Are currencies doing thier ‘job’?

One purpose of floating exchange rates is to help global imbalances resolve themselves (at a basic level if you are running a trade surplus then your currencies should rally (purchasing power becomes greater, other regions become more competitive, and hopefully at some point the surplus (savers) country will spend their funds…so that they debtor country doesn’t explode)).   But currencies have a large number of other influences on them (the most significant of which is capital flows), so does it work just this way.  We’ll here’s a chart that tries to tell when currencies are doing the job of resolving global imbalances (when the blue line is positive it is ‘working’).

The charts shows the 12 mth moving average of the slope of an OLS (regression…read ‘a line drawn through points’) on the real exchange rate against the current account balance.  If you are running a surplus then your currency ’should’ go up (this would mean that a positive slope suggest that the currency markets are working’).  The blue line is the sum of countries current accounts as a % of local GDP…this is supposed to get a the size of global imbalances.  So what you’d like to see it the red line (the imbalances line) close(r) to zero but to the extent that it is not one would hope that the blue line would become go higher.

Admittedly this is way too complicated for what it is trying to do and it has problems in that it is dealing with a change (in the currency) and a level, sort of, in the current account balance.  The results are some what sensitive to the period that is chosen for the currency change.  (if you are interested I’ve chosen 24 month changes).  All that said I still think it is an interesting picture….why?

Because it shows that global imbalances blew up after 97/98 when the currencies stopped ‘working’, getting more in balance as currencies ‘worked’ between 00-03, and then expanding again when currencies stopped working again.  (Although given that the world has significant non-floating currencies, its not fair to blame it all on ‘non-economic’ markets)…

What is behind the dollar fall?

The US dollar has fallen of late and speculation about a dollar collapse driven by expansive monetary policy and fiscal profligacy and facilitated by scared global and domestic investors has started in the rumor mills.  Although this speculation never stopped in some corners and it is not total without basis although I find it hard to see the dollar breaking down without the breakdown of Bretton Woods II which we seem to be returning to rather rapidly.  But that is another story….I want to point out the the recent fall in dollar might possibly be just a return to normalcy (removal of the inverse risk premium), this would match some risky asset markets but it can also be seen when you look and see that the people (at a country level) who scrambled for dollar when the crisis started are paying it back (the dollar loans the federal reserves gave out to foreign central banks are being paid back rather quickly).   (Add this to recent reserve growth and then compare that rate of growth to pre-crisis growth rates…)

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. 

Reading Between the Lines

I’m hesitant to point out this weekend’s G-7 statement because I typically think these addresses don’t really matter (and are given much more weight than they actually deserve). Although they do not directly have any significant economic impact they can affect perceptions and do provide an opportunity for global economic collaboration and help keep open and better establish the lines of communication. One interesting thing to note in the Feb 14th statement was the reversal (at least on the US side) of rhetoric with regards to China not being a cooperative economic player (remember during the treasury secretary confirmation hearings he said that they manipulated their currency). The paragraphs read like this…

We also welcome and appreciate the prompt macroeconomic response from others throughout the world. In particular, we welcome China’s fiscal measures and continues commitment to move to a more flexible exchange rate, which should lead to continued appreciation of the Renminbi in effective terms and help promote more balanced growth in China and the world economy.

We reaffirm our shared interest in a strong and stable international financial system. Excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We continue to monitor exchange markets closely, and cooperate as appropriate.

Pointing out China as having been particularly helpful seems like a stretch. Their stimulus is tiny compared to the US (particularly when adjusting for it actual and not headline impact). [as an aside consider the chart from CFR that compared the stimulus based on where the countries is relative to the world imbalances]

Given China’s desire to be perceived as a cooperative and not as an instigator this statement is likely to their liking. It also worth to note that they have noted continued appreciation in effective terms, which leaves open the window for real appreciation via inflation differentials rather than nominal appreciation. That path would be trying to walk a tightrope but it doesn’t appear to me that China has any easy paths. Export driven growth has proven to be unstable, so they need a more diversified demand base, but if the let the RMB appreciate they will have to take massive losses on mismatched foreign assets funded by domestic liabilities so the appreciation must be slow (or impair the banking system again?). It is a tough position with lot of uncertainty. A situation highly disliked by the Chinese* which seems to point toward stable or very slow appreciation.

