Friday, August 04, 2006

A trillion dollar question

Brad Setser notes that China's dollar reserves will soon surpass the trillion mark, if they have not already. Where to invest all those dollars? OPEC nations, Russia and other Asian exporters (Korea, Taiwan, Japan) share the same problem.

Hedge fund quiz question #1: Is the yield curve flat because traders think the fed is likely to overtighten (leading to a recession in a year or two), or because of all those foreign central bank dollars looking for a parking spot?

By my count China already has over a trillion dollars in reserves and reserve-like assets. But I am counting the funds the PBoC shifted to the state banks. In a couple of months, though, China will formally announce that its reserves now top a trillion dollars. So it isn’t exactly a surprise that Chinese policy makers would be spending a bit of time thinking about how to use those funds.

The key fact for the global economy is not that China holds a trillion dollars in reserves. It is that those reserves are growing at a pace of around $20b a month/ $250b a year. This reserve increase has continued even as interest rate differentials have moved steadily in the dollar’s favor. China constantly struggles not just to invest its existing reserves productively, but to find new places to park its ever growing reserves.

Right now, there is no reason to think that China won’t have $1,500b in reserves in about two years time. Not unless Chinese policy makers show an ability to act far more decisively than they have so far.

$250b is a lot of money to invest every year. I suspect there are some constraints on how China can invest it. There aren’t many – strike that, there aren’t any – emerging markets that could absorb inflows on that scale. Modest sized industrial economies like Australia and the UK are also too small to absorb more than a small fraction of the total. Look at their respective current account deficits in dollar billions.

Japan’s government debt market is very, very big. But JGBs don’t pay much interest, and the PBoC likes a bit of carry. So China really is left looking at the US and the European market. I don’t really buy the notion that European debt markets are too small and illiquid for China. China likely has been placing funds in some smaller and less liquid debt markets in the US, not just the most liquid of instruments. But I do think that it would be hard for China to continue to peg to the dollar and dramatically increase its euro allocation.

Suppose China now invests 25% of its reserve growth in euros. That is $60b a year or so. Real money. Suppose it decided it wanted to invest 50% in euros. That is $125b a year. I suspect that a $60b increase in net flows to Europe would have an impact on the euro/ dollar exchange rate. And if it did, China’s peg implies that the RMB would depreciate along with the dollar. That would force China to buy more reserves.


brad said...

A little bit of both, I suspect ... Tis clear that CBanks (and oil investment funds) have not been big net buyers of Treasuries so far tis year. But they hold a big enough share of the stock that they certainly should influence the market. And they have been big buyers of close subsitutes (agencies) and must have tons of money parked in s-term deposits ... or so it seems to me.

Plus, there are definately some folks in the market (Bill Gross most obviously) who are convinced that the fed has already overtightened. tho i think his current position (long duration from the latest McCulley/ Balls piece) only makes sense if you think that future fed loosening will have similar effects to the last fed loosening -- i.e. the $ starts to fall, Asia intervenes to avoid appreciation and there is a ton of demand for US fixed income instruments that can serve as reserve assets.

Steve Hsu said...


I agree with your analysis. I heard an interesting Bloomberg podcast over the weekend in which someone claimed that there is historically about 100 bps between the short and long ends, so Gross (calling 5 percent a fair yield for the 10 yr note) must be expecting a recession leading to Fed easing down to 4 percent sometime in the next few years. The 100 bps number is a bit arbitrary as far as I can tell, but the point is that anyone buying at 5% is expecting a recession, unless of course they are driven by something other than ROI concerns (i.e., CBanks).

Even if CBanks are not directly buying treasuries this year, their buying of agency debt probably helps keep the yield down on treasuries. (If demand is high for Honda Accords it also drives up the demand for Camrys, as some would-be Accord buyers are forced into the Camry market by price or scarcity.)

Anonymous said...

1. China leaving peg may cut that trillion by 30%-50%

2. Some argue that it's agood tim eto position in US equities as future target by foreigners with cash.

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