Will Americans lose confidence in the dollar before foreign central banks …

There are two groups of investors that are massively overweight US assets: the world’s central banks, who still hold most of their reserves in dollars, and US domestic savers. US residents keep the overwhelming majority of their assets at home.

The most recent TIC data report showed a fall in net financing for the US in October -- the $48 billion in financing from the net sale of securities was less than the $55.5 billion trade deficit. There are, of course, other ways of financing a trade deficit -- FDI, and bank lending notably. Still, the fall in net purchases of securities was rightly considered a bad sign by the markets (until they bounced back on the current account data).

Nouriel and I have focused on the risk that foreign central banks may become increasingly unwilling to provide the new financing the US needs to run a large current account deficit -- remember, they have to keep on increasing their exposure to the US, not just hold on to their existing dollar assets, in order for the US to keep on consuming and importing at its current pace. But the current equilibrium could also come to an end if even a small number of US investors lost confidence in the dollar, and decided to shift a tiny share of their accumulated US assets abroad. That is what happened, on a very small scale, in October: the fall in net financing in the TIC report stemmed more from a rise in US purchases of foreign assets rather than a reduction in foreign purchases of US assets.

In October, foreigner investors bough $63 billion of US assets -- more than enough to finance a $55.5 billion trade deficit. But rather than using the entire inflow to finance the trade deficit, the US in effect used the inflow of funds from abroad to finance the purchase of $15 billion in foreign assets-- Euro denominated bonds, Asian stocks, you name it. That left only $48 billion to finance the trade deficit.

The "equilibrium" that provides the $55 billion plus in monthly financing the US needs could come unglued either if foreigners stop buying $60 billion plus of US dollar debt -- something that would happen if the world’s central banks stopped buying dollars. But it also could come unglued if US residents decided they wanted to keep on buying $15 billion in foreign assets, or even increased the pace of their foreign purchases.

That could only be sustained if the US trade deficit fell, or foreigners -- read foreign central banks -- stepped up their financing to let Americans diversify their portfolio and hold more foreign stocks and bonds. Does the world really want to finance $50 billion plus (at least $600 billion a year) US trade deficits and $15 billion a month ($180-200 billion a year) in US capital flight? We will see ...

One last point: the TIC data suggests that private investors abroad bought $49 billion in US assets, including $23 billion in "Agency" bonds, while foreign central banks bought $14 billion in US assets (and sold, in aggregate, almost a billion in Agency bonds). Put differently, netting out US purchases of foreign assets, the "private sector" provided the US with $34 billion in net financing, and central banks provided $14 billion in net financing.

I don’t buy that breakdown for a second. $15 billion in central bank financing a month implies foreign official institutions are supplying the US with $180 billion in net financing a year. That is not going to be close to the right number once better data comes in.

Remember that the BIS data for 2003 indicated that on average foreign central banks provided $35 billion in financing a month, or $420 billion a year. I would not be surprised if the final BIS tally shows $480 billion in reserve financing in 2004, or a monthly pace of about $40 billion. Unfortunately the BIS data for 2004 will not be available til the summer of 2005. But already know enough to know that foreign central banks supplied more than $15 billion in new financing to the US in October.

We know the TIC data does not capture all foreign central bank financing of the US, notably US assets bought through private intermediaries on behalf of foreign central banks. Andy Xie of Morgan Stanley is reporting a surge in private inflows into Asia in the fourth quarter -- inflows that would show up in the form of higher reserves. Dow Jones reporting suggests that China alone accumulated $20 billion or so of reserves in October (overall reserves went up more because of valuation gains). We also know China has shown increasing interest in Agency bonds. It seems pretty clear to me that the surge in "private" purchases of Agency bonds in October reflects unrecorded central bank buying.

If I am right, and inflows from central banks are closer to $40 billion than $15 billion, official institutions provided most of the $48 billion in net financing the US received in October...

More on this later.