Sovereign Wealth Funds are sexy, but the real story right now comes from plain old central bank reserves …
I tend to agree with Tony Tassel and Joanna Chung of the FT. If sovereigns shift from buying bonds to buying equities, the impact on equities is rather more ambiguous than many think. More demand is good, but private equity has already been pretty effective at transforming central bank demand for debt (counting private demand for debt that yields more than the debt that central banks buy as a knock-on effect from central bank demand) into demand for equities. And if shifting from bonds to equities drives down bond prices and drives up rates, well, that isn’t obviously good for equities.
If central banks want to shift from “safe” – at least in the sense of lacking credit risk — Treasuries and Agencies to various spread products, they risk buying in at the peak. After all, in recent years (and especially 2006) central bank demand for safe assets topped the creation of safe assets, so private investors who sold their treasuries and agencies to central banks bought risky assets. Add in the impact of the CDO put, and, well, it is hard to imagine how sovereign wealth fund demand for “spread” products could drive spreads down further ….
The only strong conclusion that I have been able to draw from looking at the asset allocation of existing sovereign wealth funds is that they, unlike central banks, don’t shy away from emerging markets. But then again most emerging markets don’t need any more inflows. The last thing Brazil – and a host of other countries –want is for China’s new investment fund to start to play the carry trade and add to the pressure on Brazil’s currency. The oil funds would love to invest in Asia, but what Asian country currently needs the money? Almost all can finance their existing level of investment out of domestic savings. India invests more than it saves, but it already is attracting more funds than it needs.
Until more emerging economies follow the example of Eastern Europe rather than the example of China, I don’t quite see how sovereign wealth funds can finance the emerging world. One surplus country (Saudi Arabia) cannot finance another surplus country (China). While everyone has been debating how sovereign wealth funds will change the world, central banks have quietly gone on piling up assets. The latest data from the BEA showed $440b of central bank inflows to the US in 2006 – and an increasable $380b in central bank purchases of traditional reserve assets (more here). Central banks now buy Agencies as well as Treasuries, but otherwise, 2006 looks a lot like 2004.
Moreover, the BEA data almost certainly understates central bank purchases in the second half of 2006. Remember, the data for the first half has been revised to reflect the findings of the most recent survey, but the data for the second half has yet to be revised. Expect that a lot of the private purchases of Treasuries and Agencies in h2 2006 will turn out to come from central banks. The revised 2006 data – which won’t come out until mid-2008 – is likely to show $500b or so in in official inflows.
After all, we know from the IMF’s data that central bank reserve growth accelerated over the course of 2006, so there is good reason to think central bank purchases of US bonds picked up in the later half of the year.
Reserve growth then accelerated a bit more in q1 2006. The BEA data shows that official actors – in principle central banks and sovereign wealth funds but in practice mostly central banks – bought $150b in US assets in q1 – a record $600b annual pace. And that too is an understatement. My measure of global reserve growth suggests the pace of reserve growth in q1 was around $250b in q1, and I would bet that more than $150b found its way into dollars. In April and May, global reserve growth probably picked up to a $300b quarterly pace, so $200b in central bank demand for dollars in q2 — at least up until June — seems about right. That is, to put it mildly, a lot.
Steven Englander of Merrill Lynch is quite right to observe — in a recent note — that:
“What this [the large share of the 2006 deficit financed by central bank buying] suggests is that there is a big gap between the US funding needs and the foreign private sector’s desire to acquire USD assets. The implication is that the dollar is being buoyed largely by official purchases. … What is more interesting is that the most of up data suggests that, if anything, central banks have accelerated their buying so far this year …”
If you project that kind of sovereign demand for financial assets out forward, but assume all the incremental demand will come from sovereign wealth funds , you can quickly generate impressive sums. If you assume that some existing central bank asset, which, counting all of the Saudi Monetary Agency’s foreign assets, are now probably closer to $6 trillion than to $5.5 trillion, will be shifted to sovereign wealth funds, then sovereign wealth funds will get really big really fast.
