Brad Setser on Continued Increased Foreign Central Bank Demand for Dollar Assets
Foreign central banks continue to raise their bets on the future strength of the dollar. Brad Setser reports:
RGE - Still going strong (Bretton Woods 2): I watch the data on global reserve growth rather closely. But I was still surprised to see (via Global Liquidity Blog) the scale of the growth in the Fed's custodial holdings so far in the first quarter. Since December 27, the securities the Fed holds on behalf of foreign central banks have increased by $123.8b.... Annualized, it works out to a stronger increase than in 2004, back when Japan seemed to be buying every Treasury note the US government issued. And the Fed data just covers the securities -- the safe securities -- held by the Fed. Central banks also hold Treasuries and Agencies through private custodians. They have dollars on deposit in the US. They have dollars on deposit outside of the US. They hold "private" mortgage backed securities (especially the PBoC). They hold corporate bonds (though not very many) and so on.
Stephen Jen puts global reserve growth at $75-80b a month, which seems about right to me.... That is roughly a $1 trillion annual pace, nearly all from the emerging world. There shouldn't be much doubt left over who finances the US current account deficit.
Mohammed El-Erian and Michael Spence... argue that the rise in US consumption is a natural consequence of the rapid increase in the value of US assets over the past few years -- along with the emerging world's willingness to finance the resulting US deficit. The uphill flow of capital, in turn, explains most recent asset market conundrums (“excessive compression in risk spreads, the unusual collapse in market volatility, the inverted shape of the U.S. yield curve”).
I basically agree. But I am not sure, though, that the story really starts with an increase in the value of US housing stock, which in turn leads US households to naturally want to consume more.... [M]y telling of the story would put a bit more emphasis on exchange rates – and how the impact of dollar pegs on emerging economies changed when the Fed cut US policy rates and the dollars started to tumble in 2002. Asian currencies -- as Jon Anderson has demonstrated -- still track the dollar closely. So the change in the dollar's trajectory against Europe had a big impact on Asia, not just on the US...
Back when Jeff Sachs, Rudi Dornbusch, and Charlie Kindleberger taught me this stuff, they told me that processes like this couldn't go on for very long because the country whose reserves were being accumulated would be increasingly viewed as likely to be unstable, and no central banker would want to have to explain to his or her political masters just why their foreign exchange reserve portfolio had lost half of its value. Yet this doesn't seem to be something that is worrying the BoJ or the PBoC right now.
It's a remarkable mystery.
