from Follow the Money

What are Zhou and al-Sayyari doing? Reserve management and the Fed’s balance sheet operations

March 10, 2008

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Paul Krugman noted that his discussion of the Fed’s recent policy steps was rather wonkish. If that is true, my comments will be off-the-wonkish charts.

I want to try to bring the actions of foreign central banks into Krugman’s discussion of recent Fed efforts to use the "asset" side of the Fed’s balance sheet to stabilize financial market conditions.

Krugman argues that the literature on sterilized central bank intervention in the foreign exchange market can be used to understand the Fed’s recent policy steps.

When the central bank sterilizes, the "liability" side of the central banks’ balance sheet doesn’t change. It doesn’t print any more money, or issue any more bills. That is what "sterilization" means.

What changes is the asset side of the central banks balance sheet. It might for example sell US Treasury bonds and buy German government bonds. That increases the supply of US Treasury bonds in the private market, and reduces the supply of German government bonds in the private market.

Krugman - building off the thought-provoking work of Mr. Waldman - argues that the Fed is effectively reducing the supply of "Agency MBS" in the market while increasing the supply of Treasuries in the market. It is trying to keep a surge in private demand for Treasuries (and a surge in private sales of Agency MBS) from pushing up the price of Treasuries and pushing down the price of Agencies (increasing the "spread" between the two bonds well beyond historical norms). He writes in today’s column:

Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

Krugman (with some support from Delong) then applies the standard critique of sterilized intervention to the Fed’s actions - namely, that just as central banks fx purchases and sales are too small to have much of an impact on the a multi-trillion dollar fx and bond market, the fed’s purchases of Agencies will be too small to have much of an impact. Krugman, from his blog:

... this is just like the way you analyze sterilized intervention in currencies. And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it’s usually because of the "slap in the face" effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses.

That piqued my interest, because I have long wondered if central bank actions - counting the actions of emerging market central banks -- are still really "a drop in the bucket" in the foreign exchange and government bond markets.

The Fed and the ECB typically do intervene in small quantities - a few billion here, a few billion there - and for a short period of time. But the Fed and the ECB aren’t the only central banks active in the US and European government bond market. China has something like $60b to place in these markets every month right now.

That doesn’t strike me as a drop in the bucket.

If it put all $60b in Europe that might make difference on the euro/ dollar, and on bund yields.

Conversely, if it put all $60b in Agency MBS market and stopped its existing purchases of euros, it could provide a fair amount of support to that market - and perhaps for the dollar.

And it is a sustained flow. A change in China’s pattern of purchases and sales in the fx market today could signal a change in how it manages its $60b plus flow next month.

The fact that this is a sustained flow -- and that there is no hard upper limit on how much foreign exchange China can accumulate -- potentially differentiates China’s $60b a month from the $40b the Bank of England spent defending the pound back in the early 1990s.

I should note though the there is an enormous debate on how central bank actions impact the fx market. My sense is that most traders think central bank flows matter, and have an impact on price. And my sense is that most central bankers think that central bank flows don’t matter all that much, because private investors offset their impact.

This view, for example, informs Alan Greenspan’s view that a complete shift in China’s purchases from dollars to euros would not increase US bond yields by more than 50 bp (See the Age of Turbulence). That was back when China was adding a bit less than $660b to its portfolio a year. But it is typical of the dominant view in the Fed and perhaps the ECB as well. China’s sales don’t changing any of the "fundamentals" so private investors should be quite willing to buy what China wanted to sell without much of a change in price.

Nonetheless, if my characterization of the views of traders and central bankers is right, the gap between the view of the trading floor and the view in the central bank’s board room is potentially quite large.

And on this question, I tend to be sympathetic to the view of the trading floor -

That has one sort of surprising conclusion.

Central banks - globally -- have not been helping during the recent "liquidity" crisis.

A few quick points.

