from Follow the Money

Still going strong (Bretton Woods 2)

March 25, 2007

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Monetary Policy

I watch the data on global reserve growth rather closely.  But I was still surprised to see (via Global Liquidity Blog) the scale of the growth in the Fed's custodial holdings so far in the first quarter.   Since December 27, the securities the Fed holds on behalf of foreign central banks have increased by $123.8b.   That is only through March 22 – so it isn’t for the full quarter, and it still is quite an increase.  Annualized, it works out to a stronger increase than in 2004, back when Japan seemed to be buying every Treasury note the US government issued.

And the Fed data just covers the securities -- the safe securities -- held by the Fed.   Central banks also hold Treasuries and Agencies through private custodians.    They have dollars on deposit in the US.  They have dollars on deposit outside of the US.  They hold "private" mortgage backed securities (especially the PBoC).  They hold corporate bonds (though not very many) and so on.

Stephen Jen puts global reserve growth at $75-80b a month, which seems about right to me.  China has not reported data for January or February, which makes it hard to know.   But Brazil (reserves up $6.5b so far in March), Russia (reserves up $6b in the first two weeks of March) and India (reserves up a billion last week -- which is nothing compared to February) are all set to add $20b or more to their reserves in the first quarter.  Japan's reserves should increase by $10b a quarter on interest payments alone.  China is probably good for $20-30b a month even in q1 -- or $60-90b for the quarter, though a lot depends on what China decides should show up on the balance sheet of the PBoC and what will be placed elsewhere.   

Throw in the growth in the assets of the oil investment funds, and official institutions -- central banks and oil investment funds -- probably added $250b to their assets in q1.  That is roughly a $1 trillion annual pace, nearly all from the emerging world.    There shouldn't be much doubt left over who finances the US current account deficit.

Mohammed El-Erian and Michael Spence noted the uphill flow of capital in their Saturday Wall Street Journal oped as well (Hat tip, Mark Thoma).  They argue that the rise in US consumption is a natural consequence of the rapid increase in the value of US assets over the past few years -- along with the emerging world's willingness to finance the resulting US deficit.   The uphill flow of capital, in turn, explains most recent asset market conundrums (“excessive compression in risk spreads, the unusual collapse in market volatility, the inverted shape of the U.S. yield curve”).  

I basically agree.  But I am not sure, though, that the story really starts with an increase in the value of US housing stock, which in turn leads US households to naturally want to consume more and thus borrow from the rest of the world – something that the rest of the world accommodated.  El-Erian and Spence write:

“In an open economy like ours however, we can consume and invest more than output by importing more than we export -- and we did. Hence the trade deficit. However, this ability is dependent on the ability and willingness of the rest of the global economy to accommodate the US desire for higher consumption by investing in the US.”

To the extent  extent low rates in the US and Europe have stimulated the increase in home prices -- and to the extent these rates reflect an increase in the pace of central bank reserve growth in the emerging world -- the world’s central banks didn’t so much “accommodate” higher US consumption as “induce” higher US consumption.

Consequently, my telling of the story would put a bit more emphasis on exchange rates – and how the impact of dollar pegs on emerging economies changed when the Fed cut US policy rates and the dollars started to tumble in 2002.   Asian currencies -- as Jon Anderson has demonstrated – still track the dollar closely.   So the change in the dollar's trajectory against Europe had a big impact on Asia, not just on the US.

There is a debate about what changed to propel the big surge in Chinese savings -- and the resulting surge in China's current account surplus.  Chinese investment growth has been very strong; savings growth was just stronger.   But something clearly did change.  In 2000, China wasn't a big source of financing for the world.   In 2006, it was.   That shift presumably explains a lot of different financial market conundrums.