from Follow the Money

Stephen Kirchner needs to spend some time looking for petrodollars …

November 18, 2005

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Stephen Kirchner (Institutional Economics) has taken particular glee in the recent TIC data, as recent inflows into the US has been large enough to finance even larger current account deficits than the US currently is running.   A $1 trillion current account deficit in 2006?  No problem. 

The FT is no longer worried either -- its leader to today argues dollar strength (v. Europe and Japan) can be sustained for several more years.    And according to the TIC data, most inflows needed to sustain large deficits are coming from private investors, not from central banks.  Mr. Kirchner argues that the increase in the dollar v. the euro, yen, pound, swiss franc and Swedish krona (the components of the USD index; it is industrial country heavy) means that there is less pressure on "managed exchange rate regimes."

However, given recent gains in the USD index to two year highs, a reduction in foreign official sector purchases should come as no surprise, since there is less pressure on the managed exchange rate regimes of foreign central banks. 

I challenge him to back up that assertion. 

And to be honest, I don't think he can.

It is certainly true that Japan is doing less management these days.  It stopped intervening in 2004.  Right now, Japanese private investors are buying tons of foreign securities, bidding the dollar up.  The Japanese government has been more willing to intervene to keep the yen from strengthening than to intervene to keep it from falling. It also is true that most of non-China emerging Asia has scaled back its intervention.  India for example certainly is intervening less, but it is also not entirely out of the exchange rate management game either.

Malaysia and China are the obvious exceptions.

But China is kind of big.    And China has hardly stopped managing its exchange rate.  It spent something like $270 billion managing its exchange rate between over the last four quarters (q4 04 - q3 05) last I checked.  That is more "management" than China has ever done in the past.

Yes, the RMB is appreciating along with the dollar against the euro and yen.  But China still has to buy an awful lot of dollars to keep its currency from appreciating against the dollar and rising even faster against the euro.  Something like $20b a month, maybe more.

There has been no fall off in pressure on China's de facto peg.

And there has been an increase in the pressure on the dollar pegs/ managed floats of the oil exporters.  Both Russia and Saudi Arabia are adding to their reserves at an impressive clip (counting all SAMA foreign assets as reserves) right now.   Like China, they have to intervene to keep their currencies from rising against the dollar, and thus from rising even more against the euro.

The Saudis limit their official intervention by just depositing the government's dollar oil revenues directly in the central bank.  But running huge budget surpluses and saving rather than spending the oil windfall has a similar overall impact to intervention.  Both are ways of building up the country's official assets.

Kuwait and the Emirates may not be adding to their formal reserves, but their government-run investment companies are flush with cash.

Brazil is adding to its reserves.  And given high local interest rates, sterilizing their reserve increase is not cheap.  Argentina's reserves are growing too.  Colombia too.

Global reserve accumulation, at least judging from the IMF data through q2, remains strong.   The annual pace of reserve increase in the first two quarters of the year was around $600 billion, once adjustments were made for valuation.  

I need to get the IMF's end September numbers to produce a formal estimate for reserve accumulation in q3.  However, given what we do know about q3, it would not be surprised if reserve accumulation tailed off a bit -- to something like a $400 billion annual pace.  But that is a bit deceptive: Russia paid down debt rather than built up reserves in q3, and the IMF's data does not include the growth in the growth in the non-reserve foreign assets of the Saudi Monetary Authority, or the growth in Russia's  oil stabilization fund. 

I would argue that official intervention has not really fallen off over the course of the year so much as shifted from intervention conducted "on the books" by Asian central banks to intervention that is kept "off the books" of the world's oil exporters.   Or at least partially off the books - Russia's foreign exchange reserves and Saudi official assets both may increase by $60 billion.   Russia's reserves are up by $40 billion so far this year in dollar terms - and that gain comes in the face of significant valuation losses on their euro holdings, so the underlying pace of reserve accumulation has been stronger.  So China, Russia, and Saudi Arabia combined will probably add close to $400 billion to the reserve and official assets under the management of their central banks.

Not a small sum.

Combine the current account surplus of the major oil exporters (OPEC and Russia) with the reserve accumulation of emerging Asia and I suspect you get a sum of around $700 billion.  A bit over $300 b from China, Korea, Taiwan, India and Malaysia, all on the books of the central bank.  Then add in $400 b from the current account surpluses of oil exporters.   That allows these countries to buy lots of US and European assets -- and I am not sure that it matters so much whether the buyer is a central bank, an oil investment fund or an oil sheik.

All in all I expect emerging economies with pegs or managed floats to add at least least $500 billion to their reserves this year, after adjusting for valuation losses.   I would guess that at 2/3s of that reserve increase is invested in dollars right now and I would not be surprised if something more like 3/4s of the increase is going into dollars.   Interest rate differentials and all.    Plus, known reserve diversifiers like India and Thailand are now running current account deficits and are not adding to their reserves at a fast clip any more.  Higher oil prices and all.

So four questions for Mr. Kirchner:

  1. What is your estimate of global reserve accumulation?
  2. Does that total include or exclude the increase in the "official assets" of the Saudi Monetary authority, Russia's  oil stabilization fund (set to top $50b by year end, up $30b in 2005 alone), the investment funds of Kuwait and the Abu Dhabi Investment Authority?
  3. What fraction of that increase is going into dollar assets?
  4. And if you think the total is consistent with $4 billion a month in official purchases of dollar assets ($50 billion a year), where else is the money going? 

One aside: the $4 b number for September seems to reflect Norwegian sales that offset $8b or so of Chinese inflows.   But even $8b a month/ $100 b a year in dollar purchases implies something like $400-500 b of official purchases of non-dollar assets ...  That is a pretty big flow.  A $400 b central bank inflow into say euros could be offset by private flows out of the euro -- but I want the supporting data.

I will grant Mr. Kirchner that relative to the overall US current account ($820 b this year), dollar reserve accumulation (maybe $400b) is down.  So a rising share of the US deficit is being financed by private flows.   Last year the US current account was $670b, and dollar reserve accumulation was $500 b.  If all those dollar reserves were invested in US assets, private investors only needed to supply $170 b of net financing.    This year I think net private flows might be enough to finance a $400-450 b deficit.   That is a significant increase.  But it also is not enough to finance anything like the entire current account deficit.

I also suspect central banks are a lot happier buying dollars this year than last.   China's central bank is getting more on its dollar assets, and paying a lower rate on its sterilization bills.   And this year its euro assets - not its dollar assets - are sinking in value.  Its profits on its dollar investments are up, so to speak.

Bottom line: If someone wants to convince me that central banks in emerging markets are not financing the US, you need to show me what else they are doing with their still growing reserves.  

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