Implications of Repricing of Dollar Denominated Assets

In the wake of global financial events, a couple of articles have caught my attention in terms of implications for the dollar. First was this Reuters account of a People’s Daily editorial, suggesting “diversification”. But it’s hard to discern the underlying message given the low signal to noise ratio in official publications. Today’s article in the IHT is a little more informative, not just about what’s going on in China but in Asia (where a lot of that “saving glut” was alleged to come from):

In Asia, bloom is off the U.S. rose

By Keith Bradsher, Published: September 18, 2008

HONG KONG: Tremors from Wall Street are rattling Asian confidence, leading many investors to question the wisdom of being invested in the United States to the tune of trillions of dollars.

Asian investors were starting to show hesitation even before the financial earthquake of the last week. Now, a wariness toward the United States is setting in that is unprecedented in recent memory, reaching from central banks to industrial corporations, from hedge funds to the individuals who lined up here to withdraw money from the American International Group on Wednesday.

Asian savings have, in essence, bankrolled American spending for decades, and an Asian loss of confidence in American financial institutions and assets would have dire consequences for the U.S. government and American taxpayers.

The potential for panic is stoked by Asian news organizations, which tend to focus more on business and economics than on politics, which can be touchy here. Their coverage has been obsessive and unrelentingly negative about the bankruptcy of Lehman Brothers, Merrill Lynch’s rush to find a buyer, and the turmoil at AIG.

The nonstop deluge of bad publicity for American investments seems to be seeping into the consciousnesses of the rich and middle class across Asia.

The asset management operations of American banks have steered many Asian investors into American securities for years. But Thomas Lam, the senior treasury economist at United Overseas Bank in Singapore, said many of these investors had not fully understood what they were buying. They became more curious and more concerned when, for example, Fannie Mae and Freddie Mac were placed in conservatorship.

“All these top executives, Indonesians and others, started asking, ‘What do they really do?’ ” Lam said. “They bought because the next company did.”

Some experts say that with the phenomenal economic growth in Asia, savings are piling up so quickly that those funds will inevitably start flowing again to the United States at a fast clip. (The Chinese economy grew 23 percent in dollar terms last year.)

“The interest for the moment is depressed, but the trend is, we have a lot of savings in Asia and this is a bargain time” for assets in the United States, said Paul Tang, the chief economist at the Bank of East Asia in Hong Kong.

For now, though, Asian interest in American assets is wilting, a trend that seems to have started over the summer.

The article then proceeds to discuss “a little noted Treasury report”. But actually, Brad Setser did catch the rather startling implications of this TIC report:

The flight from risky US assets

Posted on Tuesday, September 16th, 2008 by bsetser

It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right.

It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.*


And that was July.

Brad tends to focus on the flow implications, and given the (still) massive US current account deficit (it’s true, we do have to finance the total trade deficit, not just the trade deficit ex-oil), that makes sense. I tend to think in terms of a portfolio balance model, where the stocks of — and demands for — dollar denominated assets versus euro and other denominated assets matter. I discussed that view in “Implications of adjustment to riskier dollar assets in a portfolio balance framework, illustrated in three steps” from July 23 (seems like ages ago). I’d say we seem to be somewhere in-between steps 2 and 3…

Now, it may be that all this is a short term episode, and the phenomenon of perceived “deep and liquid capital markets” in the US relative to the rest of the world will re-assert itself (cyclical factors will obscure some of these effects [1], as will short term flight to safety). And, indeed, it’s all relative — one has to wonder what will happen to the desirability of financial assets in Asia and Europe, and hence the demand for dollar assets. But I don’t think we’ll get a quick return to the days of 2005.

15 thoughts on “Implications of Repricing of Dollar Denominated Assets

  1. Buzzcut

    How exactly would the Chinese maintain their currency peg if they didn’t recyle their trade dollars back into US assets?
    If they diversified, their currency would appreciate relative to the dollar, and their mercantile trade policy would quickly fall apart.

  2. DickF

    To follow-up on the comment by Buzzcut, the US balance of payments resulted in dollars going to China to pay for goods. The Chinese had to either exchange the dollars for other currencies or invest them in the US. Their decision was to buy government (Fannie/Freddie/Treasury) paper. With the change in the exchange of yuan for dollars Chinese exports to the US declined and this has accelerated as the dollar fell in relation to other currencies. The Chinese simply do not have as many dollars to invest.
    But that said I am sure that the Chinese are questioning how secure their investments are in the US and there will be a reduction in their investments. I know if I were making the decisions I would question the safety of US investments.

  3. Menzie Chinn

    Buzzcut and DickF: As I mentioned before, I tend to focus on stocks relative to demand for assets, and in this framework, one doesn’t need flows to change in order for valuations to change (indeed, in most formal asset pricing models, excepting the microstructure models, no trades need occur for prices to change.

  4. Anonymous

    RE: low signal to noise ratio
    The pieces you quoted use a lot of words to say Chinese investoprs are wary of US investments.
    Only one sentence says anything solidly quantitative: “Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.”
    So: Implications of Repricing of Dollar Denominated Assets = China sells low after buying high?

