Ladies and Gentlemen,
The following is an explanation of the underlying issues that contribute to fluctuations in our money markets. It should provide a relatively sufficient means for conceptualizing the import of a forthcoming Financial Times (FT) piece below:
Economists have been debating the following issue for some time now: If China stubbornly refuses to stop buying dollar denominated assets at a rate commensurate with new Fed money creation (to ‘sterilize’ the Yuan/Dollar exchange rate), a growing resistance between real world (market) interest rates and China’s rates will become a rather combustible mixture. Without proper foresight and measured adaptations, this relationship could result in that spring action I was referring to in the ‘State of the Union’ email (2/31/06), whereby currency values fall [suddenly] and interest rates go way up. That would be bad for global price stability and it would throw a lot of businesses into a tailspin. Accordingly, it would behoove US and Chinese policy makers to work together to assuage the issue. But – and this is a big but – the onus of responsibility lies upon the US consumer, as we wouldn’t be in nearly the financial position we are in today if [the average household] were not profligate.
Not to point fingers, but an informed body-politic makes wise decisions, while an uninformed one just decides to put-off hard questions for later (e.g., Social Security and Medicare entitlements unfunded liabilities crises, but I digress).
Let’s use broad strokes to check out the rationale behind this currency mechanism by which the Chinese have been hoovering cash right out of your wallets and furthermore, investigate the consequences of such policy both at home and abroad. First, we’ll briefly identify the primary forces which cause money values to rise and fall, then we’ll proceed with an illustration of how money is created and how the Fed affects interest rates. Next, this email will attempt to concisely identify the process by which China manipulates its currency vis-a-vis the United States in response to Fed actions and suggest the consequences which this policy has for the Chinese economy. Lastly, this email will suggest two or three possible scenarios regarding the relationship of the Chinese and the American, hence, world economy going forward.
Any attempt to explain value fluctuations in what Benjamin Graham (the dean of Wall Street) famously referred to as the ‘abstruse money market’ must begin with the notion of something called an [uncovered] interest parity condition, which works symbiotically with the so-called Fisher effect, such that [the amount of] money supply creation, hence the concomitant relative value (or price) of a currency and rates of interest on said currency, are inversely proportional. Or simply: As the money supply increases interest rates will fall.
The following is an example of the process by which money is created:
The US Government, via our Treasury, writes an IOU, or a bond, with a specific interest rate; the Fed then buys the bond via the Government from the Treasury with cash delivered on order from the Bureau of Printing and Engraving. The US Government then takes that cash and transfers it to commercial lenders (banks) by hiring so-called employees and buying so-called products, with government checks, which are deposited into these institutions as ‘federal reserves’. In a fractional reserve banking system, commercial banks can lend out a certain percentage of their deposits (usually around 90%), while keeping the balance (usually around 10%) on reserve. Obviously, a Fed’s increasing available reserves for banks frees up said banks’ loanable funds and, via the money multiplier, the overall money supply in the economy increases (like tenfold or something).
The actual interest rate mechanism is set in various ways, but in the main, rates charged between banks for overnight loans form the basis for interest rates charged for loans [to entities other than banks] in the economy. The discount rate also has an effect, albeit somewhat negligible by some accounts, but that is the rate banks can borrow (now a half a percentage point or fifty basis points higher than the fed funds rate) directly from the Fed in the short term. This is a stop-loss measure; it’s good for things like liquidity crises (not that we know anything about that).
What China is doing today is essentially buying up incoming dollars with newly issued stock of Yuan/Renminbi to keep the differential values constant between the currencies (i.e., to prop up the value of the dollar against the Yuan/Renminbi). This has a price – namely, the difference in rates of return on Fed bonds and those of China’s money. One one hand, it only costs 2.07% interest to hold US money (based on the current 1-month Treasury yield rate), but on the other hand, that money is only earning a 2.07% return, while the Chinese money rate is closer to 4%. The difference (about 200 basis points or two percent) is what it costs China to buy US monies and ‘sterilize’ the currency (to peg the value at a constant rate).
You might ask, ‘Well, why doesn’t China just lower its cost of money and erase the differential or close the gap?’ The reason being, grasshopper, is that China’s inflation rate has been out of control (OC). There have been pork shortages so people have boiled dogs and cats for dinner (no lie), volatility has been on the rise; therefore, companies have a hard time deciding which investments will be profitable. Consequently, companies (mostly run via government through banks) cut back and people lose jobs, this affects a death spiral on GDP/incomes per capita, hence consumption, investment and round and round.
It is costing China a certain amount to hold our currency at the levels which they now hold (there are currently over $1.5 Trillion worth of reserves being held in China, but the exact proportions of that pie denominated in American dollars is uncertain)* and there is an offset between the export-driven gains of holding the currency at those amounts and the fiscal losses due to the costs of money related to holding those amounts. Accordingly, any major decision China makes regarding these funds will have an impact on the United States – indeed, on the entire global economic system.
Generally, neither America nor any country should feel itself hostage to the political fortunes of sovereign wealth fund manager’s or their bosses’ decisions. However, one might say that it is not unwise to try and manage realistic expectations about those decisions for the good of the nation and for the global economy-at-large. To that end, we have two, perhaps three plausible scenarios for Sino-American economic relations going forward:
1. China decreases the rate at which it buys forthcoming dollars, thereby allowing the Yuan/Renminbi to strengthen, which, by virtue of Hume’s price-specie flow mechanism, will restore equilibrium in markets. Consequently, US exports increase along with the rest of Europe compared to financially repressive neomercantilists and, ceteris paribus, the world economy is liberated from an otherwise looming recession.