But for now, old-fashioned central bank reserves are still growing faster than sovereign wealth funds. Central banks just don’t seem to be buying Treasuries. Not in April, when they sold Treasury bills to buy notes.
Brazil bought a lot of Treasuries in April. The other big central banks not so much, China reduced its holdings of short-term Treasury bills, and didn’t use the resulting funds to buy longer-term Treasuries (it preferred Agencies). Russia scaled backs its holdings of short-term agency bills even as it increased its long-term holdings.
Recorded inflows from both Russia and Chiha were small in relation to the pace of their reserve growth in April– suggesting that both are also buying through London intermediaries. But it isn’t clear that they are buying Treasuries even in London. In April, the UK was a net seller of Treasuries. And judging from the anecdotes circulating through the markets (covered well by the Financial Times), central banks didn’t buy many long-term Treasuries in June.
Central banks equally clearly didn’t stop adding to their reserves in June. OK, Russia’s reserve growth has slowed from insanely fast ($5-10b a week) to merely very rapid ($3b a week). Most of the oil exporters are flush with cash. Brazil is still intervening, though perhaps at a slower pace than before. It is hard to tell so long as its central bank refuses to release its reserves data. India continued to intervene in the first week in June. And China clearly hasn’t stopped intervening.
Those funds have to be going somewhere. Bank deposits? Equities? Agencies/ MBS? Corporate bonds …
I certainly don’t know, but if i had to guess, I would bet that a lot more is going into bank deposits and other short-term instruments than into equities.
But that is a hard case to make based on the April data. The TIC data suggests that the world’s central banks built up their bank deposits, but they reduced their holdings of short-term securities even faster …
However, there is a lot we don’t know. About June. And even about April. More official reserve growth — judging from a likely $100b plus pace of reserve growth in April — takes place in ways that don’t show up in the TIC data than in ways that do.
UPDATE: A bit more from HMC’s El-Erian. I highly recommend both El-Erian’s article and the Tassel/ Chung article (the link is above)
30 Responses to “Sovereign Wealth Funds are sexy, but the real story right now comes from plain old central bank reserves …”
“The implication is that the dollar is being buoyed largely by official purchases.” Merrill then suggests selling the USD against most other G10 currencies.
This simplistic conclusion ignores the fact that not all dollar crosses are created equal. The dollar is being buoyed against the RMB, RUB, SAR, et al by official purchases. The dollar is NOT being buoyed against the EUR, CHF, CAD, and most of all the JPY by official purchases; in the latter case, Japanese private sector retail is doing a fine job of buying dollars all by itself. (Some would argue that the $ is being buoyed against JPY by mercantilist BOJ monetary policy, but that is at the very least a subject worthy of debate.)
Let’s be clear here: that the dollar is being supported against fixed currencies by official demand is essentially a tautology: official demand for USD is the instrument of maintaining artificially weak exchange rate regimes.
The typical investment conclusion that the dollar should and will fall against all currencies if the official support is withdrawn is almost certainly, misplaced however; if official financing support is withdrawn, the dollar will fall, perhaps precipitously, versus those currencies against which it has been supported. Ironically, the market ruptures that would result (higher interest rates) could well entice the private sector to support the dollar against the very G10 currencies that many recommend to buy!
“Those funds have to be going somewhere…”
The real reason why treasury yields have gone up is not because of central bank not willing to buy treasuries but treasury is not issuing new notes.
Since US federal debt has not gone anywhere suggest that govt is not expanding debt. that’s why no new t-bills are issued.
private investors have stratagies in investing in treasuries. they buy bonds at lower rate from treasury and sell them to central banks for a profit.
As liquidity in treasury is reduced(treasury not issuing new notes because of debt limit of federal govt),there is no point for private investors to stay in market.
That’s why yields are rising. sooner debt limit will be hiked and new t-bills will be issued. Then yields will start to fall
Might be interesting to compare:
global equity market capitalization
expected trend pace of growth in same
expected trend pace of growth in same
share of global reserves invested in equities
expected trend pace of growth in same
Could be quite some time before equity reserves put a market share dent in global equity market capitalization.
