Capital Flows

China has accumulated a massive stock of U.S. dollar reserves in recent years. Statements of concern from China regarding the risk that U.S. economic policy might undermine the future purchasing power of these assets has fuelled the market’s concern that China may shift away from dollar purchases. Yet the chart shows that over the 12 months ending in July 2009 China accumulated more dollar-denominated assets, mainly U.S. Treasuries, than foreign assets in total. Despite its rhetoric, China has thus far taken no actions to wean itself off of the dollar. CGS Chart Book: Foreign Exchange Reserves in the BRICs (Updated 10/09) Wolf: The Rumors of the Dollar’s Death Are Much Exaggerated Evans-Pritchard: China Calls Time on Dollar Hegemony Bloomberg: Hu Says Currency-Reserve Nations Must Be Aware of Global Role Guha: Down But Not Out

This chart shows who financed the massive amounts of debt that the U.S. government issued in the first half of 2009. The total net issuance of treasuries and agencies is shown on the left, and economic sectors are ordered from left to right by the size of their total purchases. Given the federal backing of the GSEs – government sponsored entities such as Freddie Mac and Fannie Mae – it is best to look at the sum of treasuries and agencies rather than treasury issuance alone. Through the first two quarters of 2009, issuance has been financed primarily by official buyers. Official buyers often have motivations other than profit. The Federal Reserve is buying debt as a part of its quantitative easing program, while some foreign central banks are accumulating debt as a function of their currency policy. The Federal Reserve plans to slow and then stop its purchases by the end of the first quarter of 2010. This raises the question of who will replace this source of demand, and at what price. Wolf: Finding a Route To Recovery and Reform Gets Tough Now Hughes: Short View: Treasury Market Coote: On The Money

This chart shows China’s overweight or underweight observed external investment position since 2000 in a given sector relative to that sector’s share of world market capitalization. A positive number indicates that China is overweight in a given sector; a negative number indicates that China is underweight. As the chart below shows, China is most overweight in materials and energy. This reflects a desire for stable economic growth, which, in the Chinese government’s view, requires a secure source of inputs. As other sectors in China develop, along with the managerial skills required to integrate international acquisitions, China’s aggregate portfolio allocation will likely even out. Economist: Sino-Trojan Horse Shearer: The China Paradox BBC: China Invests in Canada Oil Sands

This chart shows the yearly change in purchases of securities backed by U.S. government-sponsored enterprises (GSEs) and in securities issued by the U.S. Treasury. In late 2008 and early 2009, U.S. households and the rest of the world began selling GSE-backed securities, such as those issued by Fannie Mae and Freddie Mac, and began purchasing more Treasury securities, which are considered lower-risk. American banks, however, moved in the opposite direction, increasing their purchases of GSE-backed securities. This suggests a growing appetite for risk in the banking sector. Lee: Fewer Banks Tightening Credit Standards Braithwaite: Banks Slow Credit Tightening

