Dollar Trap

A somewhat popular topic of late is the ‘dollar trap’that China is in.  The short story is that China has held down their currency in order maintain domestic stability (the connection is lower exchange rate means a more competitive export sector which means faster economic growth which means increased domestic stability).  The price for holding down the currency is that they have to buy dollars at an overvalued price.  They have been doing this for years and have a accumulated a large  quantity of dollar assets (let’s say 1.5 trillon).  That means relatively small changes in the dollar exchange rate will cause large losses (which in the context of a slowing economy may inspire domestic strife…remember goal number one is domestic stability).  If they stop buying dollars the RMB will appreciate against the dollar and they will lose competitiveness and exports growth will slow (it has collapsed of late due to the down turn; remember you can be the most competitive but in a shrinking market you’ll still lose sales) but if you continue to buy dollar this rope around your neck will tighten (What I mean by the rope tightening is that (1) if you buy the dollars with unsterilized RMB inflation will occur (eventually) which is very destabilizing, (2) if you buy the dollars with sterilized RMB you have to fund it with debt which will eventually cause an asset liability mismatch which will bankrupt the government, or (3) if you sterilize the transaction with surplus receipts you’ll impoverish the people (destabilizing) negating the point of economic growth. 

Zhou Xiaochuancame out with a proposal to allow the PBOC to exchange their dollar at the IMF for SDR (a diversified currency basket), this would only change the trap from a dollar trap to a global currency trap and move some of the dollar risk on the IMF.  I’m also skeptical of the idea of the SDR replacing the Dollar as the world reserve currency (I won’t go tangent with this topic as that not what I’m trying to get at).  I would be very surprised if this were to happen. 

The economist has an article on this topic and a response came from Fred Bergsten at the Peterson Institute for International Economic which I found very odd. 

SIR – The punchline to your article on China’s foreign-exchange reserves is that “China cannot sour on the dollar without letting its own currency rise” (Economics focus, April 25th). This is not correct. China can continue to hold down the yuan’s exchange rate by buying dollars but then convert those dollars into euros or other hard currencies. The exchange rate between the dollar and the euro would change but the yuan would remain substantially undervalued.

Maybe I’m missing something but he seems to suggest that one could influence the FX markets but routing your trades through a middle currency.  This doesn’t strike me as right.  It doesn’t matter what currency is the transaction currency or the middle man currency but rather the final demand (the ‘final’ resting place) of the value.  His statement seems to suggest that when the market has dollars sold into it and the euro bought from the market that they are stuck with those assets.  The traders will look across all the pair and see where they can get the best deal for the dollar they bought with the euros…the ‘final’ resting place will determine value.  Thus if China want to ensure a cheap RMB vs the dollar they must store the value in dollars. 

He also suggest that the SDR swap would be a means to convert the portfolio without taking exchange rate risk; this strikes me as missing the point.  We could do a swap that would get China out of this position but that would ignore the imbalances that they have fueled and encourage others to do the same.  (And no one is going to want to take the other side of that swap).  Like I noted above the SDR swap would convert the dollar trap into a global developed currency trap (or anything else that we want to swap it to) which would not resolve the underlying issue that the RMB is undervalued and would only allow the imbalance to continue. 

The problem is imbalances and the cost to Chinese is excess dollar accumulation….they can’t escape those cost but hopefully the more obvious the risk become the more willing they will be to help resolve the imbalances. 

More of the Same

The Fed’s Flow of Funds came out last week.  For the most part it wasn’t particularly surprising but in a way this seems like a misstatement because it was what one would expect it was also extreme. 

(1) Federal Deficit Grows – Federal Debt grew at an annualized rate of 37%. The government (in a extremely useful way) moved to fix the banking system and facilitating the deleveraging process (and will continue for years – although this growth rate will likely drop, but the $ amount will remain high).  The federal government doesn’t usually have large net financial investments (buying of financial assets) for the last 2 quarters it has run at an annual rate of 1.3 trillion dollars.  While the increase in debt has run at an annual rate of over 2 trillion (2.35 trillion in 4 Qtr). 

(2) Monetary Authority – The central bank has taken over the banking system.  Expanding its liabilities in the 4th quarter, on an annualized basis, by 2.2 trillion dollars (nearly half of that going direct into the credit market and a quarter doing to foreign central banks and bank loans). 

(3)De-leveraging – Household debt dropped by 2% and business debt grew by a anemic rate of 1.7%.  HH saving has jumped from 32.5 Bill (2005), to 70.7 billion (2006) and 57.4 billion (2007) (read as no savings) jumped to 343.2 billion in the 4th QTR on an annualized basis.  This has likely accelerated into 2009 (assuming income haven’t fallen hard enough to induce the real paradox of thrift).  The way in which they saved (or what they did the savings) was also interesting.  Instead of buying more financial assets they tended to pay down debts.  Not surprising given the environment but not usual. 

(3) Financing – Credit markets continued to be ravaged by the collapse in the securitization market.  Home mortgages credit dropped by 248 billion on an annualized rate.  ABS issuers withdrew 371 billion and finance companies withdrew 102 billion.  Commercial Banks did not help in the 4th quarter withdrawing 144 billion.  The only provider of credit was the GSE and GSE backed pools which provided 86 and 287 billion respectively. 

Small Note: Security credit tanked in the 4th quarter, contracted by over 1 trillion on an annualized basis.  It could be interpreted as margin credit being bulled from small investors.  Was it due to margin calls due to falling equity prices or did brokers tighten credit and cause sales which hit equities.  Can’t tell just from that line but it is an interesting small note.