Tokyo-Sao Paulo-Rio-New York-Washington …
Plenty of signs suggest that a fair amount of money is leaving Japan to look for higher yields elsewhere. More and more of those outflows seem to be coming from leveraged investors who borrow yen to buy other currencies – look at the excellent analysis by Hali Edison and Chris Walker in the IMF’s Asian regional outlook (box 1.4).
But it doesn’t seem like much of it going to the US. At least not directly.
There are plenty of places that offer higher yields than Japan that don’t even have current account deficits – the eurozone for one (its deficit is very small). Brazil for another. Russia too.
There are places that offer higher yields than the US but run smaller deficits. The UK comes to mind. India too. Australia perhaps fits here – its overall deficit is about the same size as the US deficit (though its composition is different; Australia has a smaller trade deficit but a large deficit in investment income)
And then there are places with bigger deficits than the US. New Zealand. Iceland. Turkey. All offer higher yields than the US.
So how then has the US managed to finance its deficit? After all, current ten year Treasury yields don’t suggest “foreign flight”?
Let’s start in Sao Paulo (or Brasilia). Brazil’s reserves rose by $4.6b last week. The workers in Brazil’s central bank were on strike last week; foreign investors were not. The central bank was back in the market again today, to no one's surprise.
$4.6b in a week works out to an average of $0.9b a day — just under $1 billion. $1 billion a day is a China-like pace of reserve growth. Or at least it used to be a China-like pace – I suspect China has raised the bar this year. Its reserve growth has likely accelerated from about $20b a month over the past couple of years to around $30b a month, if not more.
Brazil still runs a current account surplus, but its current account surplus maybe explains $1-2b a month of reserve growth. Not $1b a day. Brazil is attracting large amount of foreign capital.
Let’s assume that that the money flowing into Brazil comes from a hedge fund that borrowed yen from a bank in London that itself borrowed yen in the interbank market in Tokyo. That is an assumption, but not a totally implausible assumption. In practice, I suspect a lot would be done through derivatives, with banks hedging their derivative position generating a lot of the “actual” flows. No matter. What counts is that Japan’s spare savings is effectively channeled, with a bit of help from the world's banks and a few hedge funds, to Brazil.
The logic of this trade is easy to understand. Real-denominated debt pays 12%. Borrowing at 1-2% in a depreciating currency and getting 12.5% in an appreciating currency is fun.
But Brazil doesn’t actually need the money. It has a current account surplus. It saves more than it invests. Its central bank doesn’t want to cut rates (which might encourage more investment) and it doesn’t want the real to appreciate (Brazil has a manufacturing sector that competes with China as well as a commodity sector that sells to China). So it buys the dollars and sterilizes by selling central bank bills at high rates.
The central bank effectively ends up paying the 12% interest rate in real to foreign investors.
And what does it do with the dollars is buys with the real-denominated debt it issues to sterilize the inflow?
It sends them to the US, and probably has the New York Fed invest them in Treasury securities, financing the US government in DC. We know that Brazil’s holdings of Treasuries are rising rapidly, and I would assume that the BCB accounts for some of the rapid growth in the Fed’s custodial holdings.
What does it get on its Treasuries? A bit less than 5%. Brazil's central bank effectively borrows in real at 12.5% to build up reserves that earn less than 5%.
I can see why Brazil needs around $100b in reserves (10% of its GDP is a reasonable benchmark for reserve adequacy). But not $200b. Yet unless its pace of reserve growth slows, it will hit $200b rather quickly. Well before the end of the year. If last week’s pace continues, it could hit $200b in about four months (think $1b a day *83 working days) …
That is how a portion of the US deficit is now financed.
Tokyo-Rio-New York though isn’t the only route that brings Japan’s spare savings to the US. Tokyo-Mumbai-New York also works. The RBI though likes euro and pounds, so it sends almost as much to London and Frankfurt as to New York. It isn’t the most efficient routing. Tokyo-Moscow-New York has the same problem. It really is Tokyo-Moscow-London-New York, and some funds never make it all the way to New York.
Beijing-New York-DC is more efficient.
Brazil reports its reserve growth with a very tiny lag, so we know more or less what its central bank did last week. India and Russia report with a week’s lag, so we only know what they did in the second week of April.
India’s reserves increased by $2.8b. The euro rose by about 1% that week and the pound by a bit less than 1%, so the rising dollar value of India’s existing euros and pounds explains maybe $1b of that increase. The rest came from intervention, as the central bank resisted pressure for further rupee appreciation.
Russia’s reserves increased by a whooping $10.3b in the second week of April (after increasing by $7.6b in the first week of April). Russia has a lot of euros and pounds, but the rise in their value explains at most $2b of the increase. Russia’s current account surplus explains at most $2b – and probably far less – of the increase. That implies at least $6b, if not a bit more, in net capital inflows to Russia …
Suppose that after adjusting for valuation, India added $2b to its reserves in week, Russia $8b and Brazil $4-5b. China is now adding at least $5b a week. Since the PBoC had to drive the RMB down against the euro and pound in the second week of April, I wouldn’t be surprised if it bought even more. Say $10b. The BRICs then are currently adding $20-25b a week to their reserves. $20b a week is $1 trillion a year. $25b a week is $100b a month, $300b a quarter, $1.2 trillion a year …
That truly is unimaginable large.
