from Follow the Money

The quiet bailout continues ...

July 7, 2008

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Monetary Policy

The roughly $30 billion sovereign wealth funds provided to troubled US financial institutions (Citi, Merrill, Morgan Stanley) attracted a lot of attention.*

The (almost) $30 billion of Bear Stearns’ assets that the Fed took onto its balance sheet (as explained here) to facilitate JP Morgan’s takeover also has attracted a great deal of attention. Understandably so. The Fed’s decision to orchestrate JP Morgan’s takeover of Bear and its subsequent decision to make liquidity available to the broker-dealers are, as of now, the defining moments of the crisis.

The $283.5 billion increase in central banks’ holdings of Treasuries and Agencies in the custodial accounts of the New York Fed during the first half of 2008 hasn’t attracted nearly as much attention.

But $283.5b -- $567b annualized -- is a big number. A 10% fall in the dollar against the currencies of those countries adding to their accounts at the New York Fed would generate paper losses equal to the total (known) exposure of the world’s sovereign funds to US financial institutions, or the Fed’s total exposure to Bear’s own debt portfolio. A bigger fall in the dollar would produce bigger paper losses. And given that many of the countries adding to their reserves most rapidly are doing so precisely because their currencies are facing strong pressure to appreciate, such a slide in the dollar isn’t hard to envision. It might even be probable ...

Between June 4 and July 2, central banks added $45.2b to the custodial accounts at the New York Fed; between May 28 and July 2 (a five week period) central banks added $54.6b to their accounts. That wasn’t as much as April -- but it was a lot more than May. It brought the total for Q2 up to $132.7 billion (nearly equally split between Treasuries and Agencies) -- only a bit below the $150.8b increase in q1.

Not all central banks make use of the New York Fed, though someone big clearly is. The growth in the the Fed’s custodial holdings consequently is a minimum, not a maximum. Total official purchases of US debt are far higher than the increase in the custodial accounts at the Fed. Nonetheless, it is worth noting that the increase in the Fed’s custodial accounts so far this year, annualized, is well in excess of total recorded official purchases in 2007.

This matters. The US had a large external deficit going into the subprime crisis. That means it has a constant need for external financing. Foreigners need to more than just hold their existing claims on the US, they need to add to them. The US responded to the subprime crisis with policies -- a fiscal stimulus, monetary easing -- designed to support domestic US demand, not to assure ongoing demand for US financial assets. And for a complex set of reasons - ongoing growth in China, energy-intensive growth in the Gulf, limited expansion of supply and perhaps monetary easing in the US -- the price of oil has shot up even as the US has slowed. Higher oil prices are likely to push the US trade deficit and the US need for financing up -- not down - at least in nominal terms.

So far that hasn’t been a serious problem. Central bank reserve growth has been very strong, most because a couple of big countries are adding to their reserves at an incredible rate. The New York Fed data tells us that a lot of that growth has been channeled into safe US assets. But there are also growing signs that rapid reserve growth is causing some countries -- including some big countries -- trouble.

Yves Smith is worried. With reason. I started to worry about a year ago, when it became clear that the slowdown in US growth relative to global growth had prompted a fall in private demand for US assets, a surge in demand for Chinese assets and a strong acceleration in global reserve growth. Since then central banks have consistently made up for any shortfall in demand for US assets, allowing the US to conduct its monetary and fiscal policy without worrying too much about how its external deficit would be financed. If I had to bet, I would bet that this won’t change in the near future. As Nouriel Roubini hints, a sustained period of high inflation in the emerging world now looks to be the most likely way Bretton Woods 2 ends.

I have continually been surprised by the willingness of the world’s central banks to buy dollars, or perhaps by the reluctance of the leadership of many key countries to shift away from managing their currencies against the dollar. But the strains on the current system -- high inflation in a host of countries adding to their reserves rapidly, and unwanted capital inflows into China -- have become rather visible.

*Sovereign funds also provided additional capital to European institutions (notably UBS and now Barclays) to help cover their subprime related losses. Adding in those funds would bring the total sovereign wealth fund financed recapitalization of the US and European financial system to around $50 billion. Sovereign funds also participate in private equity funds that have injected capital into US financial institutions.

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