Macroman – you make a good point. Holding say the RUR down v. the $ (and in Russia’s case a $/ euro basket) doesn’t obviously support the $ v. other g-10 currencies. and absent central bank support, us rates would need to rise (or the $ fall) to the point where private investors found US assets attractive/ cheap. that said, the sheer scale of $ purchases over say the past year, but particularly the last 3qs (i.e. q4 06 thru q2 07) does suggest that there are lots of c banks with more $ than they ideally would like, and that they would, if given a chance (i.e. if the $ rallied big time) be willing sellers of $ into the rally. that point in the ML report made sense to me.
guest — interesting point. all the more true if CB/ SWF demand for equities bids up prices … less true if SWFs buy into a down market …
06-19 09:27:57 – to really mean all that much, wouldn’t we have to account for differences between ‘public’, ‘private’ and equity derivatives, as well as the class of ownership, perhaps dividend rate categories too given interest rate sensitivity, exposure to currency and regional risks and different sectors – the list goes on – but fairly complex asset class, and becoming more so in my view.
GCC is a down market – so presume that’s why HMC is venturing in with other players. Interesting thing is that assuming they may all be of similar caliber, market moving in themselves – given a recent article’s reference to the Harvard brand’s power to attract capital.
as well as more meaningful break-outs of market movers with different objectives, capacities and risk tolerances – and within the context of this post – their relationships with different central banks. perhaps CAD and NZD being two quick examples, given there current challenges in balancing internal factors with significant external players.
Whether or not quite so relevant to this post, also interested in interactions between ‘official’ players and black markets: “…Banks have profited as well from Argentine bonds they bought from the Venezuelan government in 2005 and 2006 at the official exchange rate. Then they sold the bonds for dollars and profited by buying bolívars at a higher black market rate..” http://www.nytimes.com/2007/06/15/business/worldbusiness/15venezbank.html?pagewanted=2&adxnnl=1&ref=business&adxnnlx=1181901711-DviS+3Ynd7qI+ma3FSFgkg
guest — the vennie purchases of argentine bonds are trivial relative to global flows, and any profits vennie banks have realized on the argie bonds are trivial relative to the gains from simply lending funds out — with real rates very negative, it is hard for borrowers to go bust, and the banks intermediate, so the real losses on the low real rates are passed on to vennie’s savers.
could we limit this discussion to the big flows in today’s global economy, not to subsidiary flows.
China, Russia, India, and Brazil seem to have relatively large informal/black markets, so just grabbed the most available example.
true, but their central banks don’t generally operate in those black markets, at least not when they are buying big quantities of us debt … if someone has a different view, do tell. but this post was about the core flows coming out of the CBank world.
thought one of the concerns was about transparency, gaps in purchases and speculation about where the money goes, if only temporarily.
Russian, Brazilian, Indian and Arab entities seem to hold, or strongly influence through trade relationships, so many significant assets beyond their borders, if it can be assumed that their respective CB’s objectives and actions are influenced (differently) by current holdings and country relationships, along with any expansion/diversification strategies. relatively much more time seems to be spent trying to understand how these relationships affect China’s current and future moves, perhaps at the expense of better understanding others.
Lots of ways to slice and dice the markets.
The interesting one in this post’s context is equity derivatives or derivatives more generally. This is an issue that is bigger than CB participation per se, but CBs are probably enticed by this stuff quite naturally.
Not sure how to interpret derivatives at a macro level – I seem to recall reading somewhat that the nominal value of derivatives of all types is approaching $ .5 quadrillion (although ‘market capitalization’ of the actual value of derivatives of all types would be a fraction of the nominal value). My wild guess for market capitalization of global equities and bonds is that it is more in the order of magnitude of $ 100 trillion. So nominal derivatives are a multiple of the underlying on a global basis – hence the hand wringing by many as to the real risk embedded in it all.