If you think that scale of reserve growth can continue, there is little reason to worry.
But in my view there is an interesting race going on now. Will private investors (re)discover their appetite for US assets before the world’s central banks loose their appetite for US assets? Or will the central banks lose their appetite for dollars before the private market regains their appetite?
On the surface, you can say little has changed since the 2005. The US is still running a large deficit. It still finances that deficit by selling bonds. Treasury bonds still yield between 4.5 and 5%.
Under the surface though something has changed.
In the later part of 2005, the world’s central banks were adding about $175b a quarter to their reserves, and putting a pretty high fraction of those reserves into euros and pounds. Their dollar reserves rose by only about $100b a quarter.
Now they are adding almost twice as much to their reserves. If they are trying to keep the dollar share of their reserves constant – or just finding it hard to sell dollars without moving the market – the pace of their dollar reserve growth has increased by even more.
I am truly stunned by the pace of reserve growth that I am seeing in the emerging world right now. Emerging market central banks are potentially adding to their dollar reserves at a pace sufficient to finance the entire US current account deficit.
With US Dollar hegemony, globalization means the US gets to pay in fiat dollars for things the rest of the world produces. US Dollar hegemony results from the geopolitically constructed peculiarity that critical commodities especially oil are denominated in only dollars; Oil is denominated in only dollars through US military power projection in the Gulf Arab states. World trade is now a financial game in which the US produces fiat dollars and the rest of the world produces things that dollars can buy. The adverse effect of this type of globalization on the US economy is has been a debt bubble. There is an urgent need to restructure the global finance architecture to return to exchange rates based on purchasing-power parity, and to reorient the world trading system toward true comparative advantage based on global full employment with rising wages and living standards. The starting point is for the major exporting nations each to unilaterally require that all its exports be payable only in its currency, so that the global finance architecture will turn into a multi-currency regime overnight. There would be no need for reserve currencies and exchange rates would reflect market fundamentals of world trade.
Good one Brad … and don’t miss why all those savings are leaving Japan in the first place …
http://www.ft.com/cms/s/3cf81996-f0ed-11db-838b-000b5df10621,_i_rssPage=abb716b0-2f7a-11da-8b51-00000e2511c8.html
Of course, home bias may prevail but at some point other ageing societies’ capital will go hunting for yield elsewhere too. So, at least some part of international capital flows are to be found in connection with difference in the way countries move through the demographic transition.
The vast, vast majority of household assets in Japan remain in yen-denominated instruments or deposits. This asset allocation shift remains entirely rational, and indeed is being mirrored in another low-yield economy with crappy demographics: Taiwan.
Given the government’s preoccupation with fiscal consolidation, it is probably unlikely that the FX reserves will be put to another use any time soon: the MOF is making too much money on the carry…
claus — the us is aging too, tho more slowly than the us and in europe. the full demographic argument implies capital flows from the rich and more rapidly aging to the emerging world, not to the US (as seems to be happening). but that won’t finance the US current account deficit!
china is a special case, but if what matters is the effective size of the urban labor force, it will grow for some time in china on the back of migration …
and i don’t quite see how aging (a long-term trend) explains the upturn in EM reserve growth from around $100b a year (circa 2000) to around $1,000b a year (2007)
Macro man — any thoughts on the sustainability of $1 trillion in reserve growth (which implies $250-300b in euro/ pound purchases just to hold their share of global reserves constant)?
(1) Carry trade lubbers like ex-Goldman Sachs Treasury Secretary Paulson and his Wall Street buddies have expressed indifference to regulating the carry trade from which they obviously benefit at the expense of developing nations. Capital controls, anyone?
(2) This carry trade foolishness is a worry not only for developing countries but the EU as well, it seems.
(3) For once, I am in agreement with Dave-o-nomics:
There is an urgent need to restructure the global finance architecture to return to exchange rates based on purchasing-power parity…
According to the Big Mac index, the yuan is undervalued by 56% on a PPP basis and is the most undervalued currency on the list. Definitely, the yuan should go up by that much against the dollar, effective immediately. (Actually, I’d be happy with even a third of that in revaluation.)
Reserve growth, regardless of pace, will be sustainable (no matter how undesirable) until the costs outweigh the perceived benefits of the policy.
This may refer to sterilization costs-PBOC intervention is currently carry positive- or political costs.
Korea is instructive here- the BOK held out as long as they could, but when sterilization costs became too onerous, they had to reduce the pace of intervention- and USD/KRW went from 1100 to 940 in close to a straight line.
Because many FX reserve managers still enjoy positive sterilization carry- most notably PBOC- it may not be financial considerations that render accumulation unsustainable.
