Reporting/Market Focus from the March 2005 Edition of the SGS Newsletter

A key concern for the U.S. financial markets is foreign willingness to continue holding U.S. dollar-denominated assets, particularly U.S. Treasuries, in an environment where most investors and central banks recognize that the dollar broadly is overvalued against most other major Western currencies. The latest flow of funds data are murky in this area, although there is some suggestion that foreign investors consumed a smaller portion of net Treasury issuance in 2006 than was seen in 2004 and 2005.

In recent newsletters, I have raised questions as to the quality of statistical reporting at the Board of Governors of the Federal Reserve System (FRB), separate from the elimination of M3 reporting. In particular, unusual patterns and revisions have shown up in Flow of Funds (FOF) reporting — accounts that show the sources and uses of cash and credit within the U.S. financial system and economy. Some of these anomalies are explored as they relate to foreign holdings of Treasury securities. The problems, however, are widespread in FOF accounting.

Consider the following example. The FRB’s fourth-quarter 2006 FOF report (released March 8, 2007) showed the year-end 2005 level of U.S. Treasuries held by the "Rest of World," or foreign investors, at $1,993.8 billion, versus $1,803.5 billion at year-end 2004, an annual increase of $190.3 billion, using simple arithmetic.

The annual change reported in the flow tables, however, showed an increase of $287.1 billion for year-end 2005 over year-end 2004, a greater increase by $96.8 billion! Similar patterns in are seen in prior years.

In theory, the two approaches should come up with the same amount of change. Indeed with FOF showing the total level of Treasuries (public debt) outstanding increasing from $4,370.7 billion at year-end 2004 to $4,678.0 billion at year-end 2005, both the level differential and the flow number are the same at $307.3 billion. Unlike a number of other FOF accounts, there is no formal "discrepancy" category to balance out otherwise unbalanced bookkeeping. So where is the difference?

A similar analysis of Treasury holdings by U.S. Households shows the year-end 2005 level of $563.4 billion was down by $1.9 billion, but the flows showed an annual decline of $98.8 billion, a direct offset to the "Rest of World" discrepancy.

The FRB was helpful in explaining the matter. There is no error in the reporting, but rather some issues with the underlying source data, which in this case are provided by the Bureau of Economic Analysis (BEA), which also publishes the heavily politicized GDP report. Separate data are used for tracking flows and levels, and they do not agree. When the flows are balanced out, all unresolved differences fall into the "Households" account, which is not surveyed separately. As to which numbers best reflect foreign purchases of U.S. Treasuries, the Fed indicated the flows probably were better, while the levels were better in indicating the total amount held by foreign interests.

Accordingly, the two following graphs show alternate realities as reported by the FRB. In the first graph, foreign buying of U.S. Treasuries accounted for 69% of net Treasury issuance in 2003, 96% in 2004, and 93% in 2005 and then dropped back to 77% in 2006. A slowing in foreign purchases of U.S. Treasuries is evident in the "preferred" flow-based numbers. Of course, foreign purchases rose from 62% of net Treasury issuance in 2005, to 77% in 2006 using the difference-in-level approach. The current identical readings for 2006 will disappear when the BEA revises its base data later in the year.

The latest quarterly data are not any more meaningful than the annual tallies. Fourth-quarter 2006 flows, which are seasonally adjusted at an annualized rate, show the Rest of World net acquisition of Treasuries at $279.9 billion or 177.5% of net issuance of $157.7 billion. On the change-in-level basis, where the numbers are not seasonally adjusted, the Rest of World net acquisition of Treasuries was $70.0 billion ($280 billion annualized) or 119.7% of net issuance of $58.5 billion ($234 billion annualized).

Of course, if annual foreign debt holdings really increased by the amounts indicated in the flow-based numbers, then the level data should be higher. The second graph shows the difference starting just with the level reported for year-end 2002. The lower line, which represents reported level, would be the "preferred" Fed approach. The upper line shows the levels implied by adding on the annual flows.

These problems, exacerbated with major discrepancies of a similar nature in other accounts, suggest the FOF numbers have limited meaning and usefulness. Accordingly, we will not provide regular quarterly analyses of the data, except to highlight unusual issues in government reporting or to use a very rough and broad estimate of key numbers.

No Big Deal?! A subscriber brought my attention to a March 26th Reuters story on Fed Chairman Ben Bernanke’s comments on how China’s accumulation of U.S. debt is not a problem. From a letter to Sen. Richard Shelby of Alabama:

(1) "Because foreign holdings of U.S. Treasury securities represent only a small part of total U.S. credit market debt outstanding, U.S. credit markets should be able to absorb without great difficulty any shift of foreign allocations …"

(2) "And even if such a shift were to put undesired upward pressure on U.S. interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our economic goals …"

As to point (1), any foreign holdings of U.S. credit market instruments thrown into the U.S. market are on the margin, and represent two full years of regular credit-market borrowing, to the extent the FOF numbers can be believed. Foreign holdings also are not insignificant in the Treasuries’ market. Rest of World holdings of U.S. Treasuries likely are somewhere between 44% and 55% of the total, depending on the numbers used, and Communist China purportedly holds somewhere close to half the total of those foreign holdings.

As to point (2), this where the Federal Reserve accelerates monetizing the federal debt and initiating the early phases of the hyperinflation.