- Blog Post
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I tend to agree with Tony Tassel and Joanna Chung of the FT. If sovereigns shift from buying bonds to buying equities, the impact on equities is rather more ambiguous than many think. More demand is good, but private equity has already been pretty effective at transforming central bank demand for debt (counting private demand for debt that yields more than the debt that central banks buy as a knock-on effect from central bank demand) into demand for equities. And if shifting from bonds to equities drives down bond prices and drives up rates, well, that isn’t obviously good for equities.
If central banks want to shift from “safe” – at least in the sense of lacking credit risk -- Treasuries and Agencies to various spread products, they risk buying in at the peak. After all, in recent years (and especially 2006) central bank demand for safe assets topped the creation of safe assets, so private investors who sold their treasuries and agencies to central banks bought risky assets. Add in the impact of the CDO put, and, well, it is hard to imagine how sovereign wealth fund demand for “spread” products could drive spreads down further ….
The only strong conclusion that I have been able to draw from looking at the asset allocation of existing sovereign wealth funds is that they, unlike central banks, don’t shy away from emerging markets. But then again most emerging markets don’t need any more inflows. The last thing Brazil – and a host of other countries –want is for China’s new investment fund to start to play the carry trade and add to the pressure on Brazil’s currency. The oil funds would love to invest in Asia, but what Asian country currently needs the money? Almost all can finance their existing level of investment out of domestic savings. India invests more than it saves, but it already is attracting more funds than it needs.
Until more emerging economies follow the example of Eastern Europe rather than the example of China, I don’t quite see how sovereign wealth funds can finance the emerging world. One surplus country (Saudi Arabia) cannot finance another surplus country (China). While everyone has been debating how sovereign wealth funds will change the world, central banks have quietly gone on piling up assets. The latest data from the BEA showed $440b of central bank inflows to the US in 2006 – and an increasable $380b in central bank purchases of traditional reserve assets (more here). Central banks now buy Agencies as well as Treasuries, but otherwise, 2006 looks a lot like 2004.
Moreover, the BEA data almost certainly understates central bank purchases in the second half of 2006. Remember, the data for the first half has been revised to reflect the findings of the most recent survey, but the data for the second half has yet to be revised. Expect that a lot of the private purchases of Treasuries and Agencies in h2 2006 will turn out to come from central banks. The revised 2006 data - which won't come out until mid-2008 -- is likely to show $500b or so in in official inflows.
After all, we know from the IMF’s data that central bank reserve growth accelerated over the course of 2006, so there is good reason to think central bank purchases of US bonds picked up in the later half of the year.
Reserve growth then accelerated a bit more in q1 2006. The BEA data shows that official actors – in principle central banks and sovereign wealth funds but in practice mostly central banks – bought $150b in US assets in q1 – a record $600b annual pace. And that too is an understatement. My measure of global reserve growth suggests the pace of reserve growth in q1 was around $250b in q1, and I would bet that more than $150b found its way into dollars. In April and May, global reserve growth probably picked up to a $300b quarterly pace, so $200b in central bank demand for dollars in q2 -- at least up until June -- seems about right. That is, to put it mildly, a lot.
Steven Englander of Merrill Lynch is quite right to observe -- in a recent note -- that:
"What this [the large share of the 2006 deficit financed by central bank buying] suggests is that there is a big gap between the US funding needs and the foreign private sector's desire to acquire USD assets. The implication is that the dollar is being buoyed largely by official purchases. ... What is more interesting is that the most of up data suggests that, if anything, central banks have accelerated their buying so far this year ..."
If you project that kind of sovereign demand for financial assets out forward, but assume all the incremental demand will come from sovereign wealth funds , you can quickly generate impressive sums. If you assume that some existing central bank asset, which, counting all of the Saudi Monetary Agency's foreign assets, are now probably closer to $6 trillion than to $5.5 trillion, will be shifted to sovereign wealth funds, then sovereign wealth funds will get really big really fast.
But for now, old-fashioned central bank reserves are still growing faster than sovereign wealth funds. Central banks just don’t seem to be buying Treasuries. Not in April, when they sold Treasury bills to buy notes.
Brazil bought a lot of Treasuries in April. The other big central banks not so much, China reduced its holdings of short-term Treasury bills, and didn't use the resulting funds to buy longer-term Treasuries (it preferred Agencies). Russia scaled backs its holdings of short-term agency bills even as it increased its long-term holdings.
Recorded inflows from both Russia and Chiha were small in relation to the pace of their reserve growth in April-- suggesting that both are also buying through London intermediaries. But it isn't clear that they are buying Treasuries even in London. In April, the UK was a net seller of Treasuries. And judging from the anecdotes circulating through the markets (covered well by the Financial Times), central banks didn't buy many long-term Treasuries in June.
Central banks equally clearly didn’t stop adding to their reserves in June. OK, Russia’s reserve growth has slowed from insanely fast ($5-10b a week) to merely very rapid ($3b a week). Most of the oil exporters are flush with cash. Brazil is still intervening, though perhaps at a slower pace than before. It is hard to tell so long as its central bank refuses to release its reserves data. India continued to intervene in the first week in June. And China clearly hasn’t stopped intervening.
Those funds have to be going somewhere. Bank deposits? Equities? Agencies/ MBS? Corporate bonds …
I certainly don't know, but if i had to guess, I would bet that a lot more is going into bank deposits and other short-term instruments than into equities.
But that is a hard case to make based on the April data. The TIC data suggests that the world's central banks built up their bank deposits, but they reduced their holdings of short-term securities even faster ...
However, there is a lot we don't know. About June. And even about April. More official reserve growth -- judging from a likely $100b plus pace of reserve growth in April -- takes place in ways that don't show up in the TIC data than in ways that do.
UPDATE: A bit more from HMC's El-Erian. I highly recommend both El-Erian's article and the Tassel/ Chung article (the link is above)