from Follow the Money

If the governments of emerging economies stuck to buying bonds would everything be ok?

November 3, 2007

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Bloomberg’s Matthew Lynn argues that those countries now fretting about the impact of sovereign wealth funds didn’t complain when sovereign governments bought huge quantities of bonds:  

Nobody minded when emerging economies recycled all those dollars, pounds and euros by putting cash on deposit in our banks, or buying bonds issued by our governments. So why should we mind when they start buying companies?

Lynn continues:

"If we don't like them purchasing our equities, shouldn't we tell them to stop buying our bonds and currencies as well? "

But isn't that pretty much the US position? The US, and notably the US Congress, is calling for more exchange rate flexibility in China even though that should mean that China buys fewer dollars and fewer dollar-denominated bonds.  Remember, it also should mean that China should buy more dollar-denominated goods.

Critics of the “Bretton Woods 2” international financial system have long complained that sovereign demand for bonds masked the impact of large fiscal deficits and low household savings rates, inhibiting a necessary adjustment.   They have argued, quite explicitly, that emerging markets should be buying far fewer financial assets.

It consequently, it shouldn't be a surprise that many who thought emerging market central bank demand for US bonds financed too large a US currnent account deficit are less than thrilled by a world where emerging market sovereign wealth fund demand for equities finances equally large deficits.

Indeed, I worry that the effort that has gone into establishing sovereign wealth funds seems to have exceeded the amount effort devoted to changing the policies that gave rise to the world’s existing imbalances.    The creation of a Chinese sovereign wealth fund in a world where the RMB is appreciating against a basket of currencies (not just the dollar), China’s current account surplus is trending down and the pace of Chinese reserve growth is slowing seems rather different than the creation of a similar fund in a world where China’s surplus is still growing and China could easily add even more to its official portfolio in 2008 than it did in 2007. 

In one respect, though, Lynn is certainly right.    Emerging market governments already have the capacity to move markets.  They have been a huge presence in the bond and foreign exchange market for several years. The data on central bank reserve growth suggests that central banks have bought $800-900b of US, European, Australian and Canadian bonds over the last four quarters.    That is enough to move markets.  The IMF's data shows an increase in global reserves of over $1.1 trillion over the last four quarters -- when I throw in SAMA's non-reserve foreign assets and subtract out valuation gains and I get a total valuation-adjusted increase of around $1050b.  The increase in recent quarters has been larger.

That is a huge flow. At least so far, though, the world's central banks generally have acted in ways that buffer and stabilize markets, notably by buying dollars and dollar-denominated bonds when no one else wants to.   

Gradual adjustment is certainly better than precipitous adjustment.  And by stabilizing the fx and bond market markets, central banks certainly have helped slow the pace of adjustment.   Net private capital flows to the US have fallen much faster than the US current account deficit over the past few quarters. 

But if the world's central banks are not careful, they risk blocking a needed adjustment altogether.  

Asia's external surplus should not be rising right now.    Not with high oil prices.   Not with strong Asian growth and (setting q3 aside) weak US growth.

Back in 1980, the oil surplus was offset by deficits in Europe and Asia.  Today it is overwhelmingly offset by the US.   Some of that is the United States fault, as the US economy remains very energy-intensive.   But it also isn't entirely the United States fault.  Not when two major energy importers (China and Japan) are exporting almost as much spare savings as the world's energy exporters.  

That underlying reality -- the simultaneous combination of a large Asian and a large oil surplus and large official asset accumulation in both Asia (setting Japan aside) and the oil-exporters -- is, in my view, a concern.   And it a concern with $1.05 trillion a year in reserve growth and $100b in transfers to sovereign wealth funds .  It will still be a concern if -- as some of the investment banks now predict -- the world will soon add only $100b or so to its reserve because up to $1 trillion a year will be handed over to sovereign wealth funds. 

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