Follow the Money

I got my start, so to speak, tracking global reserve growth and then trying to map global reserve flows to the TIC data. So I have long thought that large scale central bank purchases of U.S. Treasuries and Agencies, and German bunds, and JGBs didn’t start with large scale asset purchase programs (the academic name for “QE”) by the Fed, the ECB and the BoJ. Before the crisis, back in the days when China’s true intervention (counting the growth in its shadow reserves) topped $500 billion a year, many in the market (and Ben Bernanke, judging from this paper) believed that Chinese purchases were holding down U.S. yields, even if not all academics agreed. The argument was that Chinese purchases of Treasuries and Agencies reduced the supply of these assets in private hands, and in the process reduced the term/risk premia on these bonds. Bernanke, Bertaut, Pounder DeMarco, and Kamin wrote: "...observers have come to attribute at least part of the weakness of long-term bond yields to heavy purchases of securities by emerging market economies running current account surpluses, particularly emerging Asia and the oil exporters .... acquisitions of U.S. Treasuries and Agencies took these assets off the market, creating a notional scarcity that boosted their price and reduced their yield. Because [such] investments were for purposes of reserve accumulation and guided by considerations of safety and liquidity, those countries continued to concentrate their holdings in Treasuries and Agencies even as the yields on those securities declined. However, other investors were now induced to demand more of assets considered substitutable with Treasuries and Agencies, putting downward pressure on interest rates on these private assets as well." I always thought the mechanics for how the Fed’s QE impacts the U.S. economy—setting aside the signaling aspect*—should be fairly similar. Both reserve purchases and QE salt “safe assets" away on central banks’ balance sheets.** There are now a number of charts illustrating how the ECB and BoJ have kept central bank bond purchases high globally even after the Fed finished tapering. Emma Smith of the Council’s Geoeconomics Center and I thought it would be interesting to add reserve purchases to these charts and to look at total purchases of U.S., European, Japanese and British assets by the world’s central banks over the last fifteen years—adding the emerging market (and Japanese and Swiss) purchases of G-4 bonds for their reserves to the bonds that the Fed, the ECB, the Bank of Japan and the Bank of England bought. Obviously there are important differences between balance sheet expansion done through the purchase of foreign assets (reserve buildup) and balance sheet expansion done though the purchase of domestic assets (quantitative easing).  One is aimed at the exchange rate, the other at the domestic economy. But if portfolio balance theories are right, the direct impact on bond prices from foreign central bank purchases of bonds and from domestic central bank purchases of bonds should I think be at least somewhat similar. As the chart above makes clear, large-scale central bank asset purchases in some sense preceded the global crisis.  Pre-crisis, the purchases came from emerging market central banks. China, counting its shadow intervention, bought about 15% of its GDP in reserve assets from mid 2007 to mid 2008; as a share of GDP, that is a pace of asset purchases equal to the BoJ’s current pace. More recently, reserve managers have quite obviously been selling. The reserves the PBOC bought from 2012 to 2014 were sold in 2015 and 2016. Yet with three trillion plus in reserves, and more in its shadow reserves, the PBOC hasn’t yet sold anything it bought prior to the global crisis. And more importantly, recent reserve sales have come at a time when the BoJ and ECB have been ramping up their purchases. Aggregate central bank demand for safe assets has remained elevated. There has been a significant shift in the currency composition of large scale central bank assets purchases in the past couple of years. In fact, adding reserve purchases to QE purchases magnifies the recent global shift in central bank demand away from dollars. EM reserves managers have been selling dollar assets. At the same time the Fed isn’t buying assets anymore. And the G-7 currency agreement has limited the ECB and (especially) the BoJ to the purchase of their own assets, so there has been a surge in central bank purchases of euro and yen denominated bonds. Prior to the crisis, I was never completely convinced by arguments that the currency composition of the reserves held by central banks didn’t matter. Partially that was self-interest of course; I had spent a lot of time developing my reserve tracking technology. But I also didn’t think private investors were completely indifferent to the currency composition of their portfolio of safe assets. If the central banks accumulating reserves wanted euros rather than dollars, the euro would need to rise relative to the dollar to make "safe" dollar assets cheaper and thus more appealing to private investors. Treasuries and German bunds were not perfect substitutes. Nor for that matter are Agencies and French government bonds. I still think that is the case. It matters that the ECB conducts its asset purchases by buying euro assets, not by buying Treasuries. At the same time, with ECB purchases exceeding euro area government net issuance and with BoJ purchases far exceeding net new issuance of JGBs, it is hard to argue that some investors in European and Japanese debt haven’t been pushed into U.S. Treasuries and Agencies. (This Banque de France working paper found that foreign holders of euro-denominated bonds were the most likely to sell to the ECB.) And thus there should be some impact on the U.S. yield curve from the actions of other central banks even when those central banks aren’t buying dollars. All this said, the indirect impact on Treasuries from the purchase of JGBs and Bunds is likely to be smaller than the direct impact of central bank purchases of Treasuries.