I suspect that a credible and broad-based threat of protectionist backlash might be the trigger, what with presidential elections in France now and the US next year.
To be sure, China et al will not wish to bow to political pressure. Then again, it’s not terribly difficult to see protectionist sentiment getting pretty ugly over the next couple of years if and as the cycle matures and starts to roll over in not just the US, but elsewhere as well.
You’d have to think, though, that the formal creation and funding of the PIC should reduce the accumulation of reserves in China. After all, what rational actor could possibly wish to go short RMB funded at onshore rates?
dave chiang, you repeat your point - so anyone mind if i repeat mine ? north korea is alleged to produce fiat dollars by forgery, that is, by printing them. the united states creates only a very small percentage of currrency by printing cash, the vast bulk of money is lent into existence, and creates an equal and opposite debt. low real interest rates stimulate this process. thus while the united states creates some fiat dollars (bills) the other and much larger part is slightly different, it is fiat credit.
can anyone put that into economists’ language ? the way dave chiang is putting it makes it sound as though it is about spending once-off fiat dollar bills. i don’t think it is. i said this before. no one contradicted me yet . . .
Emmanuel,
Japan’s MOF has $900 billion in FX reserves, much of which was sterilized at virtually zero.
who knows, maybe it’s $1.3tr by now…) in FX reserves, much of which was sterilized at around 3%.
Who are the carry traders again?
MoF = biggest and most successful carry trader of them all.
re: sterilization costs, i think the “carry” is now negative for Brazil, India and Russia, and the pace of
their reserve growth has picked up. With China, carry is obviously still positive (thanks to financial repression) but the future capital loss is growing (but that hasn’t constrained policy). My guess is that the politically important constraint will come from inside China’s financial system. The banks cannot be happy to have so much low-yielding paper on their balance sheets.
Emmanuel,
US political pressure on China to revalue the yuan by upwards of 40% continues. This pressure from the US is motivated by the misguided conventional assumption that a lower exchange rate of the dollar will reduce the US trade deficit, despite clear historical data showing that past revaluations of the Japanese yen and the German mark had not reduced US trade deficits with these major trade partners over the “long” term. All such revaluations did was to lower the domestic cost in local-currency terms more than raise the dollar price of Japanese and German exports.
And even if the China PBoC should stop building up its dollar reserves, it only means some other country will add dollar reserves to make up the difference as long as dollar hegemony allows the US to finance its trade deficit with its capital account surplus with impunity. Under US dollar hegemony, dollar reserves are created by US twin deficits, independent of which foreign country holds them. The solution is for the US to stop printing fiat dollars to fund its deficits, for as long as the Federal Reserve continues its permissive monetary policy, the twin deficits will continue to expand. US Dollar hegemony, a monetary regime introduced by Clinton Administration Treasury Secretary Robert Rubin, financed the US trade deficit with its capital account surplus to deliver borrowed prosperity to the US through a global debt bubble fed by the US Federal Reserve’s dollar printing frenzy. By extension, in order for the US to cure its trade problems that its own permissive monetary and anti-labor policies have created, China must revalue its currency upward by up to 40%, not because the market demands it, but because the US needs it to reduce its trade deficits. What the US is doing is asking China to pay for its own policy errors.
Hi Brad (and others)
I pretty much agree with you Brad …
(actually I had a long reply in the pipeline but the damn RGE site pushed it into the dark void of nothingness in stead of posting it :))
In essence, what I meant to say is that demographics are not nearly the full explanation here and notably China’s situation is not very well explained by demographics at this point.
What I am in essence arguing is that the furhter we venture along this path the harder it will be to re-balance the ship and one of the main reasons is the global process of ageing since this will slowly but steadily erode the roster of countries being able to sustain current account deficits relative to the surplus nations.
Macro Man, I refer to those folks mentioned at the start of the post:
More and more of those outflows seem to be coming from leveraged investors who borrow yen to buy other currencies - look at the excellent analysis by Hali Edison and Chris Walker in the IMF’s Asian regional outlook.
You might say I’m playing Clintonesque language games here, but I’m more reluctant to call those not using leverage “carry traders.” The line between “investment” and “speculation” is thin, but is there nonetheless. For instance, Japanese citizens looking for a bit of a boost from JGBs are investors whereas large financial services players and hedge funds going long BRL/JPY with highly leveraged bets are speculative carry traders.
NBER declares Chinese Yuan NOT undervalued
http://papers.nber.org/papers/w12850
National Bureau of Economic Research (NBER) Working Paper No. 12850 issued in January 2007 reports that relying upon conventional statistical methods of inference and a framework built around the relationship between relative price and relative output levels, once sampling uncertainty and serial correlation are accounted for, there is little statistical evidence that the RMB is undervalued.
Dave Chiang,
You keep raising dollar hegemony, but you did not answer my question about why China seems to fix to the dollar, and not a basket of currencies, including the euro. They could seriously undermine the dollar if they did. This is not a rhetorical question; I am genuinely interested in the answer for my own research.