  5. Mercutio.Mont

    This line, from the first article, jumped out at me:
    “Asian savings have, in essence, bankrolled American spending for decades, and an Asian loss of confidence in American financial institutions and assets would have dire consequences for the U.S. government and American taxpayers.”
    Can you comment on that statement? It seems that “bankrolling” is a two way street; “US taxpayers” benefit from cheaper credit, and “Asian savers” benefit by having low-risk low-return assets – such as Treasury Bills. This is a business exchange, not an act of goodwill, right?
    If “Asian savers” take their money elsewhere, then “American Taxpayers” will have to pay more for credit, but the “Asian savers” will also lose out by not taking advantage of the “no risk” TBills.
    The author’s notion of group and national identity seems a bit warped as well: Is it better for US taxpayers that the US government have access to lots of money? Not necessarily…

  6. DickF

    Fair enough. My comment was primarily a response to the article The flight from risky US assets that you excerpt above.

  7. don

    The ‘phenomenal’ growth in Asia, and the consequent savings glut, may be on the way out, as U.S. consumers cut back and the accelerator-multiplier mechanism hits their goods-production-intensive economies.
    Note that shifting away from long-term U.S. assets is not the same thing as shifting away from U.S. assets on net. The nominal return on short-term Treasuries has been pushed into negative territory.

  8. gina

    If i was Chinese I would knowing that the debt owed by the US would never be paid and the interest is rapidly becoming unplayable given the feds games dump GSE bonds and eat the losses and then finish the US by dumping treasuries >>New world order with out firing a shot ( for a little while)

  9. MarkS

    RebelEconomist – The nautical allusion describing strategies for the management of currency exchange rates was wonderful. I much appreciate your kindness in sharing your wisdom in the Reserved Place .

    Gina – I think that its more likely that one or two players in the Chinese banking industry will acquire American investment banking assets. This will allow the CCB more latitude in redeeming some of their accumulated dollars for better rates of return in US distressed assets than available in GSE or Treasury bonds. Politically, this is a very sensitive strategy, so I expect it to occur quietly and slowly. They have a lot of time to get the job done. Their existing US Bond assets are safe where they are, since the net effect of the credit crunch will be to reduce liquidity and money supply (deflation). I’ll leave the world domination scenarios to the pulp fiction writers.

  10. miszkam

    “The interest for the moment is depressed, but the trend is, we have a lot of savings in Asia and this is a bargain time” for assets in the United States, said Paul Tang, the chief economist at the Bank of East Asia in Hong Kong.
    But this is a bargain time for assets across the world. And isn’t that the best opportunity to start diversifying? Only the dividend return on many liquid Russian stocks (for example) now reaches 5-7%. That’s with a 100% upside. And P/E ratios are now miniscule – Russia was not overbought before the crises. This relates to many other emerging countries, whose economic systems are weathering the slump in developed countries pretty good. Emerging countries should start looking towards each other more and not only towards their developed masters.

  11. DickF

    Understanding the China connection is much more than just T-bills. China was a major investor in Fannie and Freddie, so in this way they were actually financing US mortgages. They did this because they assumed like all the other investors that Fannie and Freddie were actually backed by the government. Fannie and Freddie have now been nationalized and China is looking for payent.
    If you really are looking for the way out of this mess, I suggest that you look to someone who pulled us out of a much worse situation and the policies and procedures he followed to restore our national credit in the world. Read Treasury Sec. Alexander Hamilton’s Report on the Public Credit given to Congress January 9, 1790.
    Every breach of the public engagements, whether from choice or necessity, is in different degrees hurtful to public credit. When such a necessity does truly exist, the evils of it are only to be palliated by a scrupulous attention, on the part of the government, to carry the violation no father than the necessity absolutely requires, and to manifest, if the nature of the case admits of it, a sincere disposition to make reparation, whenever circumstances shall permit. But with every possible mitigation, credit must suffer, and numerous mischiefs ensue. It is therefore highly important, when an appearance of necessity seems to press upon the public councils, that they should exmine well its reality, and be perfectly assured, that there is no method of escaping from it, before they yield to its suggestions. For though it cannot safely be affirmed, that occasions have never existed, or may not exist, in which violations of the public faith, in this respect, are inevitable; yet there is great reason to believe, that they exist far less frequently than precedents indicate; and are oftenest either pretended through levity, or want of firmness, or supposed through want of knowledge. Expedients might often have been devised to effect, consistently with good faith, what has been done to contravention of it. Those who are most commonly creditors of a nation, are, generally speaking, enlightened men; and there are signal examples to warrant a conclusion, that when a candid and fair appeal is made to them, they will understand their true interest too well to refuse their concurrence in such modifications of their claims, as any real necessity may demand.

  12. RebelEconomist

    I suppose the idea is fairly simple, although in my experience, people do sometimes overlook the effect that trades between two currencies have on their relationships with all the others.
    But then my experience of central banking was limited to sneak-reading the notes as they passed through the mail room.

  13. Menzie Chinn

    RebelEconomist: Sorry for the delayed response. Teaching goes on even when the financial system melts down. I think you’re right in terms of the economics; in principle China could operate on the euro rather than dollar, and try to hit the desired USD/CNY exchange rate. In practice, it’s hard (I’m told by central bankers) especially as China obtains most of its receipts in dollars. But it shouldn’t be impossible — just perhaps costlier and more cumbersome. Nice pictures!

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