dramatically in April.  And hot money flows to the rest of Asia picked up, so a fall in hot money flows into China seemed, well, somewhat implausible.

Plus, the euro rose substantially against the dollar in april – going from around 1.21 to around 1.25.   That should have pushed the dollar value of China’s euro reserves up.   No matter how I thought about it, i couldn't figure out why China added only $20b to its reserves in April.  I was expecting around $30b.

A light bulb went off in my head today when I read in the Wall Street Journal that the fall in US long-term bond yields (and increase in bond-prices) in July added around $7b to Japan’s reserves, pushing Japan’s total reserves up to almost $872b.    The ten year rate when from 5.15 to 4.9 in July.   

I have been adjusting for valuation changes from currency moves.  But not for valuation changes from interest rate moves.  And valuation changes from interest rate moves just may explain the slow pace of China’s April reserve increase (around $10b after my adjustments for currency valuation, well below China’s roughly $20b a month average).   

Looking at the data on the St. Louis Fed, the ten your treasury bond are went from 4.86 to 5.15 in April. 

I think most observers think that China has a more aggressive reserve portfolio than Japan (notably holding more mortgage backed securities).    China’s April 2006 reserve increase would make a lot more sense if China had a lot of duration in its portfolio, and thus was exposed to the rise in US ten year rates.  Valuation losses there would have offset of China’s valuation gains on its euros. 

Just a thought.

I also think I have figured out why I was surprised by the size of the United States’ capital gains in the latest NIIP data.    Remember, capital gains on US investment abroad effectively offset the increase in US debt from the United States (big) current account deficit. 

Those capital gains came not from currency moves, but rather from the soaring market value of US FDI and portfolio equity investment abroad.   Equity markets outside the US outperformed US equity markets.  I was expecting some gains, but the scale of the gains still exceeded my expectations.

And the market value of foreign FDI in the US actually fell a bit.  That surprised me, since the broad US markets were up a bit.

I think I have figured out why the size of the capital gains on US FDI abroad was so big.    The data usually is adjusted to take into account reinvested earnings – i.e. if the market value of US FDI abroad increases by $200, but US firms reinvest $100b of their overseas earnings in their offshore subsidiaries, the BEA only credits the US with a $100b capital gain.  No double counting.

But 2005 was a strange year.   US firms typically reinvest $100b or so a year abroad. In 2004, that total was more like $160b.   But in 2005, because of the Homeland Investment Act, US firms didn’t reinvest a penny (in aggregate, they took about $10b out of their offshore operations).   That meant that all of the increase in the market value of US firms was counted as a capital gain –

The big surge in the market value of US firms operations abroad came even as these firms were running down their cash balances to pay big dividends back to their parents. 

The same applies in reverse.   The reinvested earnings of foreign direct investors in the US still seem small to me.  But they in 2004 and 2005, the BEA made an effort to get better data.    So reinvested earnings in 2005 were in the $45b range.   And apparently, the capital gain on foreign direct investment in the US was smaller than that.

In other words, the market value of US firms abroad soared even as US firms took money out of their operations.   And the market value of foreign firms operating in the US didn’t increase by enough to offset the money foreign firms put back into their US operations. 

Apologies for the diversions -- I suspect the only thing anyone really wants to talk about is the Fed.

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