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CiteI’ll be in England next week, visiting the Global Economic Governance Programme at University College, Oxford and participating on a panel at the Euromoney fx forum.
I plan to post on Monday and Tuesday. But not later in the week. I’ll be running around London on Wednesday and Thursday — and seeing just how far (or not) a buck takes you in Europe's — if not the world's — biggest financial center these days.
The panel is on central bank reserve diversification. If anyone has any advice on what I should emphasize (or tips about the behavior of the world’s big central banks), I am all ears!
Brad,
I am sorry that I won’t be at the fx conference myself, but here are three possible points that you could make in the panel discussion:
(1) The schizophrenic/inconsistent attitude of EMU to the use of its currency for reserves – they want it to rival the dollar, but they don’t like it to strengthen.
(2) Why isn’t the yen a bigger reserves currency? Japan is a pretty stable, reliable country with a large share of world trade and a sophisticated financial system. The yen does not pay much interest, but it is not losing internal value and is historically cheap – cf gold. Perhaps the market quietly fears that so many yen have been printed that high inflation and depreciation is a threat?
(3) Others (Russia, China) may be increasing their share of gold, so/but is now a good time for the US to sell some of its huge gold holding?
Have a good trip to Britain – weather-wise, the new France!
what about the following from lombardstreetresearch (http://www.lombardstreetresearch.com):
ZIRP – now a disaster
WE SUGGEST: BoJ should – but won’t – hike interest rates aggressively
SUMMARY: Against conventional wisdom, we have argued for some time that
normalizing Japanese interest rates would stimulate the economy. Raising rates
transfers income from debtors to creditors. It boosts demand if creditors increase
their spending more than debtors reduce theirs. This is likely to happen in Japan.
Households are the creditors. Companies, government and foreigners are the debtors.
This note looks at the impact on household income. It will be followed by others
looking at the impact on debtors.
Using orders of magnitude (as I always do), Japanese households’ gross financial assets
were ¥1,500trn at end-2006. Gross financial liabilities were ¥400trn and net assets
¥1,100trn. Nominal GDP is at an annual rate of ¥500trn and personal disposable income at
¥300trn. Household financial assets are thus three times nominal GDP and five times
disposable incomes.
Gross assets split into
· 30% non-interest bearing – mostly currency but also insurance and pension
reserves
· 20% equity and bonds
· 50% interest-bearing deposits – 1½ times GDP and 2½ times disposable incomes
Lombard Street Research – Daily Note – http://www.lombardstreetresearch.com
While interest rate changes affect equity and bond yields, they are only one factor and do
so indirectly.
Home loans account for nearly 50% of households’ gross financial liabilities. Over the next
couple of years, the bulk of home loans will be fixed rate. Most other loans from
government and public corporations are also fixed rate.i Consumer credit accounts for 10%
of liabilities and can be taken to be at variable rates. Roughly only a quarter of liabilities
are at variable rates. Japanese households have been mostly unable to take advantage of
falling and low mortgage lending rates. Early mortgage repayments are penalised. House
prices have tumbled and there is little equity to withdraw, indeed in many cases there is
still negative equity.
Receipts Consumer credit payments Home loan payments Total payments
The Japanese receive peanuts from their huge liquid interest bearing assets. Their income
interest receivable has slumped. But because so much of their liabilities are fixed rate and
long term (housing) their interest payments have hardly declined. And the interest rates
they pay on liabilities are far higher than they earn on their assets. Consequently they now
pay more interest on consumer credit and home loans than they earn on their assets. Gross
personal disposable income has slumped. But it would have fallen far less if interest
receipts had not collapsed so dramatically, while interest payments remained largely
unchanged.
Subtracting the ¥100trn of variable interest liabilities from the variable interest on ¥750trn
liquid assets gives a difference of ¥650trn. This is a bit over twice disposable incomes and
a bit over once times nominal GDP. So normalizing interest rates to say 3½% would add
6% to disposable income (assuming marginal tax equalled average tax) and over 3% to
GDP if the marginal savings rate equalled the average which is less than 3%. Consumer
spending is 60% of GDP and corporate investment 15%. To offset such a rise in
consumption, investment would have to fall 12%.
This is only the beginning of a more complex story. Changing the marginal tax and savings
rate assumptions will affect it. There is also the important impact on the Yen and the less
important effect on the budget deficit. These subjects must await later notes. But
meanwhile the following charts show that our a priori case is immensely strong. The ZIRP
Lombard Street Research – Daily Note – http://www.lombardstreetresearch.com
was designed to transfer income from creditors to debtors when company and banks’
balance sheets needed to be restored to health. It worked partly because the household
savings rate collapsed. But now companies are highly profitable and flush with cash. With
25% of GDP profit they don’t need to borrow to finance 15% of GDP investment. The
ZIRP has done its job. Now is the time to transfer income back to the personal sector.