The US earns very little from “printing dollars”. This only really applies to the money base, which is about $800bn in total, and increases at about $50bn per year.
Due to uncertain migratory patterns and crossbreeding, NBER has declared that the waterfowl populating my local pond that looks like a duck and quacks like a duck can not, in fact, be verified as a duck.
Similarly, due to uncertainties arising from trademarks and patent disputes, the NBER has declared that the gardening implement in my garage can no longer be called a spade.
Citing one paper that presumably rehashes the argument from a 2005 paper is not quite the same as saying that the NBER claims that the RMB is not undervalued.
RE, the Occam’s Razor answer to your query is that the Chinese authorities have little legitimate interest in seeing the RMB appreciate.
You wrote:
“If you think that scale of reserve growth can continue, there is little reason to worry.
But in my view there is an interesting race going on now. Will private investors (re)discover their appetite for US assets before the world’s central banks loose their appetite for US assets? Or will the central banks lose their appetite for dollars before the private market regains their appetite?”
I ask:
Suppose the latter happens. So what?
The fact that many different countries are financing the US reduces the risk of one large sudden CB drop-out.
Things “below the surface” have changed indeed, as you write, and there will be some surprises in the coming months. But apart from learning that you are “stunned”, we want your crash scenario!!
Macroman,
If you personally disagree with the statistical conclusions from the NBER that the Chinese yuan is NOT undervalued, I suggest that you write an educated and intelligent rebuttal. And who are these anonymous “credible analysts” who allegedly identify the undervaluation of the RMB by 15 to 40 percent as the sole cause of the US trade deficit. NBER finds there is little statistical evidence that the RMB is undervalued. Period.
NBER is a prestigious and highly respected private, nonprofit, nonpartisan research organization with 16 of the 31 US Nobel Prize winners in Economics.
Come on Brad! When you were ten, and you were ageing just as fast as you are now, did you put money aside for your pension? Probably not, because you didn’t have any! That is why China is saving more now than it did in 2000. Also, you should not discuss return on investment without discussing risk. That is, I suspect, why the euro is receiving some carry trade investment. The return is less than, say the US or the UK, but the probability of a large depreciation of the euro against the yen is less.
MacroMan, it’s been some times I haven’t been arguing with you. Let’s recover the lost ground.
Why China pegs to the dollar?
Your answer: they want to peg to a depreciating currency.
My first observation - They were pegging to in 1999-2002 too, when the dollar was going … bananas. + The great majority of developing countries have been always pegging to the US$, indifferently whether it was going up or down. [For ex., the Latin America Southern Cone was pegging to the dollar when in 1979 Volker was announcing war to inflation and the dollar was skyrocketing, and they kept their peg to the (disastrous) end.]
So my suggestion is: look for another explanation, beyond plane mercantilism.
My second obs. - Maybe you didn’t notice it, but China is not pegging to the dollar anymore, but to a basket of (undisclosed) currencies, with a heavy Yen weight in.
Regards
PS I went through your blog, congra!
RebelEconomist
The US earns very little from “printing dollars”. This only really applies to the money base, which is about $800bn in total, and increases at about $50bn per year.
Dave Chiang - Reply
Estimates of the discontinued M3 monetary statistics indicate a 11% money supply growth currently. Under a fractional reserve banking system, the money base can be multiplied by upwards of 50 times given the miniscule banking reserve requirement, currently under 2 percent of reserves. Under US dollar hegemony, the US government has been able to finance its massive deficit without any tears.
Thanks for engaging in debate Dave….and your answer to the euro question? If I were advising the Chinese government on foreign exchange policy, I would certainly encourage them to increase the weighting of the euro in their basket, and the yen too if they can put aside their differences with Japan.
M3 is private or inside money, and competitive forces should ensure that M3 deposits pay (including banking services) a similar return to what is earned on bank loans, but anyway, the US state does not benefit from its growth.
The way to count “US gains” from dollar “hegemony” is to multiply … not the US monetary base, but the monetary base held by foreigners times the US short term rate of interest. So neither M3 (DC) nor the whole US monetary base (RE).
Why? If the US currency was not the world reserve currency…
US residents, in exchange for the foreign goods they consume purchased on credit [so not M but (X-M)]…
would have to give interest-bearing assets…
just like australians or turkish people, say…
This is much less that would result from RE and DC calculations. But it is not an irrelevant sum at all. (But neither is a great sum). Guess how much?
Thanks Brad. So many interesting topics brought up on one chat. Hard to add much to the general mix here:
1) Positioning. While the BRL/JPY carry trade is quite popular, it’s worth noting that the BM&F long BRL positioning isn’t at an extreme level. Something like -8.5bio USD/BRL shorts held by foreigners right now compared to peaks of ard -$12bio in ‘07 and -$16bio in Mar 06.
