Nothing brings out buyers like higher prices, and other short stories

This post is by Mark Dow

DXY, a dollar index, looks like it has started to break down. At my firm, Pharo, we have been whispering on the trading desk over the last two days that this was looking increasingly likely. The implications are positive for risky assets. Markets play a lot of tricks on investors, and you can’t be too certain of anything in times as unprecedented as these, but, to us, it looks like the short dollar trade is “on”.

DXY, last 12 months

Is there a fundamental reason for this? Not clear. However, I am pretty confident that if the dollar continues to sell off the way it has started to overnight and this morning, and Treasuries continue to weaken the way they have started to, the stories of debasing the currency and Chinese diversification and the like will bob right back up to the surface. So, there will at least be a fundamental ‘story’ behind it.

Personally, I always find it hard to put too much faith in these predominately bearish dollar stories when risky assets are doing well. And, almost inevitably, risky assets do well when the dollar sells off. The correlation between the dollar and risky assets continues to be very high. Here is a correlation matrix of some proxies, using daily observations over the past year.


In the first row and column of the table you’ll see DXY, the dollar index comprising a handful of G10 currencies. The other rows represent various and sundry risky assets—mostly EM currencies, the S&P, and EEM, the ETF for emerging market equities. CCN+ is the 12 month forward for the Chinese Rinminbi, since the forward moves much more in response to market impulses than does the spot rate, which, as all of you know, is tightly managed.

For the dollar to be negatively correlated to risky assets, DXY should be positively correlated the CCN+, negatively related to SPX, AUD (since the Australian dollar is quoted in terms of dollars per Aussie dollar), and EEM. DXY should be positively correlated to TRY (Turkish Lira), BRL (Brazilian Real), and JPY (Japanese Yen).

You’ll notice that all of the correlations have the expected sign with the exception of JPY. This is due to the residual influence of the carry trade and deleveraging process. Since the yen was the other heavily borrowed currency during the levering up phase that led to the crisis (though nowhere near as abused as the dollar in this regard), the yen is the only currency apart from the dollar that is regularly negatively correlated to risky assets. It is also worth pointing out that the yen is a significant component of DXY, and, were it not there the correlations between DXY and these assets would even be meaningfully stronger.

Why is the correlation high? The simple, stylized answer is that most investment funds, irrespective of where they are domiciled, are denominated in dollars. This will change over time, and will contribute to the unwind of the dollar overhang that I wrote about here last week, but until it does, when investors reduce risk they buy dollars and “bring their assets home”, and when they increase risk they sell dollars and put their money back to work across the globe. There is more to it than that of course, but, over short spans, this is the main driver.

DXY, last 5 years

Okay. So, where does the dollar go? The market intelligence that we have put together here at Pharo tells us that market positioning—especially amongst large hedge funds—is light. The choppy markets frustrated a lot of investors, and there is very little belief in any positive economic scenario from here (true or not, this is the consensus view). In response, hedge funds reduced their longs, cut their shorts and headed for the beach, protecting the gains that they have had this year. Prop desks on the street are also protective of the profits they have generated so far this year. After an experience like last year, people really seem afraid of “doing something stupid”. The implication here is that if markets do move up, cell phones on the beach will ring and performance anxiety will start. Traders will chase. If, by any set of miracles, the fiscal stimulus or whatever starts to throw off better-than-expected news, traders would catch themselves really wrong footed, and things could get ‘ugly’ to the upside. In short, people would be much more surprised with good news than bad at this juncture. This would lead the DXY meaningfully lower, probably back to the lows of last year.

Chinese Reserves: Boiling Over Again?

This Rachel Ziemba, filling in for Brad Setser. I’m having technical upload issues so will add charts later but for now some thoughts on reserves

Chinese reserves data released today seem to be one more sign that the Chinese stimulus might be working a bit too well. China’s reserves stood at $2.13 trillion up from $1.95 trillion at the end of March 2009. Although reserve accumulation was likely lower than the headline $178 billion, it implies that hot money is back in China. Adjusting for valuation, Chinese reserve growth was likely about $140 billion, much higher $60-70 billion of China’s trade surplus, FDI and interest income in this period. This accumulation also suggests that China continues to have a hard time diversifying its holdings away from the U.S. dollar.

