from Follow the Money

Treading water (the February TIC data and ongoing central bank financing of the US)

April 17, 2006

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The world bought $87b more of US long-term debt and equity than the US bought of foreign debt and equity.    The net inflow exceeded expectations - there were some concerns that TIC inflow wouldn't be big enough to cover the February trade deficit.

I continue to object to the Wall Street shorthand that compares these inflows to the trade deficit.   The US current account deficit will be about $10b a month bigger than the trade deficit in 2006.

Of course, the US can finance its deficit by doing things other than selling long-term debt.  It can sell short-term debt (or take out a short-term loan from the international banking system).  Or attract more FDI than US firms invest abroad.

But in recent years, the sale of long-term debt has been the dominant form of financing for the US - with net long-term flows in 2004 and 2005 exceeding the 2004 and 2005 current account deficit.   So far in 2006, net flows are running about even with the current account deficit.

By my calculations, the US needs a bit over $80b a month just to cover the expected 2006 current account deficit, and over $80b a month if it wants to use long-term debt to finance foreign direct investment abroad.  Without new FDI, it is hard to see how the US can create the dark matter that Hausmann and Sturzenegger think will keep large flow deficits from leading to any rise in the US net debt.   If flows don't pick up, the US might even have to sell off some of its existing (dark matter generating) foreign assets.

To quote Lewis Alexander of Citigroup (via Mark Whitehouse in the Journal): "We need enormous amounts of capital inflows just to tread water."

And in February, that is more or less what happened.

A couple of additional points:

  • Foreign inflows into US equities have been pretty strong so far this year.  The two month January-February total ($37b) puts the US on pace to attract far more equity inflows than in 2005 ($78b) or 2004 ($26b).  Moreover, equity inflows have, so far, exceeded equity outflows.   Given all the interest in emerging market stock markets, I wouldn't have expected that.
  • Central banks have been busy.  Their purchases have averaged $19b a month this year, $38 b YTD.  That is in line with their 2004 pace and well above their 2005 pace.   China accounts for over 1/2 of these flows.    So far this year, it has bought $25.4b of US long-term debt (though its holdings of t-bills are down by $3.1b)
  • The OPEC countries finally seems to be buying in ways that show up in the US data.  Their Treasury holdings are up by about $18b in the first two months of the year. 

London's Treasury holdings are up, the Caribbean's are down.   I guess the oligarchs of the world are using their preferred tax haven (hat tip, the New Economist) to put their cash to work as well.  Combine a non-domicile tax rule, the City and a (relatively) friendly airport greeting and there is no better place than London to manage Arab and Russian oil money.

Add the $14b increase in official holdings of T-bills to the $38b in official purchases of long-term debt, and total official financing in the first quarter looks to be in the $80b range, plus whatever comes in through the banking system.

That shouldn't be a huge surprise.   Central banks are putting their cash to work.  By all measures, they have a lot more cash to play with.   China's q1 reserves are up by $56b.  Russia's reserves are growing fast; they were up almost $24b in the first quarter.  If one former communist power can add $250b to its reserves a year, why shouldn't the other former community power add $100b as well? 

Sangeetha Ramaswamy and I believe the central banks of the major emerging markets and Japan added about $170b to their reserves in the first quarter.   That total would have been higher if Argentina hadn't repaid $9b or so to the IMF.   And once we finish looking at all the small oil exporters, I would bet we will find that the world's central banks added $200b to their reserves in the first quarter alone.

And relative to $200b, $80b or even $100b in recorded central bank inflows doesn't seem that impressive.  I still think the US data isn't pickup all central bank flows.

Ultimately, I think the reserve diversification story gets too much play, when the reserve growth story matter far more.     With the current rapid growth in global reserves, the world's central banks are necessarily adding to their existing stockpiles of dollars, euros, pounds and other reserve currencies.

That doesn't mean, though, that private flows are irrelevant.  Far from it.

Say the US got $150b in financing from the world's central banks - a high 75% of their $200b in reserve increase.   That's a ton of money.  But the US would still need another $75-100b in net private financing to cover its q1 current account deficit.   

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