2) Reserve Growth. Clearly undesirable for all the USD longs given the many CBs that will continue to (sell USD) diversify a greater amount of each additional (marginal) usd inflow. Not everyone agrees that the recent reserve growth numbers are “clean”. The FX reserve accumulation surged in 1Q, averaging $45bio/month, for a total of $1.2trillion by the end of March. With trade surplus and FDI of about $60bn over the same period, suggests capital inflows have been $75bn. Some note there are two explanations for this 1) unwinding of fx currency swaps that were carried out in ‘06 or 2) some easing in macro controls that allow banks to repatriate their offshore foreign assets for extending credit onshore. (While both are recorded as capital ifnlows, they reflect repatriation of foreign funds owned by Chinese financial institutions instead of capital inflows from genuine foreign sources and strong current and cpital inflows to China)
So, i’d agree both buildups in carry positions and reserves are not on a sustainable path. However, just wanted to point out some caveats to the most recent data we’ve seen.
Gheorghius,
You are right of course…..I was thinking of the gain to the government, and even then $50bn was a misprint. Counting just the dollars held by foreigners, I guess the seignorage works out at about $20bn.
Anyway, I’m off to bed! Goodnight!
DC — I am a huge fan of Menzie’s Chinn’s work, but not a huge fan of how he and his co-authors decided to market that particular paper. The RMB is at the very edge of their statistical distribution, but it doesn’t quite fall outside the confidence intervals (95%) i think that would definitively show undervaluation (i.e. allow the hypothesis that the RMB is not undervalued to be rejected). but the chart very clearly shows that the RMB is at the edge of the band, close to confidence interval. I forget the last data point in their sample set — I think it was 2004. in 2005 the $’s appreciation helped push the RMB in the right direction. alas, 06 took it the other way.
Macroman — Morris Goldstein is fairly credible economist, and he also concluded that if it quacks like a duck and looks like a duck it is indeed a duck. Jeff Frankel reached a similar conclusion — the ration between nominal and PPP GDP in China is very low, even for countries at a comparable stage of development. As have Gian-Maria Milesi-Ferretti and his team at the IMF, though you have to read between the lines there — the Chinese won’t allow the IMF’s esitmate of RMB undervaluation to be published, but the IMF can and does publish simulations for emerging asia …
Gheorghius — if foreign central banks stopped buying before private demand picked up, i would want to be short both treasuries and the dollar (v. emerging currencies). US rates would rise; the $ would fall v most emerging market currencies.
Ah, ok Brad! I though you were worried for the “common good”, the world economy, and so on… I didn’t know you were a speculator… Well, now I fully understand your reiterated concerns on global imbalances. What should I say: good luck!
RE: about $15-20bn, yes
Gheorghius — I thought you were asking about market implications. When it comes to the real economy, what counts is the speed. if the dollar declines gradually and the us gradually shifts into the production of tradables, it is all good. but if something happens precipitously — especially a shock that raises us int. rates/ hurts us asset values/ lowers consumption faster than exports can gro — that is bad.
West Coast Macro.
I agree that the $135b number isn’t clean (I have also argued in the past that 06 Chinese reserve growth numbers weren’t clean, as China was hiding some reserves). But q1 is also typically china’s low quarter for foreign asset accumulation (b/c of seasonality in trade) and given the current export and import growth rates, I am fairly confident that Chinese foreign asset growth will top $400b this year (the current account alone could reach $350b on current x and m growth trends). That comfortably puts monthly foreign asset growth in the $30b plus range. who knows how much will show up in reserves — the SFEIC will have an impact.
the positioning data on the BRL is interesting — i don’t usually follow it, but i probably should. the positioning data presumably doesn’t capture all flwos, but it does suggest that long BRL positions aren’t cpming through forwards, at least not in public markets.
on the other hand, the pace of reserve growth suggests lots of inflows — and the feb. bop data (admittedly a lagging indicator) suggests that those inflows are coming from the interbank market (this is tied to hedging, from what I have been told — there is a premium for onshore $ that can be sold for real to hedge forward positions, and foreign banks lend $ to brazilians to take advantage of this) and from foreign purchases of BRL securities.
Still, i wish i had worked the positioning data into my argument — where is the best source for this data? (I am lazy and use the i-banks for the $ positioning data)
… and seigneurage gains are “gains of the government” of course… implying lower taxes 20 bn a year for us taxpayers… You may doubt that the US gov is the gov of the people, but in principle it’s the same thing! Good night!
Am I missing something? The money flowing into Brazil are borrowed YEN; Japan’s spare savings end up in Brazil, which doesn’t need the money. So it (Brazil) buys the . . . . DOLLARS? How did the yen become dollars?
As Brad alludes, Goldstein (2004) finds an RMB undervaluation of 15-30%, Frankel (2004)finds an undervaluation of 36%, and Coudert and Couharde (2005) have found undervaluations of 18%, 23%, and 49% using different techniques.
The Frankel paper at least was published by the NBER. Golly, the NBER sure has changed its tune! Or is it possible, DC, that viewpoints in papers published under the auspices of the NBER do not necessarily reflect the organization as a whole, contrary to your implication?