Adjusting for valuation – the changes in value of the non-dollar holdings in China’s reserves — would imply reserve growth of around $135-140 billion. This accumulation rivals that of Q2 and Q3 2008 for the highest quarterly level.

It is one indicator that suggests that parts of China’s economy may be overheating as China tries all measures to stoke growth. It seems well in line with almost 40% y/y urban fixed investment in May 2009, and loan growth equivalent to 25% of 2008 GDP. However, it just underscores some of the difficulties in both stoking growth and avoiding future distortions.

China’s rapid reserve growth is but one of many indicators that might be worrying monetary policy makers. While consumer prices are still falling on a y/y basis, as companies can not pass on higher costs to consumers, the current lending growth and money supply growth could lead to inflationary pressures ahead. China is again trying to ease and tighten its monetary policy at the same time. It recently began issuing sterilization bills again to try to mop up the liquidity generated by buying the foreign exchange. And investors anxious to get a part of the new IPOs and worried about inflation have been reluctant to buy some recent low-yielding bond issues. Despite the risk of overheating, other parts of China’s economy continue to be weak, suggesting that tightening could be politically difficult especially if it contributes to asset market correction

The potential risks stemming from the Chinese monetary (mostly lending) and fiscal stimulus is one of the reasons that we at RGE are still somewhat cautious about the mid-term outlook for Chinese growth (as summarized in this excerpt today). There is a risk that China might be forced to use rather blunt policy measures to try to cool the overheating in some parts of the economy and, especially, its asset markets before the real economy gets on to a sustainable growth path. Or, they might not reign in the spending and it could contribute to asset bubbles and inflation that could lead to a double-dip, if as RGE fears, the U.S. and global recovery is sluggish.

But back to the reserves. Given the size of China’s reserve growth in Q2 — in the face of a shrinking trade surplus and lower foreign direct investment than in 2008 — the country is likely experiencing short term capital inflows “hot money” again. Economists tend to sum the trade surplus (the largest component of the current account) and FDI. What is unexplained by these inflows is often deemed to be hot money - short-term capital inflows. China’s trade surplus fell to $35 billion in Q2, about half that of Q1. FDI was about $21 billion taking the total to $55 billion.

Income on China’s past investments could explain part of the increase. Given the stock of China’s assets, even low yielding assets could garner a significant absolute figure, but it seems insufficient to make up the difference. Moreover, despite the mid-Q2 increase in bond yields, income on bonds remains relatively low. China’s stock of equities likely saw a bounce from Q1 levels. Yet, it is thought that China does not mark its portfolio to market. Moreover, much of the $100 billion in U.S. equities China holds were acquired between June 2007 and June 2008.

Remittances also might account for another part. These are only reported with a significant lag making comparability difficult. However, given the scale of Chinese reserve growth and adding up all the “explained capital inflows”, it seems likely that China has received hot money inflows of around $60-$70 billion. A reversal from the approximately $70 billion in outflows in Q1!

Unlike many other emerging economies, China remains quite closed to foreign equity investment. Thus, it seems likely that Chinese (including Hong Kong-based Chinese) may be trying to get money back into China again. Foreign investors may be contributing to the property market revival. Although currency appreciation is not expected in the short term given weak exports, consensus expects a stronger RMB over the course of the next few years. 12 month non-deliverable forwards, albeit not necessarily the best indicator of future levels, are barely pricing in an increase. However, there is general agreement that the RMB will have to appreciate.

In the short term this means China’s reserve diversification may have stalled. By putting pressure on the U.S. dollar, Chinese rhetoric about moving away from the U.S. dollar as a reserve currency earlier this year might have added to pressure on the renminbi and actually delayed the Chinese diversification path. China doesn’t release the currency composition of its reserves, but the dollar is thought to make up around 65% of the portfolio. That share could actually have increased slightly in Q2.

Euro assets make up most of the rest, along with a small amount of pound sterling, yen, and likely even a small amount of Canadian and Australian dollars. China has also increased its gold holdings. Despite the increase, gold makes up a less-than 2% share in Chinese reserves, much smaller than its share in U.S. or European reserves.