2. a) China fails to decrease the rate at which it buys forthcoming dollars, which, in turn, increases the cost of holding those reserves and lowers China’s Return-on-Investment (ROI). At some point, the ROI will become negative and there are three main things which must be taken into account to determine this. First, we already know that China foots the bill of a cost differential of about 200 basis points by holding our currency. Second, the Chinese need to figure out if they are making more than 2% after inflation on export-led growth (net real income). You could say that their cost of capital, in an inflation and tax-neutral environment is 2%. But factor in an 11% inflation rate with much room to rise and you’re looking at gains which must exceed 13% or more to break even. (And that’s before the 3% profit margin incentive which investors consider prudent, so in reality we’re looking at over 16%.) If the Chinese keep buying our currency, and we buy less of their exports; if the rest of the world slows down in buying Chinese exports as well, due to a global slowing phenomenon, China’s margins are going to get squeezed. Technocrats could decide, then, in all probability, to diversify into other currencies (maybe some southeast Asian ones) and/or liberalize their economy somewhat for flexibility in responding to inevitable [demand] shocks. As a result, trade relations between China and the rest of the world could normalize somewhat and ties of mutual interest might incentivize further Chinese liberalization, hence normalization of trade relations in a virtuously self-reinforcing manner.
2. b) The scenario plays out as in 2a above, except Chinese technocrats respond to the imminent zero hour by financial brinkmanship and subsequent panic after crossing the point of no return (when all foreseeable returns go negative). As a result, financial markets go into a protracted hysteria, businesses get cold feet regarding new investments and the world sinks into a depression.
2. c) The scenario plays out as in 2a above, and Chinese technocrats respond with financial brinkmanship as in 2b, except the increasing pressure of decreasing margins turns into a critical mass which explodes, not when returns go invariably negative, but when an exogenous supply shock (e.g., leading to a major energy price swing) causes these countries decide that each other’s currencies just aren’t worth what was previously thought and consequently, there ensues a speculative financial collapse, badly damaging the value of debtor nations’ currencies (e.g., US, Britain and the Eurozone) and, by extension, the value of China’s foreign assets**. Thereupon, business investment halts at each nation’s respective borders and a new era of protectionism ensues; world GDP falls by 75% over the following decade.
*$1.5 Trillion in reserves. If we considered the average ratio of the world’s reserve currency denominated in dollars to be 75%, it may hold, but of course that’s any man’s (or woman’s) guess. Individuals familiar with the matter suggest there is probably a somewhat diversified mix of industrialized nations’ currencies (e.g., Pound Sterling, Dollars, Euros, Yen).
**China’s foreign assets. China’s central bank purchases foreign reserves with checks written against itself. In a double-entry bookkeeping system, that means if China purchases one dollar, it must offset that dollar [asset] with one dollar’s worth of a liability. So China goes negative in its Financial Account in order to keep a surplus in its Current Account (its net exports or Exports minus Imports). Accordingly, China’s costs of maintaining a hefty surplus in their Current Account are coming home to roost. And the subsequent problem is that, if the value of American dollars, British pounds and European Euros goes down, the value of Chinese assets goes down. This paradoxical situation is what one might refer to as fiscally irresponsible or a “lose-lose situation”.
US rate cut adds to pressure on China
By Richard McGregor in Beijing
Published: January 23 2008 18:10 | Last updated: January 23 2008 18:10
The sharp cut in US interest rates has increased the conflicting pressures on Beijing’s management of its economy and its simultaneous efforts to stem potential losses of billions of dollars in its foreign exchange holdings.To keep the currency stable, the People’s Bank of China buys almost all incoming foreign currency, and then attempts to “sterilise” the monetary impact by issuing renminbi bills to take the funds out of circulation.
The US cut means China’s central bank will pay almost 200 basis points more on the bills it issues at home to manage its currency than it will get on purchases of US Treasuries.The PBoC pays about 4 per cent on its so-called “sterilisation” bills, while one-year US Treasuries now carry an interest rate of 2.07 per cent.Both countries are likely to maintain their policy biases in coming months, the US cutting rates, and China lifting them, a trend that will intensify the pressure on Beijing’s currency policies.”Things just got a lot more complicated for the managers of China’s economy,” said Stephen Green, of Standard Chartered bank, in Shanghai, on Wednesday.China does not release the exact makeup of its foreign exchange holdings, nor how they are invested, making it difficult to get a precise reading on their profitability.But Hong Liang, Goldman Sachs China economist, calculates the PBoC is losing about $4bn a month on its bills because of the turnround in the interest rate differential over the past 18 months.
“The trend is clearly accelerating as the reserves continue to grow faster than GDP,” she said.
China has lifted rates eight times since early 2006, to cool an economy that grew by more than 11 per cent last year and, more recently, to combat inflation, which hit an 11-year high in November.
But further use of interest rates is constrained by Beijing’s tight management of the renminbi, a policy aimed at preventing it appreciating too rapidly.
The government fears more rate rises could attract speculative capital inflows, adding to already swollen foreign reserves, which stood at $1,530bn at the end of 2007.
Despite this objection, the government’s commitment to fighting inflation means further rate rises are inevitable, China economists say.
The PBoC, in expectation of losses on its sterilisation bills, has used other tools in the past year to drain the funds, mainly by requiring commercial banks to leave more money with it on deposit. Chinese banks are required to place 15 per cent of their deposits with the PBoC, at a much lower interest rate than the 4 per cent offered by the sterilisation bills.
The heavy use of this measure has allowed the PBoC to limit losses on its foreign exchange holdings.
Some economists argue the reserve losses are only on paper, but “at some point, that paper loss may result in a fiscal loss”, said Brad Setser, of the Council on Foreign Relations. “It certainly represents a fall in domestic purchasing power of China’s external foreign assets. Money held in dollars will end up buying fewer Chinese goods in five years than it does now,” he said.
Copyright The Financial Times Limited 2008