For equities, as other derivatives, the natural net supply is the underlying. Derivatives create liabilities as a function of the underlying, so the existence of derivatives at the macro level doesn’t increase the net supply of potential long equity exposure. Derivatives are basically a risk transfer between two counterparties with a net 0 exposure in the combination.
So the underlying capitalization is still the core market size. Derivatives leverage this exposure and literally multiply it by creating new liabilities and new opportunities for risk and reward.
I don’t know where that gets us but as I said it’s a difficult area.
“One surplus country (Saudi Arabia) cannot finance another surplus country (China). ”
What if Saudi Arabia invests in China, and China invests roughly the same amount in Saudi Arabia? Isn’t the effect the same as if both invested domestically instead of in foreign reserves? Say, both Saudi and China have 100 units of reserve holdings each in the US. Then each disposes of 10 units, and invests in each other’s assets. What is the net effect? Isn’t it a round-about way of increasing domestic investment and reducing US$ reserves? The key here, I suppose, is whether local central banks will continue to sterilise these ‘South-to-South’ cross-investments in the same way as other foreign direct investments… if they do, the net effect is that SWFs in both countries now have 10 units of reserves in each other, but then the local central banks have a net increase of 10 units each in US Treasuries…
Therefore, the key, most likely, is local exchange rate policy of respective central banks…
Brad – “Those [CB] funds have to be going somewhere. Bank deposits? Equities? Agencies/ MBS? Corporate bonds …
I certainly don’t know, but if i had to guess, I would bet that a lot more is going into bank deposits and other short-term instruments than into equities.”
Well, I am really confused now. I was hoping quite honestly that you would have this sorted out. This is one of your areas of expertise. I way back at the end of the pack on understanding some of these movements.
I don’t understand what is driving the CB moves from U.S. Treasuries to Notes to Agencies to whatever else. What is driving the movements? Did the New Zealand move lead to most of this, or was that just part of the shift?
I was almost burned on a big $$ deal a few weeks ago because loan rates moved too quickly in the period of three days. A fifty basis point move overnight, as one example. I was stunned, but recovered quickly enough to shift to other sources and means to keep from absording more costs.
Any thoughts on how long this cycle will run? Or how high the interest rates may go in the USA for the 10 year note? And so on…
I know how my comments sound, but hey – I have read quite a bit and still don’t follow all of the logic in the scramble.
“One surplus country (Saudi Arabia) cannot finance another surplus country (China). – What if Saudi Arabia invests in China, and China invests roughly the same amount in Saudi Arabia? “
I’m sure you’re more interested in a response from Brad, but let me also take a shot at this, because it’s an interesting question.
As for the first sentence above, I’ll let Brad speak to that, but I think he’s merely referring to the reality that surplus countries fund deficit countries globally, on a net basis. Much of the actual gross flows are superfluous to the net balancing requirement for current accounts.
Otherwise, the CB/SWF nexus can be thought of as a consolidated balance sheet with reserve and ‘extended’ reserve assets, and a variety of liabilities. The CB has the power to create the monetary base as a liability, with the ability to adjust the base up and down via monetization and sterilization (debt essentially). The consolidated liability structure is for the most part a mix of the monetary base and sterilization debt.
There are a couple of channels at least, by which each CB can dispose of 10 units of US reserves:
a) Sell the assets for dollar bank balances, and use the dollars either to shrink the monetary base on a net basis (essentially selling foreign exchange directly to domestic buyers), or do this in conjunction with a ‘buy back’ of sterilization bonds (which leaves the monetary base unchanged on a net basis).
b) Sell the assets for dollar bank balances, and use the dollars to purchase the assets of the other country, leaving the other country to deal with the dollar exchange risk
I’ll assume b) for this example.
So each of Saudi Arabia and China use dollars to buy assets from the others’ private sector.
From the perspective of each CB, one asset (China or Saudi) has replaced another (US).
From a private sector perspective, each private sector is long dollar balances and a currency mismatch.