Gheorghius, my comment to RE was not meant to suggest that the Chinese wish to weaken the RMB per se, but rather that they are not especially committed to strengthening it, whatever they may tell the US, IMF, etc.
As an aside, have you tried regressing USD/CNY with any of the supposed basket constituents? I have, and there do not appear to be stable relationships. I think the basket is, at the moment, largely a rhretorical device, though in the future it might be the basis for FX policy a la Singapore.
Anonymous, not everyone buying BRL is selling yen, of course. Certainly the Japanese retail outflow has demonstrated a greater appetite for regional equities than for carry currencies in recent month. But the mechanics of the trade are simple: one need only buy dollars and sell yen, then take those dollars and sell them for BRL (with Bacen on the other side.)
Assume exrates all 1:1, and further assume 3 players: Mitsubishi, Market, & BCB (Brazil central bank)
Mitsubishi has 10 Yen. He wants Real.
Mitsubishi sells 10Yen to Market to buy 10$ from Market (because he can’t buy directly real with yen in forex mkts in large quantities)
Now Mitshubishi has 0 Yen and 10$
And Market has -10$ +10Yen
Now Mitsubishi, with 10$, buys 10 Real from Market
Mitsubishi has 0$, 0Yen, 10real. Now he is happy. Market has -10+10=0$, +10Yen, and -10Real
So: Real are getting scarce on the market, and tend to appreciate. Now BCB is unhappy. He provides 10Real to Market, in exchange buys 10$ from Market
Market now has -10+10-10=-10$, +10Yen, and -10+10=0Real
If you add up Mitsubishi and Market on one side, and BCB on the other side, you find that:
BCB has now more dollars, and
M+M have more real, less $ (and same Yen).
“Oh Happy Trick! (Oh Happy Trick!)”
(from Sister Act 3: “Accounting is the basis of macroeconomics”)
MM, what have you regressed precisely? and on what time period?
Gheorgius, I have regressed changes in the CNY with changes in other currencies over varying periods of time. (I use as basket of 11 currencies.)
What I have observed is that coefficient weights that appear to explain CNY movement in period t don’t appear to do a terribly good job of explaining CNY movements in perids t-1 or t+1; the coefficients are not stable.
Now maybe the basket consitutents change over time, which explains the lack of a stable relationship. However, I ‘d suggest that frequent, arbitrary changes to a reference basket is pretty close to not having a reference basket at all.
Macro Man, Gheorghius,
The Chinese announced the currencies in the basket, but did not give the weights. According to the FT, the four leading currencies are the US dollar, yen, euro and won, and the minor currencies are Can, Aus and Sing dollars, baht, pound and ringgit. That is ten! Then there are various other moving parts, such as the reference period for the exchange rates and any tolerance band for the yuan, how soon they correct it etc. Even if the basket is fixed, it may be difficult to work it out by regression.
Correction:
The FT missed the Russian rouble out of their original report, so that makes 11…..sorry!
Yup, those are what I have in my regressions. While there can certainly be perturbations on a high frequency basis, the fact the PBOC claims that the daily band has never been anywhere remotely close to being used suggests that those should be relatively small beer.
Macro Man — I have seen a couple of papers that have found a similar result. The coefficients dont’ seem to be stable. and at times small currencies (the won if I remember correctly) seem to have a big weight. my conclusion on all this — it isn’t really a basket. tis a crawling peg v. the $ with a rate of crawl that changes depending on the policy winds. if another currency happens to correlate with that policy wind, it shows up in the regression.
I think Frankel has published his estimates as well.
Well, if the basket has never proved to be a constraint, I don’t suppose you can expect to infer its weights from regression. It sounds like the Chinese intervention has always been, in the old ERM terms, intramarginal.
No, what they are saying is that the RMB has never approached of its fluctuation band w/r/t the basket…in other words, the RMB value you see is very close to wher the basket supposedly says it should be.
If regressions yielded slightly different coefficients, one could attribute it to rounding or noise. That they are very substantially different raises eyebrows (well, mine at least).
Brad, that is more or less my view- that the basket is a front for what is essentially an artibtrary dollar peg. If you can remember any of the papers that have looked at this with more rigour than me, by all means pass them along…
Ok, MacroMan and others, let’s talk markets.
Assuming that current trends of O.R. accumulation are unsustainable in some developing countries, and that after the collapse of those pegs these exrates will rise fast, and that they are almost a one-wy bet, what currencies are easily tradable, and among those what currencies you would like to be long (ordered by preference)? BWS hinted at some of them…
(I think one would like to know the CuA/GDP, Foreign Debt/GDP, Fiscal Deficit/GDP, OR/GDP, speed of OR accumulation, interest rates… )
Ah, Gheorgius, there’s the million dollar question! The answer of course depends on the natue of the de-pegging; if PBOC were to completely step away and say have at it, RMB would be the obvious one. But they won’t, so it probably isn’t.
Over the last few years, Asian currencies like KRW and IDR have seen sharp rises in the REER, so they are out. I personally think BRL at the deuce becomes a political football in Brazil. Recent changes in bacen suggest to me that they be more prepared to go for growth, and defend against currency strength with lower rates if intervention doesn’t work.
