Brad Setser, a source for thorough, thoughtful coverage on currencies and related topics, provides his monthly parsing of the Treasury International Capital report (this one from January, plus its survey of foreign holdings of US securities as of the end of June 2007) and does not like what he sees.
Since the August TIC report, Setser has identified a worrying trend, that private foreign capital inflows (required to fund our massive current account deficit) have pretty much dried up. Nearly all our international ifunds come from governmental sources, namely central banks and sovereign wealth funds.
Even more troubling, Sester sees signs that the overseas buyers are participating heavily in the flight to safety (Treasuries), exacerbating market instability.
As he observes:
Both data releases tell the same fundamental story. The US now relies very heavily on foreign central banks for financing.
The January data also hints at another important but less obvious story, namely that central banks seem to be less willing to take credit risk than in the past.
So long as they are piling into safe US assets, central banks are contributing the “liquidity” to a market that doesn’t need any liquidity. They are helping to push Treasury rates down. And their activities, while rational from the point of view of conservative institutions seeking to avoid losses (beyond those associated with holding the dollar), also may be aggravating some of the difficulties in the credit markets. Private funds fleeing the risky US assets for the emerging world generally end up in central bank hands and currently seem to be recycled predominantly into safe US assets…..
I would bet that current official purchases are overwhelmingly weighted toward super-safe assets. There are hints of that in the January data. China stopped buying Agencies, preferring Treasuries and short-term debt. Korea seems to have stopped shifting into Agencies. In total, nearly $60b of the $75.5b in total official inflows went toward Treasuries and short-term deposits and securities.
If I am right, then the official sector — foreign central banks and sovereign funds alike — isn’t coming to the rescue of the credit market. Indeed, by buying only safe assets at a time when private demand for risky assets has disappeared, the official sector is adding to the current market dislocations rather than reducing them.
Look at this picture. Due to a combination of private capital flight and foreign central banks making a higher proportion of their securities purchases in Treasuries, the very large foreign inflows have moved heavily into Treasuries, depressing yields. This increases the so-called TED spread, the difference between short term risk free rates and interbank rates.
The widening of that spread was one reason the Fed implemented and later increased the size of its Term Auction Facility. If the Fed has to increase the size of the TAF yet again or engage in other heroic measures, it only has $300 to $400 billion before it runs into balance sheet constraints. Of course, it could issue liabilities to continue its market intervention, but an operation of that scale is characteristic of third world countries fighting a financial crisis. That move alone could increase worries about the dollar. More currency instability will only make a difficult situation even more complicated.
Setser’s post provides considerably more detail.
We have also warned of a bigger risk: that our friendly foreign feeders of our overconsumption habit may finally tire of our profligate ways and quit sending money. Various observers have asserted that would never happen, that would lead the dollar to fall and lower the value of their holdings.
Well, our very own Fed has taken to trashing the value of the dollar portfolios of foreign central banks. Since we have no inhibitions about debasing our currency, why should they double up on a losing bet? Of course, that logical response will only accelerate the dollar’s slide.
From Bloomberg (hat tip reader S):
Central banks from 16 Asian nations may invest more of their $1 trillion of foreign reserves in the region’s debt as Federal Reserve interest-rate cuts reduce returns on U.S. assets.
“This is something that most of us, that are not yet investing in, will be looking at,” Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a March 23 interview in Jakarta. There can be “some kind of shift” to Asian sovereign bonds, Central Bank of Sri Lanka Governor Ajith Nivard Cabraal said in a separate interview on March 22, after a weekend meeting of policy makers from the region.
Asian countries pummeled by a financial crisis in 1997-98 have spent the past decade hoarding reserves to help protect their economies from external disturbances. A looming U.S. recession means the world’s biggest economy may no longer be the best place for the region to invest those funds.
Indonesia’s 10-year dollar-denominated bonds, for example, have a yield of 6.06 percent compared with 3.33 percent for similar maturity U.S. Treasuries. Local-currency Philippine debt maturing in 2018 yielded 7.16 percent as of March 19.
“Given the volatility in the U.S. dollar, some diversification won’t hurt,” said David Cohen, an economist at Action Economics in Singapore. “Even if the U.S. does slide into a recession, continued growth in places like China” may help maintain economic expansion in the region….
Governors from the South East Asian Central Banks grouping, or SEACEN, include Indonesia, Malaysia, Singapore, Thailand, Brunei Darussalam, Vietnam, the Philippines, Cambodia, Myanmar, South Korea, Mongolia, Fiji, Nepal, Papua New Guinea, Sri Lanka, and Taiwan. They manage about $1 trillion in reserves, according to Bloomberg data.
Sri Lanka’s Cabraal said he is looking at “possible avenues to invest in other Asian countries.”
“It wouldn’t have been on the agenda some years ago, but it is now very much on the agenda,” Cabraal said. “You can see quite a clear shift in the mindset.”
Tetangco from the Philippines said central banks in the region will have to make decisions about investing more in Asian debt “at some point in the future.”
“We are looking at the opportunities for diversification into high-quality assets such as sovereign or quasi-sovereign securities,” he said.