Monetary Policy

A common explanation for low Treasury yields is that low rates outside the United States have piled into the U.S. market, as investors in Europe, Japan and elsewhere look to the United States for a reasonable mix of safety and yield. That is part of what Gavyn Davies, in one of his typically thoughtful posts, argues that the Fed has learned over the past year. The United States is no longer a (monetary) island, the rest of the world matters. Of course, what Lael Brainard called the elevated sensitivity of exchange rate moves to monetary surprises is also a part of the global story. It isn’t just a flows story. An awful lot of the tightening in U.S. financial conditions that occurred in anticipation of the Fed raising rates came through dollar appreciation; too much in my view. The apparent problem with this the "foreign demand is holding down Treasury yields" thesis: Foreign investors pretty clearly have sold Treasuries over the past 12 months. And not just a few Treasuries. Net foreign sales of long-term Treasuries over the last 12 months of data are around $250 billion. So what is going on? It is actually pretty simple, in my view. Treasury sales in the Treasury International Capital (TIC) data (and also, I suspect, most of the sales of U.S. equities) are linked to the fall in global reserves. Over the last 12 months China has sold several hundred billion of reserves (though most of those sales were in the fall of 2015 and early 2016, recent sales are more modest), the Saudis have been selling and Japan—for reasons of its own—has been selling securities while increasing its deposits (Japan has reduced its long-term securities holdings by a bit over $100 billion over the last two years, while raising its short-term deposits by a similar amount, according to the SDDS data). A plot of estimated growth in global reserves (I sum the reserves of a broad set of countries, and assume the currency distribution of reserves maps to the IMF COFER data on reporting countries) against official bond sales in the TIC data suggest the official sales are in line with the fall in global reserves. So why hasn’t the fall in official demand for Treasuries had an impact on Treasury yields? Well, China’s reserve sales have come with a globally deflationary shock. The yuan has depreciated over the last year, and weakness in Chinese investment demand has pulled down commodity prices (the IMF estimated that between 20 and 50 percent of the fall in broad global commodity indices over the past few years is due to China; see paragraph 18). In that context, there is little reason to think China’s sales should be driving up U.S. yields. Particularly not when China’s current account surplus—and thus the net acquisition of foreign assets (or net reduction in foreign debt) by Chinese residents—is still around $250 billion (it was over $300 billion in 2015, but fell a bit in the first half of 2016). Official Chinese sales of Treasuries are offset by a buildup of private Chinese assets abroad (even if they are hard to track) and the repayment of debts Chinese residents owe to the world’s banks. Big repayments too. The banks then have to park the funds formerly lent to China somewhere. If you strip out official sales, foreign private demand for Treasuries looks solid. And more importantly, foreign private demand for U.S. bonds of all kinds, including close substitutes for Treasuries, is actually pretty strong. Right now, unlike in many past periods (2005 to 2007 for example, or 2010 and 2011) I suspect most of the "private" purchases of Treasuries and Agencies in the TIC data are actually private purchases, not official purchases in disguise. And then there is another, hidden source of inflows into the U.S. bond market. American investors, faced with low yields on their foreign bonds, have been selling off their foreign portfolio and bringing the proceeds home. To the tune of $270 billion over the last 12 months. Sum up American selling a portion of their existing holdings of foreign bonds and bringing the money home and around $400 billion in foreign private purchases, and there is an almost $700 billion net inflow from private fixed income investors in to the United States. One small subcomponent of all this: foreign investors have rediscovered their love for Agency bonds. You need to go back to the summer of 2007 to find as much foreign demand for long-term Agencies as was recorded in the TIC data this June. Throw in the fact that the Fed is clearly in the process of rethinking the path of U.S. policy rates (and Larry Summers is rethinking the Fed’s policy target) and current U.S. yields are easier to understand.

The proxies for China’s foreign exchange intervention in July are now available, and they point to $20 to $30 billion of reserve sales. The PBOC’s foreign assets fell by about $23 billion (The PBOC’s foreign reserves, as reported on the PBOC’s renminbi balance sheet, fell by $29 billion; I prefer the change in the PBOC’s foreign assets though, as foreign assets catches the foreign exchange that banks hold at the PBOC as part of their reserve requirement). FX settlement with non-banks shows net sales of around $20 billion. Throw in the change in forwards in the settlement data, and total sales were maybe $25 billion. All the proxies show more variation than appeared in headline reserves, which only fell by $5 billion. I trust the proxies. The bigger story, I think, is two-fold. One is that there is still a correlation between FX sales and moves in the yuan against the dollar. In June and July the yuan slid against the dollar, and the magnitude of FX sales increased. That fits a long-standing pattern. The second, and far more important point, is that the magnitude of sales during periods when the yuan is depreciating against the dollar are significantly smaller than they were last August, or back in December and January. Why? Tighter controls? Or, more simply, has a lot of the foreign currency debt that was built up as part of the carry trade (borrow in dollars to buy yuan to pocket higher interest rates on the yuan) now been paid back, reducing corporate demand for foreign currency in periods of depreciation? Either way, if a bad month means $20-30 billion in sales, China isn’t going to run out of reserves anytime soon. For now, the desire (or desire, combined with ability to execute) of Chinese savers to hold foreign assets seems to be roughly equal to China’s underlying current account surplus. Hence the broad stability in reserves. August should be fairly calm on the reserve front. The yuan has appreciated a bit against the dollar recently. And if you squint, you can argue that it also has been stable (rather than slowly depreciating) against a basket, at least for a few weeks. There is no reason to expect large sales.