My personal favourites, which entail an embedded ‘long soft landing’ position, are RUB and MYR. The current accounts are great and the carry isn’t horrible. BNM has already gone on record saying they don;t mind a stronger ringgit, and a strong rouble is the only legitmate policy option availble to the CBR in dampening inflation…
As an aside, if the CBs ever do give up the ghost on reserve accumulation and farm out a good portion of their resere stocks to wealth funds investing in equities and the like, you’ll probably want to fund the above out of euros rather than dollars…
what about singapore dollar? is their basket inferrable?
Yes, SGD basket can be replicated to a large degree. It’s not a bad catch-all way to replicate all these curencies, and has the advantages of being deliverable and at least semi-liquid across the world.
At the moment, it is at the strong end of its REER band against the basket, which has forced the MAS to be fairly aggressive in intervening recently. Given that the REER band is a fundamental monetary policy tool in Singapore, it’s difficult to see them abandoning it wholesale.
Brad,
Today’s top Business News has Japan’s Toyota overtaking General Motors in global vehicle sales.
http://biz.yahoo.com/ap/070424/japan_toyota_gm.html?.v=23
Given the fixation of Washington Consensus Economists on the exchange rate as the panacea to every economic problem, I’m sure this latest development has everything to do with the Chinese yuan-US dollar exchange rate, and absolutely nothing to do with the fact that General Motors produces Gas Guzzler Hummer SUV’s with the price of gas heading towards $4 per gallon. Even assuming that the Japanese yen is marginally undervalued by 10%, does anyone really believe that would make any difference in the fortunes of Toyota and General Motors. Does the US auto industry have any vehicle comparable in advanced technology to the hybrid Toyota Prius? Japan’s Toyota built their business over decades, accumulating technology and developing great cars.
P.S. My 1994 Toyota Corolla built in Ontario Canada, has 265,000 miles on it, and is still driving well. It is not uncommon to have Toyotas with 300,000 or 400,000 miles. No one else in the world’s automotive industry beats Toyota in manufacturing efficiency and technology.
i was just thinking if MAS is advising PBoC on implementing currency basket (and SFEIC?) it’d be interesting to know how they’re hedging their USD exposure…
my mom still drives our ‘86 corolla
i think it’s over 300,000 now!
http://www.econbrowser.com/archives/2007/04/a_new_era_for_t.html - “Another new invention may come along to renew productivity acceleration. Or another China (or PBoC) — willing to pump up demand for dollar denominated assets — may enter global financial markets. But this hope merely highlights where macro policy of the last few years has placed us: at the mercy of the fates.”
Macro Man,
As I said when the subject of China’s investment corporation was first mooted, I doubt that it can be interpreted as backing away from the peg; in fact quite the opposite. I expect that the currency composition of the investments will remain the same, but the type of investments will change, to include less liquid but higher-yielding investments, including real assets such as equities and property, which are also less exposed to inflationary losses. To the extent that this makes the reserves holdings more economic, it can entrench the peg.
RE, I think there are two different issues at work here. In the near term, it seems likely that PIC is unlikely to change the currency composition of its holdings, and will change the asset mix relatively slowly so as not to shoot itself in the foot. (You can imagine the market reaction in the event PIC deciding to sell $200 billion Treasuries at once.) By the same tokem, it seems inevtiable to me that over longer periods of time the PIC will change the currency composition of its reserves, ultimately taking the USD to or even below its weight in, say, MSCI World- at least for its equity component.) Assuming that PIC makes its decisions based on expected local currency return, it seems inconceivable that a long -run analysis would favour a 70% or 60% or 50% weight in USD denominated securities.
More interesting to me will be the mechanics of future intervention. Will the PBOC carry on as they have been, only with a lower stock of reserves? Or will PIC take up some of the burden, being forced to issue RMB denominated onshore debt if they wish to buy dollars?
I’ve given this a lot of thought and I still haven;t made up my mind. On the one hand, one could suggest that it would be foolhardy to take on a liability in an undervalued, appreciating currency to purchase an overvalued, depreciating currency. On the other hand, PIC could be seen as having the perverse incentive to prevent any further RMB strength whatsoever, so as to avoid mark-to-market currency losses- the entrenchment of the peg that i believe you allude to above.
Or, they could have the incentive to allow massive near-term RMB strength and then use the newly strong RMB to purchase ungodly amounts of foreign assets at suddenly cheaper prices.
To a degree, it depends on what the heck the PIC will be for. If it is intended to be the foundation of China’s state pension scheme, then it will need to increase its AUM exponentially. Eventually, this should come from government tax revenues, but for the foreseeable future it seems it will come from the FX market.
I for one feel like I don’t have enough information to accurately forecast the impact of PIC on a 12 month horizon; I’d be curious if anyone else on this board does (and what those forecasts are.)