The U.S. data reflects the fact that China has yet to diversify much from the dollar. In fact as Brad Setser has noted, in Q1, China’s holdings of U.S. dollar assets as reported by the U.S. Treasury rose more than China’s reserves. One explanation - China was shifting within its dollar assets and asset managers, with the net result that more of its assets were captured in the U.S. data. But the data suggests China is still adding to dollar assets. Overall, China increased its short-term holdings immensely at the end of 2008 and early 2009. However, as of March and April it was paring back on its holdings of T-bills and increasing its holdings of U.S. treasuries.

The trend may still be visible in the May data which should be released at the end of this week. The scope of reserve accumulation suggests that, for now at least, China is still buying U.S. assets and helping meet funding needs. In the longer term, much will depend on China’s willingness for a stronger currency.

Given these trends, it may not be surprising that Chinese statements on new reserve currencies grew somewhat quieter in early May. Given the scope of capital inflows, these diversification statements may have seemed, as analysts for the Bank of New York have noted, to be counterproductive.

Given the increase in China’s reserve holdings, perhaps it is no surprise the Chinese investment corporation (CIC) is again becoming active, restarting its investment program. In recent weeks, the CIC announced plans to increase its stake in Morgan Stanley to avoid dilution, took a 17% stake in Canadian metals producer Teck Cominco, and announced a board of economic advisors. Further investments may follow as China continues to try to diversify its holdings.

Real diversification and liberalization of the capital account might be a longer-time in coming. Over time, some of the new capital management regulations – allowing companies to keep more of their foreign funds abroad, to use them to fund subsidiaries – might reduce inflows and funds purchased by the central bank.

So reserve accumulation is back. China is not the only country that added to its reserves again last quarter. Setting China and its estimated $140 billion in reserve growth aside, a group of over 30 countries that RGE tracks reported a valuation adjusted a net increase in reserves of about $40 billion. While not all of the countries have yet reported their June statistics, Q2 2009 is on track to be the first quarter in a year with reserve accumulation. The stocks of global reserves, are rising back towards $7 trillion again.

The pace of accumulation has slowed but the accumulators are the usual suspects –emerging economy exporters wary of currency appreciation. Many experienced sharp inflows into equity, bond and FX markets in the liquidity-fuelled rally in April, May, and early June. Russia, South Korea, Hong Kong and Taiwan account for much of the accumulation. A renewed flight from the U.S. dollar, expect these central banks to resume buying.

While some countries – like Russia -may have managed to slightly pare their dollar share in the face of capital outflows last year, the dollar still dominates reserve portfolios, particularly in Asia and the GCC. The amount of dollar liabilities in some emerging markets contributes to the need for U.S. dollars. Europe’s near abroad is similarly more partial to the euro. However, there continue to be obstacles to the euro as a reserve asset, including a fragmentation of the bond market — and the last thing European officials want is a stronger euro.

All this means Chinese reserve diversification is likely to be happening only at the margin and China (and other central banks) are likely buying U.S. assets

Will the Chinese Keep Saving?

This is Rachel Ziemba of RGE Monitor where this post also appears.

In a recent post, Jeffrey Frankel asks will the U.S. Keep Saving? noting that despite the recent increase in the U.S. savings rate, the demographics of the U.S. (as well as those of Japan and Europe) will contribute to a reduction in savings. He argues that despite the fact that wealth losses will boost savings rates, the dis-saving of the retired population will keep the savings rate relatively low, if higher than the pitiful rates of recent years.

The companion question, whether the Chinese will keep saving is equally of importance. Whether the Chinese stimulus is able to boost private consumption ahead will be critical to global and Chinese demand. So far Chinese consumption has held up and even grown slightly from a weak base –as illustrated by retail and auto sales. Yet one reason that the Chinese economic reacceleration is fragile is because it is uncertain where the new production in China’s factories will be consumed. Chinese domestic demand still seems weak and overpowered by some structural incentives to save.

In the near term U.S. savings rates, which reached 6.9% in May, seem destined to keep climbing as U.S. consumers retrench. This could contribute to slower growth in the so-called export-led economies which had grown reliant on exporting demand.