Both of the key proxies for China’s actual intervention in June are out. The PBOC’s balances sheet shows a $15 billion dollar fall in reserves. And the State Administration on Foreign Exchange (SAFE) data on foreign exchange settlement by the banking system (the PBOC is treated as part of the banks) shows $18 billion in sales from the banking system (using sales for clients, not net settlement). They paint a consistent picture. The gap between the modest sales reported in the data and the rise in headline reserves ($13.4 billlion) is almost certainly from the mark-to-market gains on a portion of SAFE’s book. The portfolio of high quality bonds should have increased in value in June. Friends who read Chinese say SAFE has admitted as much on its website. The more interesting thing to me is how modest the sales were, at least when compared to other periods of depreciation (against the dollar) in the last two years. Either the carry trade unwind is over or the controls work. Or somehow this most recent depreciation hasn’t produced expectations for further depreciation, even though the crawl down against the basket has been pretty stable. It is a puzzle, at least to me. For the conspiratorially minded, the banks do look to have sold foreign exchange from their own accounts in June, as they did last August and this January. But the sales from their own account were modest—$5 billion versus $85 billion last August and $15 billion in January. And the settlement data for forwards also shows a modest reduction in the net forward book of the banks in June. Net of the change in forwards, total sales in the settlement data look to be just under $15 billion. Not much, in other words. But there is at least a suggestion that expectations started to build over the course of July in a way that worried the PBOC. The need to break the cycle of expectations is one explanation for the decision to appreciate the yuan in the middle of the week back to about 6.7 to the dollar, even though such appreciation against the dollar meant appreciation against a basket. Bloomberg reported: "The yuan advanced the most in two weeks, with the central bank’s daily fixing adding to signs that China’s authorities are prepared to overrule the market to control the currency’s moves.The People’s Bank of China strengthened its reference rate, which restricts onshore yuan moves to 2 percent on either side, even as the dollar advanced the most since July 5. This spurred speculation that the central bank isn’t sticking to its stated policy of following the direction of the market, which would have resulted in a weaker fixing." The mystery of the PBOC’s actual exchange rate policy rule remains. Perhaps intentionally. All this matters, of course, because the exchange rate is the mechanism that most powerfully transmits any weakness in Chinese domestic demand to other manufacturing economies. Commodity exporters are, of course, impacted more directly by changes in commodity prices. The cumulative depreciation against the dollar over the last 12-plus months has reached 7-8 percent—enough that it would reasonably be expected to start having an impact on trade flows going forward.

Turkey has long ranked at the top of most lists of financially vulnerable emerging economies, at least lists based on conventional vulnerability measures. Thanks to its combination of a large current account deficit and modest foreign exchange reserves, Turkey has many of the vulnerabilities that gave rise to 1990s-style emerging market crises. Turkey’s external funding need—counting external debts that need to be rolled over—is about 25 percent of GDP, largely because Turkey’s banks have a sizable stock of short-term external debt. At the same time, these vulnerabilities are not new. Turkey has long reminded us that underlying vulnerability doesn’t equal a crisis. For whatever reason, the short-term external debts of Turkey’s banks have tended to be rolled over during times of stress.* And, fortunately, those vulnerabilities have even come down just a bit over the last year or so. After the taper tantrum, Turkey’s banks even have been able to term out some of their external funding by issuing bonds to a yield-starved world in 2014, and by shifting toward slightly longer-term cross-border bank lending in 2015 and 2016 (See figure 4 on pg. 35 of the IMF’s April 2016 Article IV Consultation with Turkey) And while the recent fall in Turkey’s tourism revenue doesn’t look good, Turkey also is a large oil and gas importer. Its external deficit looks significantly better now than it did when oil was above a hundred and Russian gas was more expensive. Turkey doesn’t have many obvious fiscal vulnerabilities; public debt is only about 30 percent of GDP. Its vulnerabilities come from the foreign currency borrowing of its banks and firms. There is one more strange thing about Turkey. Its banks have increased their borrowing from abroad in foreign currency after the global financial crisis, but there hasn’t been comparable growth in domestic foreign currency lending. Rather, the rapid growth has come in lending in Turkish lira, especially to households. So the banks appear to have borrowed abroad and in foreign currency to fund domestic lending in Turkish lira. Bear with me a bit. Balance sheet analysis is interesting but not always straightforward. Turkish banks have significant domestic foreign currency deposits, and lots of domestic foreign currency loans.** The banks have added to their domestic foreign currency funding with a lot of short-term external debt (the data in the chart above sums cross border deposits and "short-term" loans by original maturity). And Turkey’s banks also have lots of liquid foreign currency assets on their balance sheet, some abroad but mostly in the form of deposits at the central bank. When you sum it up, domestic foreign currency deposits cover domestic foreign currency lending. The IMF staff report notes: “The sector’s loan-to-deposit (LtD) ratio stands at 119 percent, with the ratio at 89 and 142 percent for foreign (FX) and local currency respectively.”*** Why then do the Turkish banks borrow in foreign currency abroad, when, on net, they seem to just park the proceeds at the central bank? And how do they finance domestic currency lending with foreign currency borrowing without running an open foreign currency position? Turkey’s banks rely on two bits of financial alchemy. First, the central bank allows the domestic banks to meet much of their reserve requirement (including the reserve requirement on lira deposits) by posting gold and foreign currency at the central bank (this is the famous or infamous reserve option mechanism). That frees up lira to lend domestically.*** And second, the banks clearly rely on “off balance sheet” hedges (cross currency swaps) for a part of their funding. Look at the financial sector section of IMF’s staff report on pp. 23 to 26. The result is an interesting mix of risks. The banks ultimately need wholesale funding in lira, which Turkey’s central bank could supply in extremis—though with consequences for the exchange rate. The banks could also offset a loss of external foreign currency funding by drawing down on their liquid foreign currency assets. Monday’s Central Bank of Turkey (CBRT) press release notes that nearly $50 billion in liquidity sits at the central bank. But if the banks ever needed to draw on their foreign currency reserves, Turkey’s headline reserves would fall fast. A lot of Turkey’s foreign exchange reserves—which are not high to begin with—are effectively borrowed from Turkey’s banks. Makes for an interesting case. And it highlights a second debate of particular interest to me. What role should domestic balance sheet vulnerabilities play in determining the “right” level of foreign currency reserves for an emerging market economy? And what kind of domestic vulnerabilities matter the most, those from domestic currency deposits or those from foreign currency deposits? Specifically, should emerging economies with current account deficits and high levels of domestic liability dollarization (e.g. countries like Turkey) hold more reserves (relative to the size of their economies) than countries with current account surpluses and low levels of domestic liability dollarization (e.g. most East Asian economies, notably China)? This isn’t entirely an academic debate. The IMF’s new reserve metric—a composite indicator that is a weighted average of reserves to short-term external debt, reserves to all external liablities, reserves to exports, and reserves to domestic bank