** Krishnamurthy and Vissing-Jorgensen’s 2013 Jackson Hole paper argued that Treasuries and Agencies weren’t perfect substitutes, which is why the Fed’s purchases of Agency MBS had an impact.  I have long thought the QE-Agency MBS-lower mortgage payments channel provided an important offset to the fiscal tightening the U.S. did in 2013, as mortgage refinancing put cash directly in the pockets of many households. And the current, relatively low level of direct central bank demand for U.S. Treasuries reinforces Larry Summers’ argument that low Treasury rates now aren’t just a reflections of central banks purchases... In subsequent posts, Emma and I plan to look into these points in a bit more detail, by disaggregating central bank flows by currency and comparing central bank demand (the sum of "foreign” reserve demand and “home” monetary policy demand) to government issuance. A note on methodology. Asset purchases by the Fed, ECB, BoJ and BoE are easy to track directly. Reserve purchases come from summing the foreign exchange reserves of around 60 countries—a broad sample that replicates the IMF COFER data. China’s other foreign assets are added to the total (it doesn’t matter much, but it is a point of pride for me—these are assets on the PBOC’s balance sheet that walk, talk and quack like reserves). The dollar share of reporting economies is assumed to be replicated across the full sample (broadly speaking this produces the same result as assuming a constant 60 or 65% dollar share over time). * Signalling here means signalling a credible commitment to hold policy rates low for a long time, i.e. enhancing the credibility of forward guidance. Michael Woodford, for example argued back in 2013 that this was the transmission channel that mattered. ** Technically, a central bank buying bonds creates bank reserves when it credits the account of the seller of the bonds with cash. QE reduces the supply of safe longer-dated bonds in the market (raising their price, and reducing their yield in theory) while adding to the supply of safe short-term assets (claims on the central bank).

China released its end-August reserves, and there isn’t all that much to see. Valuation changes from currency moves do not seem to have been a big factor in August, the headline fall of around $15 billion is a reasnable estimate of the real fall. The best intervention measures -- fx settlement, the PBOC balance sheet data -- aren’t out for August. Those indicators suggest modest sales in July, and the change in headline reserves points to similar sales in August. That should be expected. China’s currency depreciated a bit against the dollar late in August. In my view, the market for the renminbi is still fundamentally a bet on where China’s policy makers want the renminbi to go, so any depreciation (still) tends to generate outflows and the need to intervene to keep the pace of depreciation measured.* Foreign exchange sales are thus correlated with depreciation. But the scale of the reserve fall right now doesn’t suggest any pressure that China cannot manage. That is one reason why the market has remained calm. Indeed the picture in the rest of Asia could not be more different than last August, or in January. The won for example sold off last August and last January. More than (even) Korea wanted. During the periods of most intense stress on China, the Koreans sold reserves to keep the won from weakening further. Not this summer. The slow measured slide in China’s currency against its basket hasn’t translated into selling pressure elsewhere. And Korea is now quite clearly intervening to keep the won from strengthening. In July, the rise in headline reserves, the rise in the Bank of Korea’s forward book, and the balance of payments data all point to over $3 billion in purchases (the forward book, one of the best measures of what might be called Korea’s shadow reserves, matters; it rose by over a billion in July). There is only data for headline reserves for August at this stage, and this points to a further $4 billion in intervention. Scaled to Korea’s GDP, Korea bought about two times as much as China appears to have sold. And I would bet Korea’s forward book also increased, so the full count for August could be higher still. And with the won flirting with 1090, the level that triggered reports of heavy intervention in mid-August, the market quite reasonably is on intervention watch again. I am a long-standing fan of Reuters’ coverage of Asian fx markets. Reuters reported on Wednesday: "The won rose as much as 1.2 percent to 1,092.4 per dollar, compared with a near 15-month high of 1,091.8 hit on Aug 10 ... The South Korean currency pared some of its earlier gains as finance ministry officials said the authorities are ready to take action in case of excessive currency movements. The warning boosted caution over possible intervention to stem further strength ..." Taiwan’s rising reserves also clearly suggest that it too is buying foreign currency. All this is very different from periods of acute China stress. I should also note that with short-term external debt of around $100 billion and over $400 billion in reserves (counting its forward book) Korea is very well reserved by traditional metrics. It even has more than enough reserves on the IMF’s metric (p. 34 of the staff report), and the IMF’s new reserve metric tends to inflate Korea’s reserve need relative to traditional balance sheet measures: Korea has a high exports to GDP ratio and a relatively high M2 to GDP ratio. If you haven’t guessed, I am not a fan of the new reserve metric’s tendency to call on economies with large external surpluses to hold more reserves, relative to their economy, than their peers with external deficits. * China reportedly intervened a bit after the G-20 meeting for example, as some believe China will now resume a controlled depreciation.