One outcome of the financial crisis has been a narrowing of global economic imbalances, as illustrated by the reduction in the Chinese trade surplus and a reduction in the corresponding deficits of countries like the U.S.. The combination of a sharp fall in consumption across the globe and withdrawal of credit, partly accounted for swift reductions in some countries. I wrote last week about the narrowing of the surplus of oil-exporters. All in all, surpluses and deficits might be smaller given the reduction in credit available even as the increase in government borrowing leads to higher long-term interest rates. This narrowing is likely despite the fact that reserve accumulation seems to have restarted in Q2. Setting aside China which will report reserves data at some point over the next day or so and adjusting for valuation, reserve growth was about $40 billion in the quarter of 2009. While this is much smaller than in the heyday of 2007, it is the first quarter of positive reserve growth since Q3 2008. Yet, there are some signs that we will not return to the earlier pace.

The U.S. current account deficit has been narrowing for some time and has fallen from 6.6% of GDP at the end of 2005 to 3.7% at the end of 2008 and the IMF estimates that it will fall further to 2.8% of GDP over the course of 2009. With U.S. consumers buying less (the savings rate rose to 6.9% in May 2009), Chinese producers need to find new markets.

The Chinese current account surplus was $420 billion in 2008 and is likely to be smaller this year. The Chinese trade surplus (the largest component of the current account) was about $100 billion in H1, but one month (January) accounted for almost half. The absolute level of China’s trade surplus has shrunk, to about $13 billion in April and May and just over $8 billion in June. While the greater cost of China’s commodity imports (watch for more on this tomorrow) accounts for part of this narrowing surplus, it may reflect a sign of things to come should Chinese exports stabilize at a weak level in the absence of external demand.

Should export-oriented “surplus” countries like China keep saving and keep trying to export demand, the reduction in imbalances could actually exacerbate the global economic contraction or contribute to a more sluggish recovery. The high savings rate or rather artificially low cost of capital in China has contributed to misallocations of capital that will be difficult to reverse and will take some time.

However expansionary fiscal policies in these countries and a reallocation of capital within these countries, could in the long-term contribute to reducing internal and global imbalances. Chinese officials seem cognizant of the need to rebalance the domestic economy even as some of their policies seem to operate at cross-purposes.

While government incentives are contributing to an increase in some purchases, Chinese consumption (and that of other emerging economies) may find it very difficult to pick up the slack from a U.S. consumer that is spending less. However, Chinese fiscal stimulus does seem to be doing more to potentially boost domestic demand. Yet the effect of some of these incentives could diminish over time and there is of course a risk that Chinese production could add to global overcapacities in the absence of an increase in domestic demand.

In the Wilson Quarterly, Michael Pettis argues that whether or not the Chinese start consuming more, their savings rate will drop from the 50% marked in 2007. Either Chinese policies will contribute to more private consumption or the reduction in global demand will lead to reduced growth, limiting savings.

So what would be the package of consumption-led growth?

Eswar Prasad details how China and other Asian savers might rebalance their domestic economy through removal of the policies that suppressed domestic demand. These are largely long-term in nature including the development of China’s capital market to increase the return on domestic assets and patching holes in the social safety net.

The massive credit extension in China, which rebounded in June 2009 after slowing slightly in April and May suggests that the cost of capital in China remains well below global costs. This distortion raises the risk that non-economic projects are being financed to meet bank quotas. Thus there is a risk that even as Chinese officials try to take some steps to support domestic demand, other policies might add to the misallocation of capital, contribute to asset bubbles (especially property). Meanwhile, some Chinese investors are worried about future inflation. The blunt policy tools continue to be hard to manage.

The raft of Chinese data to be released over the next few days may give us some more clues as to the trajectory and possible risks ahead

Beat Down

I have a couple of themes on which I wanted to post, but they will most likely have to wait for later. The market, in the words of the E*Trade commercial, is issuing me a bit of a beat down today, and I have to focus on a little risk management. C’est la vie….

Weekly Federal Reserve balance sheet update

This post is by Mark Dow

This just hit my inbox, from the research team at Barclays. Since we’ve talked a fair amount of late about the Fed balance sheet, I thought I’d pass it on.

“Weekly Federal Reserve balance sheet update

Usage of the various Federal Reserve liquidity programs continues to erode as outstanding loan amounts mature and are not replaced with new borrowing. The overall size of the central bank’s balance sheet is now 9% smaller than it was at the start of the year.”

Chinese Handcuffs? No, Chinese trade deficit

This is Mark Dow. Brad is away.