liabilities (M2)—effectively says that countries with large banking systems (like China) need to hold more reserves against the risk of capital flight than countries with heavily liability dollarized banks (like Turkey). And to get all wonky, this is because of the weight the IMF’s reserve index puts on the “M2” variable and the IMF’s decision to omit “foreign currency deposits” from its metric. There turns out to be large variance in the ratio of M2 to GDP across large emerging economies And for those countries, high levels of M2 to GDP are not, in general, correlated with high levels of liability dollarization, while a high level of M2 to GDP, it turns out, is correlated with a current account surplus. Let me be more concrete. M2 to GDP is about 200 percent of GDP in China. It is around 100 percent of GDP in Korea. And about 50 percent of GDP in Turkey. Five percent of M2 (the IMF’s norm for most emerging economies) works out to be roughly 10 percent of GDP in China, 5 percent of GDP in Korea, and 2.5 percent of GDP in Turkey. So there is a meaningful difference across countries. Ten percent of M2—the IMF’s norm for countries with fixed exchanges and open financial accounts—would work out to be about 20 percent of GDP in China. As a result, the M2 (broad money) variable drives much of the variation in the amount of reserves that large emerging economies need to hold to meet the IMF’s reserve norm. the following table, prepared by the CFR’s Emma Smith, decomposes reserve needs at the end of 2015. The IMF also has a somewhat cumbersome reserves data tool here. For countries with high levels of short-term debt and a low level of M2 to GDP, the IMF composite metric can have the effect of reducing the reserves that they need to hold relative to simple measures like reserves to short-term-debt. For example, in December 2015, when Turkey had a bit more short-term debt ($120 billion, by residual maturity) than it does now, the IMF’s metric would have been met with slightly fewer reserves ($115 billion) than Turkey’s short-term external debt. Conversely, for countries with low levels of short-term debt and a high levels of M2 to GDP, the IMF’s metric has the effect of raising needed reserves well above measures based on short-term external debt. China is the most obvious example, but not the only one. Turkey still needs to have a decent amount of reserves relative to the size of its economy to meet the IMF’s metric, especially after the lira’s 2015 depreciation. As it should given its large stock of external debt. I would argue it actually needs even more. $90 billion in foreign exchange reserves is low for a country with lots of foreign currency denominated internal debt (e.g. foreign currency deposits, which fund foreign currency loans) and lots of foreign currency denominated external debt. And I find it a bit strange that with the IMF’s metric China—even with a relatively closed financial account—needs substantially more reserves, relative to the size of its economy, than say Brazil or Russia. Brazil runs a current account deficit and Russia has significant domestic liability dollarization.**** The IMF argues—in its staff guidance note on the reserve metric—that there is no additional risk from high levels of liability dollarization. They didn’t find evidence of more or bigger runs in economies with dollarized liabilities. I am not sure I agree with their interpretation of the data on runs—I remember Uruguay’s crisis, and Ukraine lost substantially more reserves over the past few years than the IMF initially forecast in part because of a draw-down in its domestic foreign currency deposits.***** But more significantly, I would argue that the consequences of a run out of foreign currency deposits are much larger than the consequences of a run out of domestic currency deposits. There is a limit to the ability of most central banks to act as a lender of last resort in foreign currency.****** Technical stuff. But important. It has a big impact on who needs to hold what. * The standard explanation is that some of the funding comes from wealthy Turks with funds offshore. I though wonder if that is still the case given the magnitude of the banks’ external liabilities. ** Turkish firms have increased their foreign currency borrowing from the domestic banks from $50 billion in 2008 to around $180 billion now; the Turkish central bank helpfully provides all the data on this here. The resulting risks are well known. *** See table 6, on p. 44 of the IMF’s staff report for changes in the loan-to-deposit ratio over time. **** See the peer comparison on p 38 of the IMF’s staff report for Turkey, among other sources. ***** See Figure 9, p. 29 of the IMF’s April 2015 paper on reserve adequacy. ****** I tend to compare foreign currency debts to foreign exchange reserves—leaving out gold reserves. I followed that convention in the chart above. I am reconsidering a bit, given Venezuela’s apparent ability to borrow against its gold. But in Turkey’s case, I suspect most of its $20 billion or so in gold is likely borrowed from the banks (through the reserve option mechanism), and thus not really available to meet a foreign currency liquidity need.

There are plenty of possible explanations for the surprise jump in China’s headline reserves in June. A high allocation to yen (up around 6.5 percent), for example, or a low allocation to pounds (down nearly 8 percent). Headline reserves are reported in dollars, and thus change when dollar value of euros, pounds, yen, and other currencies held in a typical reserve portfolio change. But, absent a much bigger allocation to yen than to pounds, it is hard to see how currency moves in June can explain the $13.5 billion increase in headline reserves. My simple valuation adjustment actually churns out a tiny valuation loss from currency moves, so it implies a slightly higher underlying pace of reserve accumulation than the rise in headline reserves. However, some countries—following the IMF’s SDDS standard—also report the market value of their securities portfolio. And rises in the value of a portfolio that consists primarily of bonds could easily explain the rise in China’s June reserves. A two-year Treasury should have increased in value by about half a point, and a five-year Treasury rose by almost two points. I get bond valuation gains of very roughly $15 to $20 billion on a stylized version of China’s U.S. Treasury portfolio,* and there should also be gains on China’s euro portfolio and other fixed income assets. 5 year bunds were up a bit under a point. Extrapolating a bit, across all currencies bond market gains could have added something like $25 billion to the value of a bond portfolio that likely tops $2.5 trillion by a significant margin (not all of China’s reserves are in bonds). Of course, it is also possible China also might have started to buy dollars in the market. This though feels like a stretch — most observers suspect China’s central bank is still selling dollars through the state banks, at least in the offshore market in Hong Kong. China seems to have wanted to make sure the CNY’s depreciation against the dollar in June was orderly, and that the CNH moved in line with the CNY. This recent Reuters article, for example, hints that China still is selling foreign currency ("further weakness was capped as the central bank was suspected of intervention to offset massive dollar demand from banks’ clients, traders said"). The uncertainty about the sign of China’s activity in the market makes the foreign exchange settlement and the PBOC balance sheet data that will be released toward the end of the month all the more important. The settlement data and the PBOC’s balance sheet data often provide a cleaner read on China’s actual intervention than the change in headline reserves. [*] Ballpark math: if China held around $1.5 trillion in U.S. Treasuries (I added Agencies to my actual estimate and rounded a bit), with two-thirds at an average maturity of two years and one-third at an average maturity of 5 years (to fit with the data showing total returns on both maturity buckets) the mark to market gain on its Treasuries would be around $15 billion. If two-thirds were in five-year bonds and only a third in two-year bonds, that would be $20 billion. All this is very rough. Precise estimates here would stretch the technology a bit too far, given all the uncertainty about China’s reserve portfolio. Most Treasuries held in central bank reserves, according to the Treasury data, have a maturity of less than five years; see pp. 24-25 of this Treasury report.

