Last week, I argued that the emerging world’s governments have been provided the US with an enormous credit line – one large enough to prop the dollar up – even in the absence of any formal institutions to help coordinate their actions. This credit line has even been increased as the United States financing need increased – largely because falls in private financing to the US translated into increased intervention by central banks unwilling to allow appreciation against the dollar. A desire not to appreciate (by too much) against the RMB, together with policy inertia in the Gulf, substituted for formal coordination.
But that doesn’t mean that the existing system hasn’t given rise to some coordination failures. I want to highlight two –
A lack of coordination between central banks and sovereign wealth funds inside a de facto currency union. This coordination failure effectively shifts unwanted dollar exposure – as the core issue facing the global financial system is who holds the unwanted exposure to a depreciating dollar and the resulting losses (see Barry Eichengreen's 2004 paper) – from a country’s sovereign wealth fund to its central bank.
And a lack of coordination across countries that may have allowed some Gulf countries with sovereign wealth funds to shift exposure to the dollar to emerging Asian economies reluctant to allow their currencies to appreciate against the RMB.Both arguments are a bit speculative. Absent detailed information about the portfolios of the GCC investment funds and emerging Asian central banks, I cannot prove either argument. I still suspect both are potentially real issues.
First, the lack of coordination between a region’s sovereign wealth fund and its central bank.
Suppose that the GCC’s various wealth funds have been reducing the dollar share of the (rapidly growing) portfolios. This doesn’t mean selling dollar assets – but it does mean using the (dollar-denominated) oil revenue stream to buy European, Asian and even Latin assets rather than US assets. Both Kuwait and Qatar have indicated that they have reduced the dollar’s share of their portfolio. Abu Dhabi has a bigger investment fund than Kuwait, but roughly the same flow from its oil revenues. It isn’t clear whether ADIA has reduced the dollar share of its holdings recently or simply moved away from the dollar (and toward emerging economies) earlier than the other funds. No matter, it is likely that less than 60% of the oil revenue stream that the big GCC investment funds are managing is going toward US assets.
Now suppose that the Gulf investment funds portfolio shift has put downward pressure on the dollar. The smaller Gulf countries have a current account surplus of over $100b (see talbe 15/ p. 58), and are likely adding at least $80b to their investment funds (the IMF estimates the sum of official outflows and reserve growth from the Middle East in 2007 will top $200b).
That is a meaningful flow in a global sense: It is between 15 and 20% of the emerging world’s surplus. In a paper that became an instant classic, my friend Ramin Toloui of Pimco calculated that if less than 60% of global oil revenue flows into dollar assets, a rise in the price of oil is dollar negative.
A fall in the dollar pushes the Gulf’s currencies down v. their major trading partners. They still peg to the dollar after all. And the fall, in turn, creates expectations that the Gulf will eventually allow their currencies to appreciate. Pegging to a falling dollar as oil rises massively in real terms doesn’t make much economic sense. That pulls in speculative flows.
The net result: the GCC countries central banks are intervening in the currency market, and adding to their reserves. The $15b increase in the Emirates fx reserves in the first half of the year didn’t come from Abu Dhabi’s oil revenue. And almost all of it seems to be in dollars.
GCC investment funds end up with fewer dollars and more European and Asian assets, but GCC central banks end up with more dollars. The region’s total holdings of dollars continue to rise. And the US still gets the financing it needs ….
This story has broader relevance. SAFE – together with Huijin – used to manage almost of China’s foreign assets. And both SAFE and Huijin reported to the PBoC. Now though a broader range of state institutions – whether the China investment corporation, Citic, CDB or the state oil companies/ other state firms holding cash offshore – are managing China’s foreign assets. Each can potentially maximize its performance by minimizing its dollar holdings. But if all try to do this, they are likely to put more pressure on the RMB’s dollar peg – and force the central bank to intervene more.
The second coordination failure occurs across borders, not within them. And it likely has the character of shifting dollar exposure from oil exporting economies to oil importing economies that produce goods that compete with China.
Suppose the Gulf investment funds decide to increase their investments in emerging Asia. They cannot easily invest in China. China has capital controls. And China doesn’t need their money. It has an even bigger surplus than the Gulf, even with oil at $85-90 a barrel. But they can invest in other Asian economies with more open capital accounts – whether Pakistan, India, Thailand, Malaysia or even Korea. I wouldn’t be surprised if Gulf flows have contributed to the performance of the KOPSI, for example. But all these countries are already attracting more inflows from the rest of the world than they want. They are all already intervening in the foreign exchange market to keep their currencies from appreciating against the RMB.
More flows from the Gulf then just lead to more to intervention. And, in effect, the dollars that the Gulf doesn’t want get passed to central banks in Asia.
That isn’t a good outcome for those central banks. Many of these Asian economies pay more on their sterilization bills than they get on their dollars and euros – and they also are stuck with depreciating dollars. They would rather the Gulf just keep its dollars, or that it buy more euros. But unless they wall off their capital accounts, they don’t have much choice …
And they are likely dreading a wave of investment from China’s investment fund. They are already intervening to keep their currencies from appreciating against the RMB. The last thing they want to do is intervene even more to allow China to diversify away from the dollar. They could quite reasonably argue that if China wants to maintain a de facto crawling peg v the dollar – all the econometrics suggest that China doesn’t really have a basket peg – it ought to keep all the dollars the PBoC ends up buying.
But absent a bit of coordination, emerging Asia has no way to require than China hold its dollars.
What conclusions do I draw from this analysis?
Well, I suspect that the rise of sovereign wealth funds will pose something of a challenge to the basic dynamics of the Bretton Woods 2 system – and not just because the emerging world is starting to demand US equities in exchange for financing the US trade deficit. Central banks basically just hold dollars, euros and pounds. Sovereign wealth funds have more freedom – which means that they can try to sluff some of their dollars onto other emerging economies. Or, if they are not careful, onto their own central bank.
Moreover, the shift toward SWFs coincides with a period when US growth is subpar, the United States' comparative advantage at creating complicated securities no longer looks like much of an advantage. That suggests – at least to me – that the coordination problems associated with the Bretton Woods system could become much more serious.