China has become the obsession that Japan was back in the 80s. And rightly so. It is a huge place, with a robust secular growth force underlying it (remember the conditional convergence growth hypothesis?). Rumors of China doing this or that have become a daily staple of the market.

Lately, the discussion has focused a lot on their willingness to continue to buy US treasuries. I know Brad does a lot of good work on this issue in this space. Much less attention, it seems to me, has been placed on their need to buy more Treasuries.

It has long been my contention that the large global imbalances were mostly a function of risk appetite and financial innovation leading to an explosion of the money multipliers all over the world—especially in countries with a greater degree of financial sophistication and/or capital account openness (I almost said promiscuity).

Here in the US, we were the leaders. It had less to do with Greenspan, less to do with Congress, Fannie Mae, and Freddie Mac, and more to do with the private sector taking excessive financial risk. After all, it was a global phenomenon. Over the course of history this tends to happen any time there is a period of macroeconomic stability coupled with the observation that others around us are making money. People tend to pile on and take things too far. It is in our very nature. (I would recommend Akerlof and Shiller’s “Animal Spirits”, or Kindleberger’s “Manias, Panics, and Crashes” for anyone interested in these behavioral phenomena).

In this case, it led to a huge trade imbalance with China. Credit allowed us to consume beyond our means, and demand spilled out over our borders into China. The Chinese obliged and became huge holders of Treasuries. While it is true that the Chinese exchange rate regime was an amplifier of this story, I think it was more of a passenger than a driver. The driver was credit.

Today the credit bubble is popping (whence my view on inflation and the money multiplier). At the same time the Chinese are trying to prop up aggregate demand by controlling the only thing they can: domestic demand. This to me means the imbalances are in the process of going away. In fact, I have long said (and have made a few bets with friends) that the Chinese trade balance will likely be in deficit by the end of this year. This means that the need for China to buy our treasuries will have largely gone away. I realize this may be too aggressive a contention over this time frame, but I am convinced the basic story is right. And to my mind’s eye there isn’t an exchange rate regime or Renminbi level that can stop this from happening.

On Monday I posted a chart of the US trade balance, and we saw in it the dramatic swing that took hold as soon as the credit bubble popped. Overnight, the Chinese trade balance figures came out. Have a look at the chart below.

Chinese trade balance, 2002-2009

The chart shows China’s monthly trade balance. You will note that every year around March there is a big dip. It is a seasonal anomaly associated with the Chinese New Year. What you will observe is that the post-Chinese New Year rebound this year was much less pronounced, and, unlike in previous years, it soon rolled over. The trend now appears to be going the other way. This is despite Chinese government incentive to support exports and China increasingly taking market share from other Asian countries. It may well turn out that quite soon a Chinese trade deficit will have allowed us to slip out of—at least from a flow perspective—our Chinese handcuffs.

GCC Sovereigns: A Little Better off

this post is by Rachel Ziemba

Thanks again to Brad for letting me fill in while he’s on vacation. Sorry I’m late catching up with you all but I’ll try to chime in on some of the key releases especially on China in the next week. But let me start out with something from the world of oil wealth.

Timothy Geithner, the U.S. Treasury Secretary, travels to the GCC (Saudi Arabia and the UAE) in a few days to commune with some of the more significant creditors of the U.S. and possibly urge these savings-rich countries to contribute to the IMF, as several emerging market economies have pledged. As a result it seems an apt time to re-estimate how much these governments and their neighbors in Qatar and Kuwait have accumulated.

While the Gulf’s holdings of U.S. assets pale in comparison to China’s, the GCC possesses the largest trove of US stocks among foreign governments. With most of its assets managed by the central bank, Saudi Arabia likely holds the most US treasury bonds. The other GCC countries, most of whom entrusted their oil windfall (and gas in Qatar’s case) to an array of investment funds, tend to have a more diversified portfolio. However, the U.S. dollar still dominates the Gulf’s foreign asset position.

With the rise in the price of oil in Q2, some analysts have again been talking again about the global role of sovereign funds. While some, such as the China Investment Corporation (CIC), for one, seem to have become more active investors again, armed with new advisers, the Gulf funds still seem to be homeward looking for now. The latest –and forthcoming - RGE Monitor Global Outlook suggests that growth in the GCC will be flat in real terms, with a slight contraction possible in 2009. The significant assets of the region have allowed GCC countries to steer their economies to a softer, if still, harsh landing. Much of the region’s output, investment and sentiment remain linked to oil despite various attempts to diversify its economy. Steffen Hertog has a nice new piece on the lessons learned from the 80s by Arab oil producers.

