from Follow the Money

The premier speaks, the analysts listen …

July 28, 2006

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China

I no longer will be able to make fun of China for letting its exchange rate float between 7.991 and 7.999.   The RMB is now toying with 7.97

China’s top leadership now seems convinced that maybe they should allow a bit more appreciation in the face of clear evidence the economy is overheating.   After Wen’s speech, China watchers in the market (the new Kremlinologists?) now forecast that China’s rate of crawl will accelerate.    That apparently is what Wen’s call to “improve the formation mechanism of the renminbi’s exchange rate in order to gradually increase [its] flexibility” means.

I certainly hope so.   And not just because Schumer and Graham’s bipartisan bill almost certainly will come up for a vote this fall at a time when the US economy is slowing.    A stronger RMB is in China’s own interest.  If nothing else, it would lower the RMB cost of China’s imported oil … 

Yu Yongding, my favorite Chinese policy maker – OK, given the constraints on the central bank, he is probably more accurately described as someone close to the circles that make policy – is leaving the PBoC.   Too bad.   And not just because Yu is generally good for a quote.  He also had a pretty clear idea where Chinese policy should be heading.    Still does:   

““We now have a relatively favourable opportunity to let market forces determine the yuan’s exchange rate,” Yu, head of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, told Reuters in an interview

(Hat tip, Survived Sars

Though no matter how much China lets the RMB creep up, my sense is that the maximum politically acceptable appreciation is still too small to offset the market pressures for appreciation coming from a $200b current account surplus (rolling 12 month trade surplus is now well above $120b – and it looks to be rising) and substantial net capital inflows.    A small rise in the RMB won’t immediately slow China’s rapid pace of reserve growth.

That brings me to a question raised by the best vowel-less econblogger (a fellow Kansan? – I can only hope):  does central bank intervention matter

I have a bit of skin in that game.  I try to make a living tracking central bank reserves and reserve-related flows.  

But I also agree with knzn – Foreign central banks are certainly not the only participant in the Treasury market, and their actions are not the sole force driving the market.   To take one extreme example, short-term rates are entirely set by the Fed, not its counterpart abroad.    

Let’s review a few stylized facts, at least as I see them:

In 2003 and 2004, US long-term Treasury rates were low and didn’t rise once the Fed started to increase short-term Treasury rates.   This led to talk of the bond conundrum.  It also was a period when Asian central banks sharply increased their intervention, pushing the pace of global reserve growth up above $600b for the first time.   Official purchases of Treasuries rose to record levels.   Though it now seems like one central bank – the Bank of Japan, acting for the MoF – accounted for the majority of central bank inflows into the US market (the evidence for this is behind RGE’s firewall

In 2005, long-term rates stayed fairly low even as short-term rates steadily rose.    The conundrum continued.    Central bank reserve growth stayed strong, particularly if you add in the Saudis.   But there was a big fall off both in recorded central bank inflows to the US and recorded central bank purchases of Treasuries.   The fall in recorded central bank inflows to the Treasury market, however, was offset by a rise in private purchases of Treasuries by investors abroad.   I think – but certainly don’t know – that reflects indirect Chinese and Middle Eastern purchases.   It doesn’t reflect Russian purchases: Russia used its 2005 oil windfall to pay back the Paris Club and to buy short-term Agencies, not to buy Treasuries.

In 2006, long-term rates have increased – and are now at levels that are consistent with those predicted by many models (See Morgan Stanley).   No more conundrum.   Or at least not as a big a conundrum.  I suspect that with 10year Treasury yields now around 5 (and heading lower according to Bill Gross), they are a bit below the levels predicted by some models. 

Global reserve growth has remained strong.  Russia, China and host of oil states.  Algeria had $66b in reserves at the end of May, up $10b at the end of 2005.    And Algeria doesn’t have that much oil.

But foreign purchases of Treasuries – whether directly by central banks, indirectly by London custodians acting on behalf of official actors – have fallen off a cliff.   That might be one reason for the end of the conundrum. 

Foreigners haven’t stopped buying all US debt – just US Treasuries. 

Though it also isn’t quite clear how the US is financing is current account deficit.  Errors and omissions were large in q1, and recorded purchases of US long-term debt have been relatively modest in April and May

How will the formal models weigh all this evidence?  Beats me.  I am suspicious of models that use the FRNBY’s custodial holdings as a proxy for central bank buying, because it is quite clear (at least to me) that Japan dominates that data set, and many other key players buy US debt in other ways.

So what is going on? 

Here is my guess.

In 2003, 2004 and 2005, central banks and oil investment funds had an incentive to buy longer-term Treasuries rather than hold short-term Treasuries (or keep funds in the bank).  Central banks do like a bit of carry.  They need income. 

That incentive disappeared in 2006.

So even though reserves are growing, central banks are not buying as many long-term Treasuries.  If a central bank wants safety, liquidity and a bit of carry, they can get all they want at the short-end of the curve -- or in a bank.  Long-term interest rates are higher than they were back in 2004 and 2005.  But so are short-term rates. And the rise in short-rates may be driving the fall in demand for long-term Treasuries.  

If central banks want a bit more yield than short-term Treasuries offer, they need to do more than buy longer-term Treasuries.    That means buying agencies, mortgage-backed securities or diversifying out of the dollar.   China is a case in point.

At least that’s my guess.  All we know is that foreign demand for Treasuries dried up in the first bit of 2006.  And that central bank reserve growth decidedly didn’t dry up – though more and more of the reserve growth is coming from oil states.

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