Assume (as per the secular trend) each private sector asset seller then sells its dollar proceeds to its respective CB.
This inflates each CB balance sheet and each has a choice as to whether to monetize or sterilize the resulting dollar purchase. Either way, the balance sheet of each CB has been inflated on a net basis, because each is still long the same dollar reserves but has added to its total reserves via what is effectively a ‘back-to-back’ reserve asset swap. Also, each CB then has the option of further managing its balance sheet by later selling dollars back into the market, which is equivalent to the situation of alternative a) above. The overall mix of monetary base and sterilization debt in the consolidated liability structure is effectively under the complete control of the CB (assuming that there is a liquid market for domestic sterilization instruments – an aspect that Brad has noted from time to time as a constraint on some of the big reserve accumulators).
jkh – loved your post! But there is an interesting point if you take this thought experiment to its logical conclusion: IF respective central bank exchange rate policies stay unchanged, more aggressive diversification by SWFs into non-US and non-Euro asset classes means even more dramatic growth of FX reserves at respective central banks… it’s a feedback loop: more reserves force central banks to shift more assets into SWFs > SWFs diversify aggressively > more reserves are acquired by the central banks > more reserves are shifted into SWFs, and so on… where does this lead? An interesting thought indeed…
There was an interesting conversation on Brad’s blog a while back, relating to the substance and size of CB diversification. My question at the time was, whether CBs could really handle the prudential instinct for diversification, while still facing global macro pressure for dollar absorption, without as a result accommodating an outsized increase in aggregate reserve levels – more than would otherwise be explained simply by the size of the US current account deficit. I think that’s what you’re getting at. SWFs are agents for this CB diversification.
At a broader level, perhaps we are witnessing the morphing of CBs and SWFs into banks of considerably more substance. Their domains are now global flows as much as their respective domestic monetary bases. And perhaps the massive increase in trade volumes over recent years is now being replicated by increases in gross capital flows, and the proportionate participation of CBs in gross capital flows, rather than accumulating reserves primarily as a function of current account flows.
And maybe CB balance sheet growth is also a reflection of the expansion of the gross size of international asset liability positions. The US external position for example is quite massive in that its gross asset size is a considerable multiple of its net liability position, even with the disproportionate size of the latter. The expansion of the US external balance sheet has allowed the US so far to mitigate its trade deficit pressures with net investment income surpluses (noted by Brad in his analysis of the ‘Dark Matter’ issue, and the expected future path of the income account on current account).
CBs and SWFs are stretching their legs now.
Remember, 20 years ago commercial banks globally began buying up investment dealers. What might CBs begin to do today if the time is right for them?
February 1998 – “…Equity derivatives are now joining fixed-income derivatives as accepted tools” …Another big area for Shaw is its equity-linked business, which it launched in 1993 by dealing in Japanese warrants…” http://www.derivativesstrategy.com/magazine/archive/1998/0298fea2.asp
2007 – “…Perhaps DE Shaw is now hyper-aware of how liquidity in a market can turn on a dime, and as it progresses into less liquid assets it solidifies its place in the world’s financial architecture…” http://www.deshaw.com/articles/Risk.pdf
I suspect jkh may have answered rozanov’s question with more depth than i can muster.
Let’s take the easy case. Suppose two central banks are both sterilizing marginal inflows. So if, for example, the Saudi central bank (SAMA) puts some of its reserves in China, it is using some of its dollars to buy RMB denominated assets, and for the sake of argument, let’s say the PBoC is supplying those assets (sterilization bills). Basically, SAMA trades some its dollars for RMB issued by the PBoC, and then uses its RMB to buy sterilization bills issued by the PBoC. Sama ends up with fewer $ and more RMB denominated sterilization bills, the PBoC ends up with more $ and more sterilization bills. SAMA has less $ exposure and more RMB exposure, the PBoC has more $ exposure.