*China history has shown on numerous occasion its distaste for volatile situations. Consider that they, while being concerned about their own independence from Russia during the 1958 Hungarian revolution, eventually supported Moscow’s crushing of the revolutionary movement. In large part because of they did not want that type of behavior (domestic uprising) to be perceived as acceptable or profitable.

Asymmetric Challanges with Currency Manipulation

A lot of rhetoric will be thrown around with regards to if China is manipulating the RMB (Chinese FX) or if it is just providing stability from swaths of speculators (two billions and growing in reserves seems to strongly suggest manipulation). Some people will argue (and I tend to lean this way) that it is better to work through back channels to encourage openness in the currency market because China does not want to appear to be submissive to U.S. demands. Others will argue that we should use our soap box and speech the truth; call a spade a spade.

A faint voice in the background may raise the following question, ‘If they are manipulating how long can it go on for?’ Currency manipulation has asymmetric sustainability. If a country is trying to hold up its currency it will only be able to do so as long as it has foreign (‘hard’) currencies to sell in order to buy the local currency (which is trying to hold up). Another possible path to defend the currency is to raise domestic interest rates. This could pull demand for domestic deposit in but is also detrimental for the local real economy because it hijacks monetary policy for external uses and may weaken an already feeble economy. Eventually interest rate increases will not be able to pull capital in because the cost will be too high (the risk of default will become very real). This game of holding up a currency is usually one that plays out over months not years (although it doesn’t always result in an fx collapse). Russia and Mexico have both been in the news of late trying to provide upward pressure on their currency. It is important to note that if a currency thinks that it will be able to unsuccessfully defend its currency it is quite likely to not use any reserves at all. Short story – holding a currency significantly above its real level for a noteworthy period of time is a losing game.

But what about holding a currency down, below its real level? This is where the asymmetry comes in. A country can hold a currency down for a significant period of time. As long as the country is willing to sell its currency in order buy foreign currency (and hold on to that foreign currency – it must because only final net demand matters) they can keep their currency down. What breaks this game down? Well eventually one would expect a country to get sick of accumulating foreign assets and want some goods instead of paper but if the entity is non economic the time required to ‘get sick’ may be very long – longer than the economic system can handle. One way this breaks is that the country whose fx is being held up against the home country fx is swamped with excess capital eventually spurring a debt crisis which makes the purpose of the policy moot (to stimulate export demand or build up foreign assets); because exports demand collapses in the falling economy and the foreign assets no longer hold their value in a failed economy (now we are not at this extreme but does this sound familiar). A second way this process breaks down is that the local country that is selling local fx is unable to sterilize it fx sales. (Meaning that it is not able to borrow the local fx to sell and needs to print it and thus expanding the money supply). This will spur inflation in the domestic country and cause real appreciation in the currency so – even if – the nominal exchange rate is kept the same it will eventually go from being an undervalued to an overvalued currency due to inflation differentials. When this switch occurs, if the country wants to continue to hold the nominal exchange rate, they will have to start selling foreign assets (hard currency) meaning they are in the second paragraph of how the manipulation unfolds. This inflationary real appreciation seemed to be happening to a number of pegged currencies about a year ago and the common belief was that they would let the nominal rate appreciate but that belief is in large part gone. The real appreciation path via inflation differentials is a risky path to work out imbalances. Inflation is not a surgical instrument but rather a snowball that you cannot control and if your goal is stability playing with inflation is not a wise strategic choice.

Did Geithnier start opening Pandora’s box of populist rhetoric?

The Bush administration or maybe more correctly the Paulson treasury used a rhetorical breeze through meetings of collaborations to urge the Chinese to move their currency toward economic equilibrium and thus easy the pressure of global imbalances.  Who knows whether this was helpful or not.  Would the fx had appreciated more or less if this encouragement didn’t happen.  In what form could we have been more forceful in demanding a solution to the global imbalances before they sunk our economic well being?  In my view public pressure on the Chinese is likely to backfire because they do not want to appear subservient to the United States.  Showing them why – although I suspect they already know – they need to adjust the currency (inflationary pressures, global imbalances) may be helpful.  As well as providing advice about a transition to a robust financial system (do we have any credibility here?). 