First, emerging market central banks likely added over $150b to their reserves (a $1.8 Trillion annual pace) in January alone. China added $55b alone, adjusted for valuation. The state banks may have chipped in a few billion, or tens of billion more. China doesn’t export oil. The Saudis, who do export oil, added $18b. There are other oil exporters as well. Brazil added $5b. India added well over $5b. My methodology here isn’t complicated. I just add up the total that various big central banks disclose. If central banks are using state banks to hide the scale of the intervention, the real total could be higher.

That $150b doesn’t count sovereign funds. It is safe to assume that the big Gulf sovereign funds received another $10b. $100 a barrel oil and all.

That $160b in foreign asset growth is well in excess of the emerging world’s current account surplus. The oil exporters current account surplus is maybe $60b a month. China’s is around $30b right now (it might rise later in the year). The rest of the emerging world is likely in rough balance ...

It consequently reflects ongoing capital inflows into the emerging world. Michael Pettis is right to be obsessed with the scale of these flows.

Private investors fleeing Agency MBS and US ABS have been fleeing into Treasuries. But they also have fled the dollar. Those investors with some remaining appetite for risk are betting on the emerging world.

Call it a flight from risk assets in the US to "risk" assets in the emerging world.

Dr. Hamilton argues that there also has been a flight from nominal assets to real assets - like commodities.

Now, the private funds going into the emerging world are in effect bought up by the emerging world’s central banks. Emerging market central banks don’t want a surge in private demand for emerging market financial assets to lead to a surge in the market price of their currency, so they intervene. That means they buy dollars. And those dollars in turn are recycled back into the US market.

And where are they going right now?

Well, by all appearances, into Treasuries, short-term debt issued directly by the federal Agencies and bank deposits. Not into Agency MBS.

In that way, a shift away from "risk" assets in the US toward "risk" assets in the emerging world leads to additional official demand for the safest of US assets precisely at a time when US private investors are also piling into safe US assets. Right now, it seems like Treasuries are the only asset that both private investors and central banks think is really safe.

In that way, the activities of foreign central banks are adding to the "liquidity" crunch in the US credit market.

And really hurting any investor who had bet on the persistence of historical spreads between Treasuries and Agencies ...

To go back to my post on Friday, foreign central banks - who also have to manage the asset side of their rapidly growing balance sheets - could take actions that reinforce the Fed’s actions. The Fed is now effectively lending cash against Agency ABS collateral (through the TAF). Foreign central banks could join in, by buying Agencies. The asset side of their balance sheet is now quite large, even relative to the asset side of the Fed’s balance sheet (and it is growing faster). Felix notes:

...some of the trillions of dollars currently being held by foreign central banks could definitely come in handy right now. They’re sitting on nice capital gains on their Treasury holdings, thanks to the current flight to liquidity. It would be great if they started dumping those Treasuries and buying the bonds of Fannie and Freddie instead, at least for the time being.

Conversely, the world’s central banks could take actions that would tend to offset the Fed’s actions - basically buying all the Treasuries that the Fed is releasing into the market as it buys Agencies. As Rebel Economist noted in the comments here, reserve managers who bet on Agencies in the past are staring at mark to market losses, and could well be told to be a bit more conservative with their money.

That brings us back to Dr. Krugman’s theoretical discussion.

If you believe that large-scale sterilized intervention doesn’t matter -- and the allocation of the emerging world’s massive reserves across different assets doesn’t matter -- then none of this matters.

Market action simply reflects a reappraisal of the Agencies "fundamentals" in a deteriorating housing market. Central bank actions cannot change those fundamentals.

The US may need to bite the bullet and use public funds to recapitalize the GSEs to shore up global confidence in their ability to honor their obligations as it turns to the GSEs to support the mortgage market.

On the other hand, if central banks actions can impact the market, the kind of coordination that now exists between the Fed and the ECB may soon need to draw in the asset managers of the big emerging market central banks.

They are the new 800 pound gorillas of the fx market.

And the Treasury market.

And, I suspect, at least parts of the agency market.

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