The current major misalignments of exchange rates are the euro-dollar rate and the dollar-renminbi rate; the euro has become too strong against the dollar, and the renminbi is too weak against the dollar. The problem is that neither Europe nor the US is inclined to intervene in the euro-dollar market, and the Chinese are determined to maintain a grossly undervalued currency with any means, including massive currency intervention.

“….the amount of official participation in global capital markets… going to crowd out the private sector and eventually the global economy is going to be centrally planned…”

even though i agree

“The refusal to let the markets adjust is disturbing”

I just meant that sometimes it is difficult to say whether the current account drives the capital account or the other way round. In this case, a carry-trade-induced yen weakening can be expected to increase Japan’s current account surplus.

Sometimes I think that the distinction between the current and capital accounts is not worth the trouble. After all, a piece of paper that generates a return (security) is not so different from a physical asset that yields a saleable product (a capital asset such as a machine). Given that the payments must balance (unless there is a net change in foreign exchange reserves), the inflow of yen debt assets from the carry trade must be matched by an outflow somewhere else, which could easily be in the form of current account items such as cars, laptops etc.

” Re: FDI not used domestically. Guest — I am surprised this isn’t intuitive, since you seem to have a good grasp of a central bank’s balance sheet.”

Sorry. On re-reading, looks like you are describing net rather than gross inflows. I’m there now. Thanks.

Thanks. That helps. I’m rusty on this stuff and may not have understood it properly in the first place. Plus I don’t really monitor China’s international balance sheet position.

But I think I understand what you’ve said. Private capital is a net flow inward to China, thereby exacerbating rather than offsetting the problem of deploying surpluses that begin with the current account but then include net capital inflows as well. The BOC must take up both.

Still, I’m confused because I read your piece as suggesting that gross FDI inflows must be taken out by the BoC because of this structure. If FDI comes in as U.S. dollars, cannot that flow alternatively be reversed by private buyers of U.S.? (e.g. the 3 % in your final example; e.g. through a U.S. dollar bank deposit in China.) This would not affect reserves. Domestic savings would be deployed privately through an effective reversal of gross inflows. Perhaps capital controls preclude this? Otherwise, it seems to me the cart is gross capital inflows and the horse is the BoC’s discretion in funding any part of this through monetization or monetization/sterilization.

I.e. doesn’t the BOC have full discretion over how much FDI linked foreign exchange it wants to monetize or monetize/sterilize? I’ve always viewed this part of central banking as a proactive decision rather than a reactive capital plug.

RebelEconomist do you mean that the carry trade effectively weakens the yen thus leading to valuation gains (in JPY terms) on the cumulative current account surplus held in foreign currency and this valuation change effectively makes the cumulative current and capital accounts equal - from an accounting perspective that is.
Aditya

that is one reason why some argue the stock of the carry trade now is big — sum up Japan’s cumulative current account surplus since early 2004, and it is starting to add up.

The twist is that the carry trade is usually thought of as a phenomenon involving debt. So if Japan is attracting net equity inflows (in Japan’s case, net inflows of portfolio equity), then debt outflows (call it the carry trade) will be equal to the sum of net equity inflows and the current account surplus. that is where definitional issues come up — is the carry trade just yen borrowed by leveraged/ speculative accounts, or do real money flows (debt purchases by japanese insurance cos) count as well.

tmchee’s data shows net portfolio (debt and equity) roughly cancel each other out - which implies large bank outflows (or large FDI outflows).

linking this up, i think one reason why there is more talk of the carry trade (apart from price moves that suggest yen selling) is that Japan’s current account is set to rise. the trade balance is growing (see January data), as the weak yen encourages exports and Japan’s commodity bill isn’t growing. and its income surplus should grow as well.

Re: FDI not used domestically. Guest — I am surprised this isn’t intuitive, since you seem to have a good grasp of a central bank’s balance sheet.

It is nothing more than an accounting identity — Reserve growth is equal to the current account surplus and net private capital flows. In China’s case, private capital is flowing into China (once you adjust for the PBoC’s swaps and various other manuevers to hold reserve growth down), largely (at least right now), because FDI inflows exceed FDI outflows. So by definition, part of the increase in the PBoC’s reserves will be financed by inflows from abroad.

Another way to look at it is that capital coming in from abroad (FDI or Debt) can be used either to finance a current account deficit (investment that exceeds savings) or to build up reserves. If it isn’t financing investment, by definition, it is going toward reserves (or various quaisi-reserve like funds).

A final way to look at it — say China is attracting 3% of GDP in FDI. That FDI is itself, obviously, invested inside China. But some domestic money that otherwise would go toward building a factory is freed up — and in China’s case, it is freed up to be lent to the central bank rather than invested in other projects. So if China savings 50% of its GDP and invests 40% of its GDP but 3% of that investment is financed by foreign money, 13% of domestic savings is freed up and not used for investment and instead lent to the PBoC to finance the expansion of its balance sheet. that total (13%) is bigger than the gap between savings and investment (10%) … ergo … the 3% inflow in some sense financed reserve growth.

hope that helps

I hear complaints like Shrek’s first post virtually every day; indeed, I am the author of more than a few of them myself.

Where it gets really tricky is with an institution like the BIS, which is simultaneously a regulator, a broker, and an asset manager. Barring effective Chinese walls, there is surely ample risk of impropriety within an institution that mixes those functions. The Larry Summers proposal of a central pool of passively managed global reserve assets makes a lot of sense to me in terms of minimizing market distortions.

Vis-a-vis the yen, I would concur that CBs probably should and ultimately will have a greater weight on yen in their reserve baskets. When this occurs, the yen will strengthen. A lot.

However, bear in mind that CB reserves are first and foremost meant to be a store of value. And on the basis of the past fifteen years, it is not at all clear to me at least that the yen can be trusted as a store of value for the next fifteen years. Ultimately, however, it will be in Japan’s interest for the yen to become a more prominent reserve currency, despite the concomitant rise in the exchange rate. This is simply because CBs could undertake to buy some of the enormous stock of government debt (assuming they are happy to have non-AAA rated paper), which will become susbtantially more costly to fund as Japanese interest rates normalize.

Again, though…I reckon Japan has to make it through a full economic cycle without receding back into crisis for the Voldemorts to keep comfortable with the yen as a store of value.