Now say the PBoC uses some of its dollars to buy riyal. SAMA buys the $ from the PBoC for riyal, and the PBoC then invests in riyal denominated central bank paper (SAMA sterilization bills). SAMA gets a dollar back, the PBoC reduces its dollar reserves …
net the transactions out and neither SAMA nor the PBoC ends up with more $. SAMA gets rid of a dollar by selling it to the PBoC for RMB, but gets the $ back when the PBoC sells the dollar for saudi riyal. Neither ends up with more $s. But both end up with a bit more of each other’s currency. The Saudis end up with more RMB assets and more SAR (saudi riyal) liabilities (the bills issued to fund the RMB purchases), and the Chinese end up with more SAR assets and more RMB liabilities (bills issued to fund the SAR purchases).
it basically works out as a currency swap, with SAMA and the PBoC swapping currencies with each other. In this scenario, best that I can tell, the Saudis win in this scenario if the RMB appreciates faster than the riyal, and the Chinese win if the riyal appreciates faster than the RMB.
But to be honest i am thinking this through. I am not totally sure i have it all right in the scenario. but i am fairly confident that China cannot finance a saudi current account deficit, nor can Saudi finance a Chinese current account deficit — at least not so long as more capital inflows (whether private or official) lead to more intervention rather than a stronger currency. Saudi purchases of Chinese assets with petrodollas = more capital inflows, more Chinese dollar holdings, and more chinese capacity to finance the US deficit …
MG — sorry. i do think the evidence that central banks have been parking funds in the t-bill market is now quite good. more on that later.
What you said makes sense only if the BRIC/Gulf countries stop accumulating official reserves, which implies a major current account adjustment. However if they merely change the composition, which currently favors USD, Merrill is correct that USD could come under pressure against other G10 currencies. I suspect in the near term the Merrill scenario has more chance of being correct than a major C/A correction.
Morgan Stanley predicts SWF growth to $ 28 trillion …
To sum up the discussion about SWFs and currency effects, the dollar-peg countries’ SWFs can diversify (a given level of) reserves between instruments, but not currencies, except in the case where they buy assets in other dollar-peg countries (in which case the currency diversification value is questionable anyway).
I struggle, however, to understand Macro Man’s argument that dollar purchases by the pegging countries does not support the dollar against third currencies, although I can see why the supporting effect would be much less than the weakening effect on their own currencies. Surely, if one central bank is taking down dollar assets, that makes them a little more valuable all round?
As MM says:
” The typical investment conclusion that the dollar should and will fall against all currencies if the official support is withdrawn is almost certainly, misplaced however; if official financing support is withdrawn, the dollar will fall, perhaps precipitously, versus those currencies against which it has been supported.”
This seems obviously true at the margin. Official support for the dollar exacerbates the need for CB diversification into non-pegged currencies, e.g. the Euro, causing the dollar to weaken against the Euro. The unwinding of official support for the dollar would unwind this requirement for further diversification, thereby removing this source of dollar weakness against non-pegged currencies.
incidentally, SWFs typically have a higher asian allocation/ lower $ allocation — which doesn’t really work from a global flow of funds point of view unless more asian economies start running current account deficits. but most SWFs have a different currency profile (even among the g-10) than a typical central bank, not just more appetite for risk appetite.
For example, compared to a dollar zone central bank — a sovereign wealth fund would typically have more in european currencies. But there is no reason why a dollar zone SWF couldn’t be focused on higher yielding dollar assets, as it did its part to help the country achieve its overall currency objective.
It is not obvious to me why central bank dollar purchases should prompt other central banks to diversify out of the dollar. Why do you say they do?
Didn’t really say that. Just that growing $ reserves in total puts pressure on to diversify.
Well, it cannot be the dollar pegging central banks that are selling dollars to diversify as that would not make sense, so it must be the rest. But why should the rest care about the dollar peggers’ holdings of dollars, especially as they are frozen by their currency policy? The only reason I can see is that they think the dollar is over-valued as a result of the buying by the dollar-peggers, which would prove my point!
“dollar-zone central banks” being ‘dollar peggers’?