I personally like the INR (nice carry, CB in tightening mode, strong appreciation pressure) and the argentine peso (as long as you get an instrument that gives you the real appreciation) as well … I like some EM oil currencies other than the ruble was well. If you could get the domestic interest rate (3%) on RMB, I’d do that too, but you cann’t. NDFs = harder bet (no coupon).
but i would a basket of the EM world v. the $ and euro as a simple long-term play.
MMan — i’ll look for the links
Since MM brought up KrW, why should Rep of Korea (or any other nation) feel any inclination to stomach 3% real rates and watch their REER vault upwards, when the largest most advanced of surplus generators has more or less epoxied their real rates to between zero to 0.5% for the better part of a decade, irrespective of regional or global monetary and economic conditions?
here is the frankel paper (CEPR or RGE subscription required)
http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6264&action.x=12&action.y=9
an older version is also here (free)
http://ksghome.harvard.edu/~jfrankel/EvaluatgChinaCurrncyOct.doc
I think some analysts at Tokyo Mitsubishi have done similar work — but i cannot remember the relevant names to do a search.
The problem for BOK is that they incur negative sterilizaton costs and are running out of share capital as a result. But they are among the most prolific holders of yen amongst CBs, as they sell USD/JPY to prevent an extension of JPY/KRW weakness (intentional or no)- which alos explains why their sterliziation costs are negative, depsite domestic rates below US rates…
It’s difficult to believe that PIC will operate in any way that conflicts with overall PBoC reserve and FX policy - particularly given the stickiness of the central planning bias. Given that FX policy, however it develops, presumably PIC will be allowed to operate within investment parameters that are consistent with it, expanding the range of investment alternatives from what otherwise would be the case, but not independently pursuing potentially conflicting currency mix objectives. In other words, its hard to envisage a future scenario in which PIC would effectively usurp market power to the degree that it derails the PBoC’s reserve and FX management control. It will likely be the implementor of PBoC policy in this regard - not a renegade formulator. And it won’t be allowed to be driven by market incentives that are outside the comfort zone of PBoC.
Guest — i strongly suspect you are right. but it is worth noting that I also strongly suspect that some gulf investment funds pursue investment strategies that don’t help support the GCC’s $ peg. the difference — the GCC countries are all sovereign, and SAMA seems to have been willing to let the others free ride on its (my guess) more conservative approach. ADIA, KIA and QIA (in this scenario) get the returns, and SAMA ends up with the dollars …
the other point of tension that one of the PIC’s mandates seems to be to invest in emerging economies — which potentially works against the PBoC’s need to add to its $ reserves disproportionately to limit pressure on the RMB/$ v other currencies (i.e. prop the $ and thus the RMB up).
If anyone thinks the PBoC has been a big seller recently, do tell — that would force me to revise a lot of my thinking/ calculations about $ reserve growth.
Brad, I think it’s fair to say that PBOC have been fairly active in selling out some of the dollars that bought in Q1.
I wonder if, had they known what reserve growth would like like over the last few years, PBOC would have substantially lowered their USD benchmark weight in their reserve basket in 2002 or so.
any guess as to how active?
Hard to say, but I think they are one of the reasons EUR/USD has rallied so much this month. Of course, it we knew where they were and what they did at all times, they wouldn’t be Voldemort, would they?
re: voldemort — true enough. i find it hard to believe tho that the PBoC really wants a weaker RMB, yet that seems to be the result of their dollar sales …
I don’t think they literally want to drive it lower. I just think they don’t particularly want it stronger or more flexible, whatever they tell the baying hounds in the US Congress.
right, and the one variable they control is what fraction of the dollars they buy in the market they sell for other currencies …
my question is:
a) is this determined by a portfolio target (which implies holding more $ when the $ is falling to offset the rising $ value of euros and pounds)
b) something that the PBoC adjusts as they seek to find the best time to buy, and that means reducing $ sales when $ is under pressure.
c) something driven by a very specific rule geared around the incoming flow, not a portfolio target — everytime we buy $10, we sell $3 for euros and pounds and yen and won.
a and b provide a bit of extra support for the $ when it is under pressure …
Brad,
I cannot provide the answer to the question you ask, but I think it is an extremely interesting question, which merits further discussion and even investigation. There are at least two aspects to it that I can think of:
(1) What is the best intervention strategy if you track a basket (assuming that China really does of course). Given that China is a big economy relative to Korea, for example, its intervention might be more effective if it buys won, for example. It depends on the price elasticity of the currency and its weight in the basket. Perhaps this intervention is routed through the dollar, but if the dollars are quickly sold for won, then the intermediate step is irrelevant.
(2) What else are China’s reserves for? If its reserves are only for intervention against the basket, then I guess it should hold them in the basket currency composition. If not, then it may be able to overlay some currency composition driven by investment considerations. But perhaps they can do this using derivatives anyway.
I would be interested if you know of anything practical published on intervention strategy. Such issues seem to fall into a crack between academics, who tend to publish useless formalisations of problems as posed by themselves, and practitioners, who are familiar with the real problem, but are not encouraged to write about such sensitive issues.