from Follow the Money

Still dependent on foreign central banks …

July 5, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I generally try to mark my views to the latest data --- 

And while the US net international investment position didn’t deteriorate as much as I expected, the latest IMF data on global reserve growth didn’t contain any surprises.

The IMF reports that reserves grew by $177b in the first quarter, with roughly ½ the increase coming from countries that report the currency composition of their reserves to the IMF and ½ coming from countries that don’t (hint: China). 

I make two adjustments to this number.  First, I add in Taiwan’s reserves and the growth in non-reserve foreign assets of the Saudi Monetary Authority.   That adds $28b to the total.  And then I make adjustments for valuation changes.   For the first quarter, that means subtracting $30b for the total.   

The result: I estimate that central banks added $175b to their reserves in the first quarter (a $700b annual pace – not much of a change).   And I further estimate – using a complex proprietary RGE formula that about $131b of that increase went into dollars … (a $520b annual pace).    I am kidding about the complex formula – if anyone can back out the relatively simple rule I am using, I’ll give you brownie points!   $130b or so is still more than the $75b in official inflows recorded in the US data for the first quarter; I still think the US data understates official inflows from the emerging world.

What of the second quarter? The latest Chinese and Saudi data  (Saudi foreign assets increased by around $9b in May) allows me to update my estimate global reserve growth in April and May.  The set of countries that I watch added around $83 billion to their reserves in April and another $93b in May.   

The May total is more impressive.   The April total was swollen by large valuation gains from the euro’s 4% rise against the dollar.  

The euro appreciated in May, but not by as much – so why reserve growth picked in May?  Simple: China and Saudi Arabia.  They combined to add only $23b to their reserves (counting all Saudi foreign assets) in April, and up to $12b of that may have come from valuation gains.   The $10b combined increase in Chinese and Saudi reserves in April (after adjusting for valuation changes) is suspiciously small.   Their May reserve growth was more like $40b. The pair may not be good for $40b every month, but they should be good for $30b given the size of their respective trade surpluses. 

June could be interesting.   It may be a tale of two cities, so to speak.  Or at least two regions.    

Emerging economies with large current account surpluses should still be adding to their reserves.    China’s reserves should continue to grow –though with valuation losses rather than gains, I would expect the headline number to fall from back from$30b to around $20b.  The Saudis certainly have plenty of cash coming in, though there is no guarantee it will show up on the balance sheet of the Saudi Monetary Authority.    

However, the big fall off in capital inflows implies that emerging economies with current account deficits presumably aren’t adding to their reserves. India’s reserves are not growing.   The value of India’s foreign currency reserves fell by about $2.5b between June 2 and June 23 (though that may reflect valuation changes as much as any thing else –India has reported that it lost $5b because of adverse valuation changes between the end of q1 2005 and the end of q1 2006; the RBI has a substantial non-dollar portfolio.  Brazil’s reserves fell by 0.7b in June.   Korea is down $0.3b, Taiwan is down $0.6b and  Turkey is selling its reserves at a fairly rapid pace. 

Russia’s reserves are flat in the first three weeks of June – a big change from the $20b increase in both April and May.   Why?  A fall off in capital flows during the big emerging market sell-off, and maybe even some outflows.  Plus valuation losses … Russia, like India, has acknowledged that it holds lots of euros and pounds.  I suspect it will show a bit of a gain in the last week in the last week of June as the euro rallied just before the month ended.  That should push Russia’s overall reserve growth back into the positive territory.    UPDATE: Russia just reported its reserves rose $3.2b in June, to $250.6b.

Indeed, I think the oil exporters and China – countries that, Russia excepted, generally report their reserves with a lag -- should be good for a June increase $40-50b without adjusting for valuation.    That would push the q2 total for my set of countries up toward $215-$225b.  In the first quarter, countries that I don’t track added $35b to their reserves.  That total should go up – lots of valuation gains on the euro reserves held by various folks.

Consequently, I would estimate a global increase of $260b, without adjusting for valuation.    Valuation changes may account for $65b of that.   If I am right, central bank reserve accumulation would be in the $190-200b range – with most of the increase coming in April and May.      

$200b should generate $150b or so in dollar reserve growth.  Particularly if central banks act like they did in 2003 and 2004 and increase the portion of new reserves that are invested in dollar assets when the dollar is falling.

Why would they do that?  Simple: they are trying to keep the dollar’s share of their portfolio constant in the face of rises in the dollar value of their euro reserves.

Sum it all up, and I would estimate that the headline increase in global reserves – counting Taiwan and the Saudis – for the first half might approach $465b ($930b annualized), with an underlying pace of growth (after adjusting for valuation changes) or more like $370b ($740b annualized) and dollar reserve growth of $280b ($560b annualized). 

Big bucks.  And that doesn’t include the funds flowing into the Gulf’s oil investment funds with oil at $70.

Why does this matter?  Simple: the US needs to place nearly $ 1 trillion in debt with its foreign creditors to finance its 2006 current account deficit and net equity outflows of over $100b.   That’s what it takes to sustain the current equilibrium in the global economy.  And I don’t think private investors abroad are willing to $1 trillion in US debt to their portfolios, even with US treasuries at 5.25 …   not after seeing how well Americans did investing abroad …

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