Brian Reading
Dollar’s drop challenges U.S. global power
http://www.iht.com/articles/2007/04/27/business/dollar.php
” NEW YORK: The United States may have no military equals, but the challenges to its financial power have become impossible to ignore.
A stark reminder came on Friday when the weakening dollar slumped to a record low against its main rival, the euro, after the U.S. economy recorded its fourth consecutive quarter of below-trend growth. The euro hit a record high of $1.3680.
“The United States is a power, but it’s hardly the only power, and it’s certainly not a superpower anymore,” said Jim Rogers, who co-founded the Quantum hedge fund with the billionaire investor George Soros in the 1970s.
The dollar is perhaps the biggest problem. As a net debtor, the United States must attract some $3 billion every working day to finance a gaping current account deficit that in 2006 amounted to 6.5 percent of gross domestic product.
Economic rivals like China and Japan, on the other hand, boast massive surpluses.
“Historically, no country that has gotten itself into this situation has ever come out without a crisis,” Rogers said. “We’re in a great amount of trouble.”
Brian, I agree about Japanese interest rates…..Making the carry trade less attractive might also be good for financial stability outside Japan.
I think that preventing asset prices from returning quickly to sustainable levels has also caused slow-burn problems as people defer activity as they wait for a correction – there was a letter about this in the Financial Times around the same time as yours. There is so much rubbish written about Japan’s “policy mistakes” by those who assume that persisting economic weakness must mean that policy has not been loose enough, and stop looking for other explanations.
But I suspect that, in making their decisions, the BoJ have also had to take account of pressure from the government who wish to keep their debt interest costs low, and to show willing to the Americans who hope that low interest rates will boost demand for American products.
Rebel, my view on the matter is that the EMU has resigned itself to a stronger Euro. There is not much that the EMU can do to persuade America to get its financial act together. By default, people will flee to Euros from the little green stinkers. The best EMU members can do is prepare for further dollar weakness–by getting its exporters to hedge, for instance.
I don’t recall there being much celebration in the EMU when the Euro surpassed the dollar in terms of worldwide circulation or in bond issuance. These countries are taking it in stride; Italy for one is not keen on being clobbered further by artificially cheap Chinese exports.
Brian Reading’s letter to the FT on how Japan can combat deflation is worth reading. They’ve tried practically every conventional remedy but haven’t escaped from it yet. My own take is more drastic and is tied to demographics. Japan should allow workers from populous Asian neighbors to immigrate to Japan. It’s probably never going to happen in such a homogeneous society, but it’s a step forward.
Who pays households the interest? – the banks. Raising short rates will put pressure on bank margins. Even if the yield curve doesn’t adjust as well, the banks will factor the difference into the fixed rates they charge – i.e. fixed rates will go up. Existing household fixed rate liabilities therefore will renew at higher rates. There’s no free lunch.
Emmanuel: There were several letters to the FT about Japan on successive days. Another one that I did not mention above argued that the Japanese were reluctant to save because they expect to need wealth in future to cover present government deficits and the reduced proportion of workers. This agrees with what I have heard from older Japanese.
Guest: Ultimately, the banks’ borrowers pay the higher interest rates, so there is a free lunch – for the Japanese anyway – if the stories about foreigners borrowing for the carry trade are true. One criticism I would make of Brian Reading’s letter is that it did not make clear what currency household’s assets and liabilities are denominated in. Anecdotally, many Japanese have foreign currency savings, which would reduce the force of his argument.
RE – Numbers cited are ¥650trn in variable rate deposits; ¥400trn in liabilities. But he focuses on short term gains on gross deposits without considering that liability rates may also go up, albeit with a lag. That could do even more damage.
Rebel–Ricardian equivalence, natch. But, why isn’t the same thing happening in the US with everyone (citizens and government) spending profusely? Surely the imminent retirement of 80+ million folks and bloated deficits do matter–we’ll see; I’m not sanguine on the fate of US sharecropper society.
Also, the letter about Japan you describe seems to bolster my case: More retirees, a smaller workforce, and large government debts could be countered with more welcoming migration policies. We can dream, no?
—
Everyone–here’s a fine, detailed article on the political dilemmas caused by a strong Euro that I found at Mark Thoma’s blog: New Euro Record Prompts Quiet Grumbles.