   

The implications of Brexit understandably have dominated the global economic policy debate. But there are issues other than Brexit that could also have a large global impact: most obviously China and its currency. The yuan rather quietly hit multi-year lows against the dollar last week. And today the yuan-to-dollar exchange rate (as well as the offshore CNH rate) came close to 6.7, and is not too far away from the 6.8 level that was bandied about last week as the PBOC’s possible target for 2016.* The dollar is—broadly speaking—close to unchanged from the time China announced that it would manage its currency with reference to a basket in the middle of December.* So the yuan might be expected to be, very roughly, where it was last December 11. December 11 of course is the day that China released the China Foreign Exchange Trade System (CFETS) basket. Yet since December 11, the yuan is down around 1.5% against the dollar, down about 5 percent against the euro and down nearly 19 percent against the yen. The reason why the renminbi is down against all the major currencies, obviously, is that managing the renminbi "with reference to a basket" hasn’t meant targeting stability against a basket. As the chart above illustrates, over the last seven months the renminbi has slowly depreciated against the CFETS basket. The renminbi has now depreciated by about 5 percent against the CFETS basket since last December, and by about 10 percent since last summer. How? No doubt there are many tricks up the PBOC’s sleeve. But one is straightforward. When the dollar goes down, China hasn’t appreciated its currency by all that much against the dollar. And when the dollar goes up, China has depreciated against the dollar in a way that is consistent with management “with reference to a basket.” That takes advantage of the fact that the yuan’s value against the dollar is what matters inside China, while the broader basket matters more for trade. And it takes advantage of the fact that politically the yuan-to-dollar exchange rate matters more than the yuan-to-euro exchange rate. So even if the yuan was a bit overvalued last summer, it isn’t obviously overvalued now. China’s manufacturing export surplus remains quite large. And export volume growth—which was falling last summer—has now turned around. It is not realistic for Chinese export volumes to outperform global trade by all that much any more; China is simply too big a player in global trade. China will have to adjust to a new normal here. My hope is that China will pocket the depreciation achieved over the last several months, and will now start managing its currency more symmetrically or even be somewhat more willing to allow a stronger dollar to flow through to a stronger yuan. Since January, the expectation of stability (more or less) against the dollar together with the repayment of (unhedged) external debt, a tightening of controls and the threat of intervention in the offshore market seem to have reduced outflow pressures. The fairly steady depreciation against the basket has coincided with smaller reserve sales.*** But there is a risk that speculative pressure could return if the market concludes that China thinks it can now depreciate against a basket thanks to tighter controls and less external debt. And, obviously, if depreciation against the basket can only be achieved through depreciation against the dollar, it is hard to see how the yuan doesn’t become even more of a domestic political issue in the United States. 6.8 against the dollar brings the renminbi back to its level of eight years ago, more or less. * Reuters: "China’s central bank would tolerate a fall in the yuan to as low as 6.8 per dollar in 2016 to support the economy, which would mean the currency matching last year’s record decline of 4.5 percent, policy sources said." The PBOC indirectly pushed back against the story, and has reiterated that it is committed to a "basically stable" renminbi. The Reuters story can also be read two ways: as a signal that China wants a steady depreciation against the dollar, or a signal that there is a limit on how far China is willing to allow the yuan to depreciate against the dollar even if the dollar starts to appreciate against the majors. ** China’s basket doesn’t mirror the U.S. basket. Japan for example, has a 15 percent weight in China’s basket versus a 6-7 percent weight in the Federal Reserve’s broad index, and Canada and Mexico figure more prominently in the U.S. index. The pound, incidentally, has a 4 percent weight in the CFETS basket. Still, the dollar index provides a rough guide to how China would move if it pegged to the dollar. *** Goldman’s Asia team has suggested that Chinese firms have been settling imports with renminbi in 2016, and this flow likely reflects an orchestrated attempt to limit pressure on the currency that should be counted as a form of hidden intervention. I will take that argument up at a later time. But even with the Goldman adjustment, the pace of reserve sales (using the settlement data) has fallen from $100-150 billion a month in January to $25 billion or so in April and May.