Many GCC sovereign funds have boosted their holdings in domestic banks, domestic equity markets other savings been drawn on to meet fiscal deficits. Meanwhile, some of the few identifiable foreign investments in H1 2009 were made by hybrid funds like the UAE’s Mubadala, which tend to invest in sectors that could help domestic economic development or in sectors they already dominate (such as oil and petrochemicals).

The foreign assets of GCC central banks and sovereign funds are estimated to have fallen to just over $1.1 trillion at the end of June 2009 from about $1.2 trillion at the end of 2008. This estimate draws on a methodology Brad and I created last year, which estimates the inflows to the funds, and assumes similar performance to benchmark indices for each asset class. This estimate though, is somewhat lower than some other prevailing estimates. Recently released analysis by McKinsey Global Institutes suggests that Sovereign investors of the GCC, one of their ‘new power brokers’ managed closer to $2 trillion at the end of 2008.

The national breakdown suggests that Saudi Arabia accounts for over $400 billion of the assets (including the non-reserve assets of the Saudi Arabian monetary Agency and the foreign assets it manages for other parts of the government). The UAE, accounts for the next largest amount, around $350 billion, not including Mubadala and some Dubai funds. Kuwait’s fund managed just under $240 billion and Qatar, over $60 billion. The remainder is managed by the central banks of the region.
The slightly more fiscally-conservative (and richer) countries with more oil reserves per capita, like Abu Dhabi and Kuwait, or gas reserves (Qatar) and their more risk-tolerant funds should have seen the value of their assets reflate along with risky assets. Despite the increase in the oil price, the correction at the end of June 2009, limited the paper gains.image003

These countries’ investment income seems to be correlated with their hydrocarbon income, though they may still not be feeling very flush given continued liquidity needs at home. Despite an increase in the value of existing holdings, and a slight increase in inflows, GCC foreign assets are still well off their highs. Assets likely peaked at around $1.4 trillion in June 2008. They began to tumble on lower returns in equities, real estate and private equity in the fall.

Yet there are some shifts in relative values. Much of the decline in H1 2009 can be explained by one fund – the Saudi Arabian Monetary Agency (SAMA) - which manages the bulk of Saudi foreign assets. SAMA’s non-reserve foreign assets, which consist mostly of bonds and US dollars, have fallen from about $412 billion last fall to $365 billion in May 2009.  The majority of the fall in SAMA’s asset has come from the drawdown of its deposit holdings, i.e. its most liquid assets. The holdings of foreign securities have fallen much less. These funds have likely been utilized to avoid having to borrow domestically to meet the governments 2009 fiscal spending needs. In contrast, the assets SAMA manages on behalf of other parts of the government haven’t fallen as much.

SAMA data for June won’t be out for another month or so, but they are likely to either show no growth in foreign assets or another slight decline given spending needs. SAMA tends to accumulate less in Q2 than in other quarters, possibly because of its fiscal cycle.

Abu Dhabi-based investment agencies like the Abu Dhabi Investment Authority (ADIA) and the Abu Dhabi Investment Council(ADIC) continue to rival Saudi Arabia’s. Saudi Arabia’s larger population and greater share of OPEC production cuts have led it to draw on some of its assets. The UAE’s fiscal spending needs have been somewhat lower and the recent reflation rally boosted the value of some assets.

Yet even Abu Dhabi’s asset allocation has shifted over the last year. Not only has Abu Dhabi needed to utilize its liquid assets to support its banks, but it also believed to have provided the capital for the bonds issued by Dubai and purchased by the UAE central bank in February of this year. Such a purchase may just be reflected in a shifting from one USD denominated claim to another. The need to do so, however, underscored the importance of liquid assets.