This post is by Brad Setser and Rachel Ziemba of RGE Monitor A score of recent reports have put the total assets managed by sovereign wealth funds at around $3 trillion. That seems high to us – at least if the estimate is limited to sovereign wealth funds external assets. We don’t know the real total of course. Key institutions do not disclose their size – or enough information to allow definitive estimates of their size. But our latest tally would put the combined external assets of the major sovereign wealth funds roughly $1.5 trillion (as of June 2009) – rather less than many other estimates. This portfolio of $1.5 trillion does reflect an increase from the lows reached of late 2008. But it is well below the estimated $1.8 trillion in sovereign funds assets under management in mid 2008. Significant exposure to equities and alternative assets like property, hedge funds and private equity led to heavy losses by most funds in 2008 – a fact admitted by many of the managers. $1.5 trillion is lot of money. But it is substantially less than $7 trillion or so held as traditional foreign exchange reserves. There are three main reasons for our lower total. First, we continue to believe that the foreign assets of Abu Dhabi’s two main sovereign funds – The Abu Dhabi Investment Authority (ADIA), and the smaller Abu Dhabi Investment Council (which was created out of ADIA and manages some of ADIA’s former assets) – are far smaller than many continue to claim.* Our latest estimate puts their total size at about $360 billion. That is roughly the same size as the $360 billion Norwegian government fund – and more than the estimated assets of the Kuwait Investment Authority (KIA) and the combined assets of Singapore’s GIC and Temasek. Our estimate for the GIC’s assets under management is also on the low side. To be sure, Abu Dhabi’s total external assets exceed those managed by ADIA and the Abu Dhabi Investment Council. Abu Dhabi has another sovereign fund – Mubadala and a number of other government backed investors. Its mandate has long been to support Abu Dhabi’s internal development ("Mubadala [was] set up in 2002 with a mandate not only to seek a return on investment but also to attract businesses to Abu Dhabi and help diversify the emirate’s economy) but it now has a substantial external portfolio as well. Chalk up another $50 billion or so there. Sheik Mansour’s recent flurry of investments also has made it clear that not all of Abu Dhabi’s external wealth is managed by ADIA, the Council and Mubadala. The line between a sovereign wealth fund, a state company and the private investments of individual members of the ruling family isn’t always clear. Abu Dhabi as a whole likely has substantially more foreign assets than the $400 billion we estimate are held by ADIA, the Abu Dhabi Investment Council and Mubadala. And despite Dubai’s vulnerabilities, it still holds a good number of foreign assets, even if its highly leveraged portfolio has suffered greatly in the last year. Two, the dividing line between China’s sovereign fund and China’s state banks isn’t totally clear. We opted to exclude the CIC’s domestic investment in the state banks from our total, as we focus on sovereign funds external assets. That is conceptually clean. But it ignores the fact that the state banks were recapitalized with foreign assets and thus manage a substantial foreign portfolio of their own. If the state banks foreign portfolio and those of the investment companies is added to the CIC’s foreign portfolio, the foreign assets of China’s sovereign funds exceed the CIC’s nominal $200 billion in size (The PBoC reports that the state banks had $220 billion of foreign assets at the end of Q1, with $120 billion in foreign portfolio investments and another $100 billion in business with offshore counterparties). Three, we would argue that stabilization funds that are managed by the central bank and counted as part of the country’s reserves should be considered reserve assets – and not included in the total for sovereign funds. Russia’s reserve fund is a case in point. Its mandate precludes investment in anything other than classic reserve assets – and it thus has a more conservative portfolio that many central banks. We would also include SAMA’s foreign assets as “reserves.” If it walks like a duck (is managed by the central bank) and quacks like a duck (is invested predominantly in traditional reserve assets), it is a duck … While SAMA’s portfolio does include equities, so do some other central banks. Those two pools add up. Russia had --at the end of June, a $85 billion in its stabilization fund and a $90 billion in a wealth fund (that is also managed for now by the central bank’s reserve managers). The Saudis have around $425 billion in non-reserve foreign assets (largely because the Saudi Treasury has substantial deposits with the central bank). But these pools are currently shrinking. The Saudi foreign assets fell by about $50 billion in the first half of 2009. Russia’s reserve fund will be depleted in 2010, if not before. Indeed, Russia’s current trajectory implies that its wealth fund – which was created to manage the surplus in its reserve fund – could also be exhausted in the near future. Kazakhstan and Chile do not count their sovereign funds as part of their reserves. But their funds are mostly restricted to high grade fixed income, and they are also being drawn on to make up for 2009 fiscal deficits. Each count for about $20 billion But the dividing line sometimes cuts the other way as well. The Hong Kong Monetary Authority has a substantial investment portfolio that isn’t invested in classic reserve assets. And Jamil Anderlini has reported that up to 15% of SAFE’s portfolio was – at least at one time – invested in risky assets. That puts SAFE’s “investment portfolio” at around $300 billion (though SAFE likely has substantial unrealized losses on this part of its portfolio, so its market value is likely less than this). If SAFE’s investment portfolio were to be considered separately, it would already be roughly the same size as many large sovereign funds. Sum it all up and the pool of assets managed by sovereign funds and central banks that is currently invested in risky assets is around $2 trillion. And in a lot of way the amount of money available for investment in risky assets by major sovereign investors is the most important concept; it really doesn’t matter that much if the investment is managed by a central bank or a sovereign fund. Will this total rise rapidly? Our best guess is that it will not. Although reserve accumulation has resumed, it remains slower than in late 2007 and early 2008. Moreover, the crisis likely led many countries to conclude that they should take fewer – not more – risks with their reserves. And perhaps some countries with sovereign funds will conclude that they would have been better served by more conservatively managed stabilization funds. The inflow into the main Gulf funds is likely to remain subdued. Most Gulf countries are exporting less oil and are spending more at home. Mega-projects aren’t cheap. $70 a barrel doesn’t necessarily imply the large inflows that ADIA and KIA received in 2006 and 2007. Moreover, the proliferation of new investment vehicles has also reduced the inflow into the traditional sovereign funds. Much of Abu Dhabi’s surplus may be flowing to the Abu Dhabi Investment Council and other direct investors like Mubadala or the International Petroleum Investment Company (IPIC). But for every rule there is an exception. China didn’t have to dip into its substantial stock of reserves during the crisis – and it now clearly wants to support the direct investments of its corporations. Vehicles like the China Development Bank (CDB) should grow rapidly. The CIC wasn’t fully invested prior to the crisis – limiting its losses. It is now clearly shifting out of cash and money market funds into various “risk” assets. And if China’s government decides it wants to hold more market risk, it could easily redirect some of its new reserve growth into the CIC – or just authorize SAFE to take more risk. Estimated Foreign Assets of Major Sovereign Wealth Funds Dec-07 Dec-08 ADIA/ADIC 476 359 30 45 Kuwait 286 230 65 60 Total GCC 883 702 371 323 Kazakhstan 26 23 40 50 Chile 19 17 1253 1089 China 90 100 245 166 Temasek 85 65 18 25 Total Asia 442 372 1682 1425 Reserve-like Funds 335 475 Russian Reserve Fund 130 95 33 90 492 700