Thursday’s Brexit vote wasn’t a “Lehman moment”, as some have feared. Instead, it was a growth moment. And that may be the greater threat. If policymakers respond effectively, the benefits could be substantial: a stronger global economy, and an ebbing of the political and economic forces now pressuring UK and European policymakers. Conversely, failure to address the growth risks could cause broader and deeper global economic contagion. In the immediate aftermath of Thursday’s vote, there were significant concerns that Brexit would generate a market reaction similar to what we saw following the fall of Lehman Brothers in August 2008. Market moves in the immediate aftermath of the vote wiped around $3 trillion off of global equity markets, mostly in the industrial world. Indeed, foreign exchange markets (and some equity markets) saw larger moves than after Lehman’s collapse, before finding a degree of stability today. Yet, by all accounts, markets moved smoothly and cleared, there were few reports of payment and settlement issues, and little evidence of financial distress affecting counterparties. No doubt, news may emerge in coming days of large loses taken by some over-leveraged investors, and periods of intense volatility are more likely than not. So we should see today’s bounce as a temporary calm, not the end of the storm. But, if we define a Lehman moment as a comprehensive breakdown in trust in markets, a collapse in creditworthiness and confidence that cascades through financial markets as we saw in 2008, then Brexit is a crisis averted. Central banks deserve a great deal of credit on this score.  According to reports, the major central banks, led by the Bank of England, had been war-gaming a Brexit vote for several weeks, talking to market participants, and stress testing banks and markets. BoE head Mark Carney had his version of ‘whatever it takes’ remarks early on Friday, and provided ample liquidity to markets (in both pounds and sterling).  The Federal Reserve, European Central Bank, and other central banks made statements of support. The broader concern for markets, and for policymakers, is growth. For the United Kingdom, which before the vote was expected to grow on the order of 2 percent, the shock will be severe, perhaps on the order of 2-3 percent over the next 18 months. Some market analysts are predicting an outright recession given the substantial political and economic uncertainty that has been created and its likely effect on investment and consumer demand. The exchange rate depreciation will over time provide a powerful offsetting boost, as will expected rate cuts from the Bank of England, but will take time to be felt. First and foremost, this is a UK shock. The more difficult question is the extent of contagion to the rest of the world. The sharp rise in the yen has intensified concerns about Japanese growth, and put pressure both on the Bank of Japan and the government to introduce additional stimulative measures. But looking beyond the immediate cyclical considerations, Europe poses the more significant concern, given the weak state of the region’s economy (and a population increasingly frustrated with their economic prospects). As in the United Kingdom, uncertainty about post-Brexit relations is likely to weigh powerfully on investment. Relatedly, it is not surprising that European bank stocks fell sharply after the vote, given a continental banking system struggling with the legacy of the crisis and weak profitability.  Lower interest rates will not help on that latter score.  The ECB can ensure adequate liquidity to troubled banks, but can’t make them lend. If Europe wants above-trend growth in this environment, fiscal policy will need to do more. My colleague Sebastian Mallaby has a sensible set of recommendations, starting with a German tax cut, but his proposals seem politically quite challenging. Failure to act may not lead to an immediate economic crisis, but a weaker European economy makes the politics of preserving the European Union all the more treacherous. The dog that hasn’t yet barked is the emerging markets, which have held up well in recent days.  In part, this reflects that commodity prices and Chinese growth, the two most important drivers of EM prospects, have strengthened in recent months and, at least compared to the start of the year, there was a buffer to absorb this most recent shock.  Also, many emerging market investors pulled back on risk before the vote.  Tax measures in some countries (e.g., South Korea and Indonesia) have boosted confidence. Perhaps most importantly, the decline in interest rates in the United States, and the associated decline in expectations that the Federal Reserve would hike rates, matters a great deal for these markets. Still, if doubts about any of these supports were to arise, particularly Chinese growth, then a European regional shock could become global quickly. Finally, in the United States, most analysts (and the market more generally) now expect the Fed to delay a tightening till the end of the year, if not cut interest rates. The prospect of a significant strengthening of the dollar will cause a drag on growth, but given normal lags the brunt of any dollar move will not be felt on the economy till 2017. Unfortunately, the political consequences of a dollar spike on the election campaign is far more uncertain, and potentially more immediate. Those who believe that the populist anger we saw in the UK will be mirrored in the U.S. elections will see opportunity here.  This may be the most worrisome source of contagion from Brexit.

The best available indicators of China’s activity in the foreign exchange market—the People’s Bank of China’s (PBOC) balance sheet data, and the State Administration of Foreign Exchange’s (SAFE) foreign exchange settlement data—are out. They have confirmed that China did not sell much foreign currency in May. The PBOC’s balance sheet data shows a fall of between zero and $8 billion (I prefer the broadest measure—foreign assets, to foreign reserves, and the broader measure is flat). And SAFE’s data on foreign exchange (FX) settlement shows only $10 billion in sales by banks on behalf of clients, and $12.5 billion in total sales—both numbers are the smallest since last June. The settlement data that includes forwards even fewer sales, as the spot data included a lot of settled forwards. A couple of weeks ago I noted that May would be an interesting month for the evolution of China’s reserves. May is a month where the yuan depreciated against the dollar. The depreciation was broadly consistent with the basket peg. The dollar appreciated, so a true basket peg would imply that the yuan should depreciate against the dollar. And in the past any depreciation against the dollar tended to produce expectations of a bigger move against the dollar, and led to intensified pressure and strong reserve sales. That though doesn’t seem to have happened in May. All things China have stabilized. So what has changed? Four theories, building on ideas that I have laid out previously: a) The tightening of controls has had an impact b) The pay-down of external debt since last August has had an impact. China had increased its short-term cross border bank borrowing by about $500 billion from late 2012 to late 2014, creating the potential for a sharp swing if cross border flows reversed. We should have data through quarter one of 2016 soon. Paying down or hedging is a one time demand for foreign currency, so outflows naturally should slow after China’s external debt has been sorted. c) The PBOC has been able to signal that it isn’t looking for a big depreciation against the dollar (even if it is willing to allow a weaker dollar to drag the yuan’s value down against a basket of currencies). d) The data masks hidden sales by various state actors that are not captured in the reserves; "true" sales are higher than the visible sales. Personally, I put some weight on all of the first three. And fairly little weight on the last argument, for now. I take the notion that China, and other Asian countries, often intervene through the backdoor very seriously. Last August, for example, a lot of China’s foreign exchange sales came from accounts in the state banks. But the available data for May—which is more limited than it should be—suggests the state banks added to their foreign exchange holdings, and rebuilt some of the buffer that they spent last August. The PBOC’s "Other foreign assets" (which corresponds to the required bank reserves that the banks hold in foreign currency) rose in May. The state banks’ forward book (net sales), based on the fx settlement data, also fell. There could be more going on, but I have not discovered it. And of course there is another factor. China’s ongoing monthly trade surplus is around $50 billion, and the ongoing monthly surplus in the broader current account should be at least $25 billion. China can finance a decent amount of capital flight (or portfolio diversification) without having to dip into its reserves.