There has been another shift – one that makes modeling these portfolios a little trickier if more interesting. Beginning in 2008, an increasing share of the UAE’s savings has been allocated to investors like Mubadala and IPIC. Mubadala alone received about $26 billion in new capital from the government, roughly half of Abu Dhabi’s surplus. ADIA clearly received a much smaller piece of the pie. In fact, some suggest that ADIA received almost no capital at all in 2008. The shift in funds to investors like Mubadala - which privileges concentrated stakes and includes domestic holdings - is but one way in which some of these funds seem to be looking inward using their savings to support their near-term and longer-term domestic economic goals.

So what does that all mean for the future? Lower asset accumulation, most likely. The growth of these funds all depends on the price of oil and how much is spent at home. With an oil price of $50 a barrel, inflows to sovereign funds and central banks would be practically negligible. Consequently, only the return on investment would boost lead to a slight increase in the assets under management in 2009.

But even at higher oil prices (see below), the savings might be more limited. Given that oil exporters are spending a lot, savings going forward might be smaller even if the price of oil climbs again.


Source: Author’s estimates, updated from Setser and Ziemba (2009)
Given the absorption of oil revenues at home through higher spending and investment (the latter intensifying in 2008), oil exporters contributed a bit more to rebalancing. This explains why few, if any, oil exporters will run a current account surplus this year even if the oil price averages $65 dollars a barrel. In fact, as shown below, even if oil averaged $75 a barrel, the amount saved in 2009 would be much lower than it was in 2006 or 2007 when oil averaged $67 a barrel and $71 a barrel, respectively.

GCC Savings

Lower oil production adds to the spending pressures. According to estimates of OPEC oil production, Kuwait, Qatar, the UAE and Saudi Arabia are now producing around 13.1 million barrels a day (mbd) of oil. (Saudi Arabia accounts for about 8mbd.) That is about 2.5mbd less than they were producing in the summer of 2008 (15.6mbd). If less oil is produced, a higher dollar per barrel price is needed to balance the growing budgets. Note that the chart above assumes that oil production will start increasing in 2010 and will return back to early 2008 levels by the end of that year.

At current oil prices ($60 a barrel), most of these countries can balance their budgets, but barely. On average, GCC countries needed around $45-50 a barrel to balance their budgets in 2008. In 2009, with spending demands higher and oil production lower, the break-even price will be higher. That adds up to less savings, especially for countries like Saudi Arabia. Unlike Russia, where an import collapse triggered by a weaker ruble, rising unemployment and a lack of credit has contributed to a narrow current account surplus, most GCC countries are unlikely to have much of a surplus this year if oil averages around $55 a barrel. This means that the GCC’s role in global asset markets may be more subdued even as their role in domestic asset markets and economies grows. Ultimately, however, much depends on the price of oil. A sustained increase in the price of oil would lead to larger surpluses and more foreign investment.

A few final considerations.

The increased need for liquidity suggests that the dollar share of GCC investments may actually have risen in 2008 as Saudi Arabia’s accumulation dominated some of the other funds. Other countries, seeing a need for liquid assets, may also have boosted dollar shares, possibly even boosting their short-term dollar assets. However, with more being absorbed at home, these countries could slow their purchase of dollar assets.

Yet, as with monetary policy, asset allocation is constrained by currency pegs. The dollar’s dominance in the region’s monetary arrangements will limit the GCC’s ability to shift away from the US dollar, especially if the currency renews its trade-weighted downtrend. Dollar depreciation could again boost the cost of imports for GCC countries, which largely import from Europe and Asia. Yet with broader disinflationary trends and currency revaluation off the table, the pressures on the currency are likely to be muted.

The biggest factor that accounts for returns of institutional investors is asset allocation. In 2008, an equity and alternative-asset-heavy portfolio faced significant valuation losses. Thus the GCC sovereign funds, exposed to equities, could also have faced significant losses.

Note: The GCC funds may have shifted their asset allocation somewhat over the last year, although there is no clear evidence. Given the domestic liquidity shortages which pre-dated the global credit crunch, some may have begun boosting liquid assets. So when updating the estimates of the funds’ AUM for the end of June, I tweaked the model slightly in order to see how performance may have been affected by a change in the allocation of the inflows of capital. Putting almost all the inflows for Kuwait, the UAE and even Qatar into bonds does lead to somewhat higher headline figures. To avoid the losses predicted by the model, older, larger funds like those of Kuwait and Abu Dhabi would have had to actually sell equities and other assets to have a more significant asset allocation shift.

This piece also appears on RGE Monitor