1) Diversification may be seeked only when reserves get large
because
WHEN RESERVES ARE NOT LARGE, they serve the purpose of CB intervention so must be kept in both US$ and in the currency of intervention, and must be invested in liquid asssets.
The crucial topic here is:
2) are EU short term bonds as deep and liquid as US, or national segmentation limits their liquidity? Yen etc.
WHEN RESERVES BECOME “LARGE”… -
3) What is “large”?
When reserves get “large”… CBs can think of diversifying, but what are the constraints to diversification?
4) CONSTRAINT1 Relationship between diversification and sterilization (div. makes ster. difficult)
but not CONSTRAINT2 “avoid div to keep the overall US$ value high”, no CB does that and since you tent to use this argument I would be careful to present some evidence or I would not use it. (“CBs in the world are many, each is smll and they don’t coordinate” is the conventional wisdom, burden of proof on you)
CRITERIA FOR CHOOSING THE CURRENCIES IN WHICH TO DIVERSIFY:
risk and reward.
Reward:
5) can CB beat mkts? I would focus on: “do CBs have some infOrmation advantage over mkts?”, try to adjourn and renew this old theme.
But “more important for a CB must be managing risk”.
6) Define risk as not just the CB balance sheet but the risk of the whole country’s Balance of Payments from external shocks.
The Currency denomination of foreign debts and assets matters. + interest rate risk + commodity prices risk + [expo & impo currency denomination AND price pass-through].
The correct diversification is the one seeking a portfolio that offsets as much as possible external shocks. For ex. if you have many US$ debts you should have Res in $ etc. The difficult problem is how stable are correlations of prices of G&S with exrates…
So CBs should use modern portfolio theory but in a higly competent and original way.
Should hire Gheorghius.
Gheorghius,
I am puzzled by your constraint 1 on large reserves. Sterilisation attempts to absorb the additional domestic liquidity created by selling domestic currency. What currency you buy as you intervene, or later to diversify, is almost irrelevant, isn’t it? I would be interested if you would expand your argument.
i would suggest that reminding folks that the total stock of dollar reserve accumulation is BIGGER than any diversification is useful. dollar diversification tends to get branded as wholesale dollar selling, even as central banks keep accumulating, accumulating, accumulating.
Diversification should correspond roughly to the importance of currencies in imports and external liabilities. But reserves for a $ pegged currency will be disproportionately large in $. Therefore diversification effectively diffuses the peg to other currencies, since $ spent are sourced from the primary peg. Once the primary peg is in place, it’s more difficult to distinguish the motive for diversification as between peg diffusion and true precautionary reserve purposes.
As Gheorghius mentions, the China yuan has been depegged from the US Dollar into a basket of currencies. The rational for previously pegging the Chinese currency to the global US dollar reserve currency was to provide monetary stability, and never to build excessive foreign reserves. It is the US government that has abused the reserve status of the dollar by running massive deficits without tears. While the daily fluctuation is limited to a fairly narrow band, the China yuan has slightly appreciated versus the US dollar over the past year. The basket of currencies for the current currency peg contains a large Japan yen component that has devalued versus the US dollar. The net impact on the Chinese yuan is the cancellation effect from the rising Euro and falling Japan yen. Until US policymakers address the carry trade that depresses the Japan yen, the Chinese yuan is unlikely to rise further versus the US dollar.
RE: “almost”, as you say.
Suppose country A pegs to the dollar, but wants to diversify its growing dollar reserves.
Diversification (selling $ against Euro, £, Yen) increases the dollars circulating, hence the downward pressure of the dollar exrate against all currencies, including country A currency. This obliges country A to more intervention hence to more sterilisation.
Gheorghius,
I see what you mean. Basically, if a country pegs to a particular currency, I think it cannot diversify without accumulating more reserves than it needs to maintain the peg only. Right?
This is something that Brad could mention. As I have said before, I do not think that China’s foreign exchange investment corporation means that they will be diversifying out of the dollar; in fact, it makes the existing currency peg more sustainable. What it does mean is that they will diversify into different instruments, including equities, property etc.
tmcghee — my instincts were very similar. the key point right now is that central banks are adding to their reserves very, very rapidly and thus buying more of everything, but crucially, providing a lot of demand for us dollar debt when there isn’t that much demand from private buyers …
who should be on a diversification watch? India is on my watch (already diversified, but might want to do more), as is Russia (same issue) and Korea …
I think SAMA should diversify, but i haven’t heard rumors …
PBoC is stuck it seems to me — as it effectively has a currency that is managed v the $ with a slow rate of crawl (it isn’t technically a peg, but it doesn’t move like a true basket peg currency either)