Marc Chandler asked why I chose to attribute Belgium’s holdings to China rather than any of the other potential candidates—notably the Gulf and Russia. The answer for Russia is pretty straightforward. Russia’s holdings of Treasuries (and in the past Russia’s holdings of both Treasuries and Agencies) tend to show up in the U.S. custodial data. Russia holds around $275 billion in securities in its reserves, and it holds a relatively low share of its reserves in dollars (40 percent still?). $85 billion in Treasuries (in March) is more or less in line with expectations. There are maybe a few billion missing, but there also is no need to search for large quantities of missing Russian dollar-denominated reserve assets. Differentiating between the Gulf and China is a bit harder. Both are to a degree “missing” in the custodial data. Both China’s and the Gulf’s custodial holdings are a bit lower than would be expected based on the size of their reserves, and for the Gulf, the size of their reserves and sovereign fund. Both are big players, so both could conceivably account for one of the key features of Belgium: the rapid rise and then the rapid fall in Belgian’s custodial holdings. So why China? Consider a plot of Saudi Reserves—looking only at the Saudi Arabian Monetary Agency’s (SAMA) holdings of securities. I also plotted the change that would be expected if say 75 percent of SAMA’s securities were in dollars, just as a reminder that the full change is the upper limit. SAMA also has a lot of deposits, but they aren’t relevant here. It is fairly clear that the changes in Belgium’s custodial holdings are a loose fit at best for SAMA’s security holdings. The big run-up in the Belgian account actually came when the pace of Saudi reserve growth was slowing. And the drawdown in Saudi reserves started a bit before the drawdown in Belgium, and has been more steady. Now consider a plot of changes in Belgium’s holdings against estimated changes in China’s dollar reserves (including all reserves throws off the scale), assuming a roughly 65 percent dollar share of reserves. Adding the change in Belgium’s holdings to the change in China’s holdings significantly improves the fit over the last four years. This is not proof of course. But it provides the basis for my adjustment.* If you plot China and Belgium’s combined holdings against China’s estimated dollar reserves, the overall fit is reasonable. The change in Belgium occurs at the right time and is of the right magnitude to match a thesis that the Chinese have kept the Treasury share of their reserves constant, and the Treasury share of their dollar reserves constant. Incidentally, the Treasury has released past “survey” data for all of the Gulf countries. The Saudis do hold a decent amount of U.S. equities—$52 billion last June. But Kuwait and the Emirates—with their large sovereign funds—hold more. Kuwait had just over $135 billion. No surprise there. A plot of the Saudi’s custodial holdings of all U.S. bonds and equities against SAMA’s holdings of securities in its reserves over time is still interesting. The Saudis, it seems, joined the Chinese and Russians in piling into Agencies just before the global crisis (quietly adding to the pressure to recapitalize them?). And even if all the Saudi assets in the TIC data, including the equities, are assumed to come from SAMA and even if deposits are left out of the analysis, there is a bit of a gap between the Saudi TIC holdings and what you might expect. Private fund managers? European custodial accounts (there are options other than Belgium)? Fancy financial engineering? Wealthy Saudis also of course have a global investment portfolio: back in 2002, Saudi’s total holdings in the U.S. data exceeded SAMA’s reserves. But Saudi private assets are even less less likely than SAMA to register cleanly in even the new and improved U.S. data. One last point: thanks to Concentrated Ambiguity , we now know the best answer to Dan Drezner’s question “where are Saudi’s reserves” is in "dollar-denominated bank deposits in London." The heavy concentration of bank deposits in dollars make sense. The Saudis do peg to the dollar after all. London isn’t exactly a surprise either. * I also erred on the side of simplicity, in part to make my estimates for China easy to verify. Adding Belgium’s long-term holdings of Treasuries to China’s is more straightforward than estimating China’s share of total Treasuries in Belgium, Luxembourg and Switzerland, excluding the Swiss National Bank’s estimated Treasury holdings. The goal is to produce the best possible estimate with the fewest possible adjustments. But it is ultimately a judgement, one subject to constant revision.

Quick answer. A lot. Between $1.3 trillion and $1.4 trillion, or about 40 percent of China’s reserves. The last year has made it abundantly clear that Belgium’s holdings of Treasuries aren’t from Belgian dentists. China’s reserves started to fall last summer. Yet China’s reported holdings of Treasuries in the custodial data barely budged. Belgium’s holdings, by contrast, fell by around $200 billion. It is now standard among those who care about this stuff to add Belgium’s holdings (between $80 and $90 billion in long-term Treasuries, and $154 billion if you count Treasury bills) to those of China ($1245 billion). A more interesting question, one that takes a bit more technical wizardry to report, is how many U.S. assets China holds. The right answer, I think, is at least $1.8 trillion and perhaps more. That is somewhat less than China used to hold—but still quite a lot. In addition to Treasuries, China has $200 billion or so in Agencies, and $200 billion or so in U.S. equities, and close to $100 billion on deposit in U.S. banks. That is more or less in line with expectations for a country with $3.2 trillion in reserves. I actually lied about the technical wizardry required. Now that the Treasury reports monthly custodial holdings of all kinds of debt along with custodial holdings of U.S. equities, the amount of skill required isn’t very high. You just need to know where to look. (Historical data is here) I do still have a few tricks up my sleeve. After all, the trick to Treasury International Capital (TIC) watching is looking at changes over time, and trying understanding the resulting patterns. The art comes in making the adjustments needed to make the custodial data better map to the transactional data. If you want a continuous time series that goes back to the start of China’s reserve accumulation, you need to extrapolate between the annual custodial surveys from 2002 to 2012. Using, in broad terms, the methodology outlined here, that can be done with a fair amount of sweat, toil, and tears. After 2012, the Treasury provides a continuous monthly data series. The resulting graph of China’s U.S. portfolio holdings (really a close up of the initial graph) relative to the amount of dollars China would need to hold to have a dollar share of reserves in line with the global average does tell a set of stories.