from Follow the Money

One easy thing China could do to help stabilize global markets: buy Agencies!

October 25, 2008

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There is constant talk – too much, in my view – about whether sovereign funds will come to the rescue of western financial institutions.

Qatar did put a large sum of money into Credit Suisse recently, but in general the Gulf funds are reeling from large losses on their existing portfolio even as they are facing increased domestic demands (see Mufson and Pan of the Washington Post and Steven Johnson of Reuters) . “Rescuing*” US banks but not your own countries’ markets – and our own countries financial institutions -- is hard. And some Gulf countries’ ability to carry out their ambitious local development plans will hinge on the availability of financing from their sovereign funds is oil stays at its current levels.

China is still cash rich. But the CIC has yet to prove that it can manage a $100 billion balance sheet (its "frozen" investment in the Reserve Primary Fund is the latest case in point) let alone manage a US or European financial institution with a far larger balance sheet. Moreover, it would seem a bit bizarre – at least to me – for the US taxpayer to guarantee the liabilities (and thus be on the hook for most future losses) of an institution that is effectively owned by China’s government. As Uwe Reinhardt notes, US taxpayers are already on the hook for most of the downside – and handing over both the upside and control to another country’s government (typically a non-democratic government) hardly achieves the goal of keeping major financial institutions in private hands.

But there is something that China could do that would be both stabilizing and pose few difficult policy issues: it could resume its purchases of US agency bonds.

The US hasn’t technically guaranteed the Agencies liabilities because it doesn’t want their (large) book to be consolidated on the US government’s balance sheet. But it has signaled that it stands behind the Agencies – and so long as the Agencies are the only source of mortgage credit for American households, that guarantee is quite credible. This guarantee led PIMCO to add to its already large bed on Agency bonds – but it hasn’t reassured the central banks that until recently were large purchases of Agency bonds.

Agency spreads remain wide. Accrued Interest has reported that they will remain wide until "real" money -- and apparently more real money than even PIMCO can mobilize -- returns to the Agency market, given the difficulties leveraged investors now face.

In the past, Asian central banks -- and especially the PBoC -- were a key source of demand for Agency paper. But the Fed’s custodial data – which seems to capture about 90% of all central bank holdings of Agency paper – leaves little doubt that the world’s central banks are now fleeing the Agency market. In the first three weeks of October, the latest New York Fed custodial data indicates central banks have added $53.9b to their Treasury holdings while reducing their Agency holdings by $51.4b. Since September 3 – roughly the time when the Treasury announced it would recapitalize the Agencies as needed – central banks have added $130.2b to their Treasury holdings while reducing their Agency holdings by $40.7 billion.

China accounts – by my estimate – for about 50% of all central bank holdings of Agencies, so it likely has contributed to the broad reorientation of central bank portfolios toward Treasuries. And China – unlike most emerging economies – still has a growing stockpile of reserves. It consequently is in a strong position to add to its Agency portfolio rather than continuing to pile into Treasuries.**

That would facilitate the flow of credit to American households willing to buy homes at current prices – and thus help to support home prices, and indirectly, the US financial system. It doesn’t offer the prospect for turbo-charged returns, but Agencies do offer higher yields than Treasuries. And the downside risk is very small – unlike the downside risk associated investing in a major Western bank.

And while we are on the topic of “stabilizing speculation,” China could also shift some of its portfolios from dollars to euros and pounds and Brazilian real and Australian dollars and Russian rubles. This is the time to diversify – not when the dollar is under pressure! Dollar strength amid US weakness strikes me as a growing problem.

*Rescue is the wrong word. Countries typically invests abroad to achieve their own policy goals -- whether financial returns or strengthening their own ambitions to be a global financial center -- not to "rescue" another country’s banks and help another country stabilize its markets. True rescues – investments with a high probability of a loss done to assure domestic financial stability – are generally done the government of the country that regulates the troubled financial institution. No country wants to “rescue” another countries’ banking system if that means losing money.

**The argument that China needs liquidity and only Treasuries are liquid doesn’t really work – China’s Treasury holdings are already so large that they are effectively illiquid, especially in the current market environment.

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