The Economist, inspired in part by a recent paper by Caballero, Farhi and Gourinchas, highlighted two key points in its free exchange column criticizing Germany’s surplus: a) Global imbalances have reemerged over the last few years (though this is more obvious from summing the surpluses of surplus countries than from summing the deficits of deficit countries): "... a sustained era of balanced growth failed to emerge [after the global crisis]. Instead, surpluses in China and Japan rebounded. In recent years Europe has followed, thanks to a big switch from borrowing to saving." b) Those imbalances are a big reason why interest rates globally are low: "Once a few economies become stuck in the zero-rate trap, their current-account surpluses exert a pull which threatens to drag in everyone else." I have only one small quibble. The rise in Asia’s surplus didn’t just come immediately after the crisis. There was also a significant rise in Asia’s surplus from 2013 to 2015. Indeed, in 2015, East Asia’s combined surplus actually significantly exceeded that of Europe, adding to the world’s difficulty generating enough demand growth even with ultra-low rates.* Yes, some of this is oil. But the oil exporters in aggregate aren’t running large external deficits financed by their high saving customers (Russia is in surplus; the Saudis are more an exception than the rule). The IMF puts the aggregate deficit of the main oil exporting regions of the world economy (the Middle East, North Africa, Russia and Central Asia) at $50-100 billion, substantially less than the combined surplus of Europe and Asia. So it isn’t all oil either. China’s unloved, credit-based stimulus, together with the large reported increase in tourism spending (whether real or fake), looks set to pull China’s surplus down a bit in 2016. But China will retain a surplus of over $200 billion in 2016, and ongoing surpluses in Korea, Taiwan, Singapore and Japan will keep Asia’s aggregate surplus high. I would bet East Asia’s aggregate 2016 surplus will still exceed that of Europe. There is one additional important difference between the imbalances of the pre-crisis global economy, and today’s imbalances. Large global imbalances prior to the global crisis came from the combination of large surpluses in Asia and the major commodity exporters—a strange combination, if you think that surpluses (deficits) in oil exporters and deficits (surpluses) in oil importers should trade off. And in both the oil exporters and in Asia, those surpluses were sustained in large part by official outflows (i.e. from governments and central banks). Private flows on net wanted to go into fast growing Asian economies, not run away from them. The puzzle in some sense was why the U.S. attracted large inflows despite having slower growth and often lower interest rates than many major surplus economies. Today’s surpluses by contrast are predominantly in countries with negative or low interest rates, and thus the flows that support today’s imbalances are mostly private. The euro area, Denmark, Sweden, Switzerland and Japan all have negative interest rates. China isn’t at the zero bound, so in some sense it is the exception. Yet so long as its currency is drifting down there is an incentive for private funds to flee. Korea is another exception, I guess, as it maintains positive interest rates. But it is cutting rates, and it also sustains its surplus in part through intervention. The best outcome for the world, as George Magnus notes, would be a surge in internal demand in one of the main surplus countries that gives the entire global economy a lift, and helps pull up nominal rates globally. In the Caballero, Farhi and Gourinchas model, monetary expansion by a surplus economy stuck at the zero bound risks exporting its liquidity trap, and pulling other countries into liquidity traps of their own. Fiscal expansion, by contrast, has positive global spillovers. But for now, that doesn’t seem to be happening, despite a few somewhat encouraging noises from the G-20. Not in Germany. And not in many of the key countries in Asia, with the possible exception of Japan. And one of the most obvious risks facing the global economy is that demand growth in one of the main surplus countries could falter. China’s unusually high level of investment over the past seven or so years did not get rid of China’s external surplus, as national savings remained exceptionally high. A more normal level of investment would mean—absent other changes in China that reduce its high level of national savings—less demand from China and more spare Chinese savings that would need to be exported to the world. Maybe a new rise in China’s surplus would be offset by a fall in the surplus of Europe, or the Asian NIEs. But, then again, maybe not. * For East Asia, I summed the surpluses of China, Japan and the NIEs (Korea, Taiwan, Hong Kong and Singapore). I added the surpluses of Sweden, Denmark and Switzerland to the euro area’s surplus to provide a fair comparison. Norway was left out because its surplus hinges on the price of oil.