** Over time, China has gone from holding Treasuries and Agencies to holding Treasuries, Agencies and equities.* Between 2005 and 2007 the dollar share likely fell from around 70 percent to around 60 percent. Almost all of that fall shows up in the U.S. custodial data. At the time, though, the custodial data was only published once a year. And since then there has been one other significant move. Starting in 2010, China’s visible U.S. holdings —counting wee little Belgium’s Treasury holdings—fell from around 60 percent of its portfolio to a low of around 50 percent. And if anything China’s visible holdings are now rising back toward 60 percent. But I also suspect that after the global crisis the change in China’s U.S. custodial holdings doesn’t fully capture the evolution in China’s holdings of dollar-denominated assets. What really happened in 2010? The TIC data is silent there. One possibility is that China could have made greater use of offshore custodians (like Belgium and Luxembourg) so that its true holdings stopped appearing cleanly in the data. China’s holdings of corporate bonds for example, are almost certainly higher than reported in the TIC data. China could have started buying more non-dollar assets—euros, Australian dollars and the like. I could be missing an important adjustment to the data. There is a bit of work required to find the best fit. I have erred on the side of minimizing the needed adjustments for the sake of transparency. Another possibility is China started lending a portion of its reserves (through complex mechanisms, like entrusted loans) to other emerging economies while still counting these less than liquid assets as reserves. We know from a Chinese data set that the foreign loans of the state banks started to increase around this time. I used to think this was a big part of the story. Back in 2013, Caixin reported that the China Development Bank (CDB) was tapping China’s reserves for financing: "The initiative is an offshoot of a forex lending service started in May 2010, when a SAFE [State Administration of Foreign Exchange] affiliate called the Central Foreign Exchange Business Center signed the first loan agreement of its kind with the government’s policy lender China Development Bank (CDB)...CDB has tapped the reserves for more than two-thirds of the US$ 250 billion in foreign currency loans that it has issued to clients since May 2010." Now I am less sure, as China’s Special Data Dissemination Standard (SDDS) reserve disclosure shows that almost all of China’s reported reserves are in securities, and China also reports over $200 billion in non-reserve foreign assets. The non-reserve foreign assets could be things like PBOC’s deposits at the CDB that finance the CDB’s entrusted loans. And what has China sold over the last year as reserves fell? The answer seems to be both Treasuries and U.S. equities. The fall in Treasuries shows up in the change in Belgium’s holdings, not the change in China’s holdings. Between December 2014 and March 2016 the long-term Treasuries held by Belgian custodians fell from $321 billion to under $90 billion (data). And the U.S. data shows a fall of around $150 billion in China’s custodial holdings of U.S. equities since last March. $20 to $30 billion of the fall might be explained by valuation changes (the last data point for now is February). But it looks like China either sold a large sum of U.S. equities, or shifted those equities to a non-U.S. custodian. China held $323 billion in U.S. equities in December 2014, and $345 billion last March. In February it had $193 billion in U.S. equities in U.S. custodial accounts. The apparent sales in the U.S. custodial data seem commensurate with the fall in China’s reserves. With maybe two-thirds of China’s reserves in dollars, a fall in reserves implies that China’s government will be selling reserves. Of course, private Chinese residents are building up their foreign assets and paying down their foreign debt. But private Chinese holdings tend not to appear in the U.S. data in any easy to track way. The U.S. data can still be used as a proxy, in my view, for the U.S. assets held by the China’s central bank and its sovereign funds. The bigger story though is that there isn’t evidence to back up some of the scare stories circulating earlier this year. Unless China has pledged a big chunk of the Treasuries, Agencies and equities visible in the TIC data, China isn’t at all short on liquid reserves. China’s holdings of Treasuries—after factoring in Belgium’s holdings—and Agencies are still substantially bigger than Japan’s. Compared to its Special Drawing Rights (SDR) peers, China has no shortage of ammunition. And—as I will discuss in another post—China’s government still has somewhat more foreign assets than it reports as reserves, thanks to foreign assets the state banks hold at the PBOC as part of the reserve requirement and the Chinese Investment Corporation’s (CIC) international portfolio. Unless its forward sales are a lot bigger than the $30 billion China has disclosed, China’s “true” reserves are probably a bit bigger than its stated reserves. A lot though depends on how the CDB’s loans register in the data. And that is where I at least have the least certainty. (*) China’s reported holdings of equities in the U.S. data are higher than China’s total (private) holdings of foreign equities in China’s net international investment position data, which is only possible if a meaningful part of the foreign assets of China’s reserve manager—SAFE—are in equities. A technique I use a lot is comparing China’s data on its foreign assets with external data that should measure the same thing, and finding the differences. Google "SAFE investments"; SAFE’s equity holdings aren’t exactly a secret. (**) I have added the PBOC’s "other foreign assets" -- reported on the PBOC’s local currency balance sheet -- to China’s reported reserves. These are required reserves that the banks are hold in foreign currency rather than held in renminbi. This adjustment adds about $100 billion to China’s reserves right now. Confusingly, the "other foreign assets" reported by the PBOC and different than the "Other foreign currency assets" reported by SAFE in China’s SDDS disclosure. Similar name, but different things. And I have assumed that China’s dollar share is roughly equal to the global dollar share of reserves. A constant "65 percent in dollars" share would yield a similar estimate.

