Monday, May 14, 2007
Financial markets are getting almost as China-obsessed as Macro Man (and Brad Setser.) Macro Man's email box is chock full of acronym-stuffed research reports, as economists and strategists debate the impact of QDII (which now allows retail investors to buy paltry amounts of foreign equities), PIC/SIC/JFEC (the yet-unamed sovererign wealth fund, which presumably will buy more serious amounts of foreign equity), and the CAS (the ginormous current account surplus in China) ahead of next week's SED (the strategic economic dialogue between the US and China.)
Whew. It's almost enough to make one wish to forget finance and take up poetry. In his periodic discourse on the FX carry trade, Macro Man has occasionally referred to SAFE as the world's biggest carry trader, given the size of their reserves and their evident aversion to low yielding currencies like the yen and swissie. Given the current focus on the RMB (which has just started to appreciate a bit more quickly against the $), Chinese equities, PBOC reserve growth, and the forthcoming sovereign wealth fund, Macro Man thought it would be an interesting exercise to figure out how SAFE's FX reserves have actually performed for them.
The rules of engagement naturally entailed some simplification and guesstimating. Macro Man assumed that SAFE holds a constant reserve basket of 70% USD, 25% EUR, and 5% GBP, and that these reserves are kept in 2 year government securities. He then assumed that all FX intervention is sterilized (which we know it is not) through the issuance of 2 year bills (another simplification.) Essentially, what we are trying to calculate is how the return on a stylized reserve basket compares with PBOC liabilities and/or domestic alternatives- short dated RMB paper. The calculation starts on the day after the RMB reval in July 2005.
Macro Man wasn't really sure what to expect from the calculation. The RMB has outperformed the onshore forwards against the dollar, but it has fallen against the euro and sterling. In any event, he knew that carry would be a substantial positive contributor to overall returns.
In point of fact, carry is the only thing that has kept reserve returns positive. In nominal terms, the RMB has appreciated 2% against the USD/EUR/GBP basket since July 22, 2005. However, the average yield on 2 year RMB paper has been 2.25% lower than that of the weighted reserve basket over the period of the study. This has taken the cumulative return from -2% to +2% over the period of the study. So it's true, then: SAFE is the world's biggest carry trader!
The numbers may also explain why China has, to date, demonstrated an aversion to the yen. Switching even 10% of the dollar exposure into yen would have a substantially negative impact upon returns, both nominal and carry adjusted. The yen's weakness against the dollar would take the nominal return from -2% to -2.85%, while the reduced carry of the reserve basket would bring the all-in return from +2% to less than +0.50%. And that, you'll agree, is uncomfortably close to a money-losing proposition.
What is particularly interesting is the trajectory of the returns. SAFE made plenty of money in the first year after the revaluation, but hasn't made a dime since. In actual RMB terms, the returns from the FX reserve holdings has actually been negative since June 2006. This, perhaps, is the real motivation behind the sovereign wealth fund. The powers that be may have recognized that returns from the business-as-usual reserve basket have dwindled to zero even as reserve growth has turned parabolic. It's difficult to justify adding so many reserves when you're not getting an economic return for it. So perhaps the PIC/SIC/JFEC has been created to ensure that the return curve swings back onto a positive trajectory. Regardless, it's hard to escape the conclusion that FX carry has been a haven for SAFE.
A couple of portfolio clean up notes. Commodities are killing Macro Man. If the Goldcorp position were any more of a dog, he'd have to put a flea collar on it. Meanwhile, the crude spread trade has run him over like a cartoon steamroller. The time has come for remedial action. Macro Man will sell out the Goldcorp on today's open and bid it good riddance. The oil spread requires a bit more delicacy. The first order of business is to trim the COZ7 short- Macro Man will bid 69.50 to cover that. Once done, he will offer the CLZ7 at 68.50. Market noise will hopefully provide him with an opportunity to leg out of the position at a one buck discount, though sod's law says the Brent leg will get filled just before the discovery of Osama bin Laden in Afghanistan and a massive deposit of crude in Nebraska.