The change in China’s headline reserves is actually one of the least reliable indicators of China’s true intervention in the foreign currency market. Valuation changes create a lot of noise. And it is always possible for China to intervene in ways that do not show up in headline reserves. Last fall, for example, much of the intervention came from changes in the banks’ required foreign currency reserves. The change in the foreign assets on the PBOC’s balance sheet, and the State Administration on Foreign Exchange’s (SAFE) foreign exchange settlement data are more useful. Still, there is valuable information in today’s release. The roughly $30 billion fall in reserves to $3,192 billion (not a very big sum) is more or less explained by a $20 billion or so fall in the market value of China’s euros, yen, pounds, and other currency holdings. Actual sales appear to have remained low. That is interesting and perhaps a bit surprising, as the yuan depreciated in May against the dollar. And in past months, yuan depreciation against the dollar has been associated with large sales of dollars, and strong pressure on the currency. We need the full data on China—the "proxies" for true intervention that should be released over the next couple of weeks—to get a complete picture. But if it is confirmed that China’s reserve sales were indeed modest, I can think of three possible explanations: 1) Renewed enforcement of controls on the financial account are working. They limited outflows. 2) Chinese companies have mostly finished hedging their foreign currency debts. They now have had three quarters to pay it down, or to hedge. And it certainly seems from the balance of payments data in late 2015 that Chinese banks and firms were paying back their cross-border loans with some speed. 3) Managing against a basket (at least some of the time) is working. The depreciation against the dollar came in the context of the yuan’s appreciation against the basket, and thus did not generate expectations that the move against the dollar was the first step in a much bigger devaluation. Of course, China runs an ongoing goods trade surplus—one that brings in roughly $50 billion a month. That helps keep the market balanced even with large outflows. There is always the possibility that intervention is being masked, and pressure on headline reserves was reduced by the sale of foreign currency by state banks and state firms. And, well, the Chinese authorities rather clearly allowed the yuan to slide against the basket when the dollar sold off on the U.S. jobs number. Since January, the trend against the basket has been down. But at least in May, and looking at only one of the relevant data points, it does not on first glance appear that the yuan’s slide against the dollar significantly destabilized expectations. Still worth watching closely.

   

China never was going to transition from one of the most heavily managed currencies in the world to a free float overnight. The critical question always has been how China is going to manage its currency, not whether China will manage its currency. The “market” in China has effectively been a bet on where the People’s Bank of China (PBOC)—and its various masters—wanted the currency to go. The reform last August did not change that. And China made its task more difficult last August by trying to get rid of one of its tools for managing market expectations—the daily fix of the level for yuan against the dollar, which in theory, though rarely in practice, sets the yuan’s daily trading band—precisely when it moved to destabilize market expectations. Both the spot (the “market” price for China’s currency) and the fix (the PBOC’s reference rate) had been remarkably stable in the three to four months prior to China’s August currency reform. Depreciating the fix to the weaker spot price sent a signal, even if the actual initial move was rather small. In a different world, it would be interesting to game out what might have happened had China guided the spot up toward the fix first. Signals matter. OK, glad I got that off my chest. Last week’s well-sourced Wall Street Journal story on the PBOC was interesting to me for its information on the domestic politics of the Chinese currency, not for the news that China’s currency is "back under tight government control." For those who like stories on China’s internal currency politics, I suspect it is up there with the Reuters story from last August highlighting the political pressures on the PBOC. And it raises one of the most critical ongoing questions in the global economy: what has driven large-scale Chinese reserve sales? There are two theories. One is that money is leaving China because of losses in the Chinese banking system. According to this argument, it is rational for Chinese savers to flee hidden losses in Chinese banks, even as China is running a record merchandise trade surplus. The other is that money is leaving China because Chinese savers—and more importantly, Chinese firms, who can use China’s large cross-border trade to move funds in and out of China more easily than most—began to expect that Chinese policymakers wanted China’s currency to weaken.* That some of these firms had built up sizeable foreign currency debts prior to last August only meant that they had a particular incentive to hedge in anticipation of any major currency move. Put differently, one theory argues that depreciation pressure is mostly a response to an underlying desire by Chinese savers to move funds out of China, a desire that had been repressed prior to financial account liberalization. The other argues that capital outflows—or to be precise, capital outflows in excess of China’s quite large trade surplus—are mostly a function of the expectation that Chinese authorities want a weaker yuan to support exports during a time of domestic weakness. The available data to my mind suggests that outflows in excess of the trade surplus stem more from expectations of a currency depreciation than expectations that depositors rather than taxpayers will be forced to recapitalize China’s banks. Consider the earlier plot, prepared by the CFR’s Emma Smith, of changes in the yuan against the dollar * and the balance of foreign exchange (FX) settlement with the banking system. The settlement data aggregates the central bank and the banking system, but it is clear that over time the central bank is the main actor. And as a result it is one of the best proxies for actual intervention by the central bank.** There is a pretty clear pattern. Depreciation induces more sales (and, in the past, appreciation induced more purchases). Stability generally means fewer sales. That is consistent with the argument that outflows—or rather outflows larger than can be financed out of the large merchandise trade surplus—are a response to expectations of future depreciation. Stories about the huge scale of outflows from China are accurate. China’s swing from massive purchases to massive sales dominates other changes in global capital flows. But I would argue that these stories often miss the fact that the pace of monthly outflows has not at all been constant. A huge share of China’s reserve sales actually came in four months—months when the currency was depreciating against both the dollar—and against a currency basket. Which makes May a most interesting month. The yuanhas been quietly depreciating against the dollar. It is getting close to testing its January lows. But it has been appreciating, at least a bit, against the basket. The recent depreciation against the dollar has largely been consistent with management against a basket rather than a desire to depreciate against a basket. * The yuan’s value against a broader basket of course matters. But to date the yuan has been primarily managed against the dollar, and outflows for now seem driven more by expectations of the yuan’s moves against the dollar than the yuan’s move against a basket. I should also note that plot lags currency moves by a day. ** For the currency intervention geeks, there are a number of indicators that provide a guide to China’s reserve sales, and the FX settlement data is among the best. The indicator that tends to attract the most attention—changes in total (“headline”) foreign currency reserves—is actually one of the least reliable indicators of true pressure on China’s currency regime. It leaves out the actions of the state banks, and month over month changes are heavily influenced by valuation changes from moves in the euro against the dollar. *** More throat clearing. I have no doubt that the unrealized losses inside China’s banking system are large. They also could be borne by China’s taxpayers, not by depositors. The logic of a run on the currency hinges in a large part on the assumption that Chinese taxpayers will not absorb the cost associated with the current round of bank recapitalization. I am among those who think that China’s failure to recapitalize its banks prior to liberalizing its financial account was enormously risky.