 

The Obama administration has quickly taken a more aggressive approach – whether this is in light of the continued large surpluses or the fact that the RMB has re-pegged to the dollar or some other reason is unclear.  This was brought into focus with Tim Geithner’s comment that ‘China is manipulating its currency.’  China didn’t take kindly to this.  I’m a little nervous about a more aggressive strategy.  It will embolden trade protectionist and its not clear to me that it will improve our chances of getting China to move it currency.  The best we can do is to adapt our fiscal situation and financial system to better handle the barrage of capital that is being sent our way. 

 

Interesting enough the last Democratic president took a similar approach to another eastern power about 15 years ago.  Japan was running significant at the time – 120 billion – trade surplus with the world in 1993 of which 60 billion was with the United States.  When talks about the bilateral imbalance stumbled comments about the problems of a weak yen emerged.  Clinton said, “there could be reasons other than closed-market policies for the lack of progress — no domestic demand, changes in exchange rates, inadequate efforts by Americans, not competitive products or services (2/11/1994)” when describing why Japan may have the surplus.  This comment was read by the markets as being negative for the dollar; bond yields rose and the yen rallied.  See the following chart for the Yen rally after the executive branch rhetoric (admittedly the massive surplus is a economic reason for the yen to rally but the 1990s were not a time of stellar economic growth in Japan).  So the very soft rhetoric worked – in large part because market participants believe that unless the Yen rallied the US would do something. 

 

 

So could the rhetoric work again except this time on China?  I’m doubtful.  First the RMB (chinese currncy) is effectively pegged; the Yen was floating – even if the BOJ would step into the fx market from time to time; thus it is not easy for the markets to do the adjustment for us (not that any spare risk capital is floating around could do the job anyway).  Hot money is already coming out (it seems like) not into China and given the state of the financial market deleveraging this seems likely to continue for some time…so sterilized fx intervention is getting easier not harder.   Second no country likes being told what to do; China especially.  I doubt they are going to take instructions from the US.  Even if we offer advice any subsequent action will need to look like it was their own.  Now if we step up the pressure via trade sanction we are shooting ourselves; demand for treasuries would fall and the world trading system – already in free fall – would become chaotic.  I suspect they would call out bluff…one of which I’m not sure we could back down from.  Did Geithnier start opening Pandora populist rhetoric?  I hope not. 

Lack of Ability or Lack of Willingness?

Ecuador defaulted on its external government debt on December 15th.  It was decried by Curtis Mewbourne of Pimco as an unusually occurrence of default based on lack of willingness rather than lack of ability because the bill was a 30 million dollar coupon payment and the country has 5 billion in reserves.  Now he may be right but I’d like to consider why his presentation is too simplistic.  He suggests that the perceived cost of a default (loss of access to the market) had gone down because they had already lost access.  This is true but it is not clear to me that Ecuador had much market access to begin with and certainty wasn’t going to build the need credibility for future access through default. 

What about the existing debt stock?  From a quick scan on my Bloomberg I see about 6 billion in outstanding debt much of it due more than 10 years into the future.  From this perspective with billions in reserves the case for willingness over ability seems very plausible.  Curtis then goes on to talk about fx policy and the significance of the federal reserve swap lines to some emerging markets for $ debt and although I agree with him on that he moved on from the Ecuador story before it was over.  Ecuador is a dollarized country.  They have no local currency so the ~5 billion in reserve is not just to pay dollar debt and pay for import but also is the money need to be the lender of last resort in the banking system and a sharp decrease in the dollar reserves could ignite a run on the banks which would require those reserves. 

Ecuador may have look at the path of reserves and said to themselves, ‘we are going to default eventually because the deleveraging cycle is not going to turn around any time soon and thus our export value is not going to recover.  It would be better to default now (and dance with some rhetoric about the illegitimacy of the debt) and have some money to back the banking system than send out our remaining reserves igniting a banking system crisis and then have no dollars to fight it.’  So at least to me it is not clear at all that the Ecuadorian default was purely of the lack of willingness…but rather a future lack of ability. 

RMB: What can the United States do?

To understand the financial crisis you have to understand the role that global imbalances played; the biggest of which is an undervalued Chinese exchange rate (and the associated public flows).  They held down the exchange to encourage their own development and growth (which provided stability).  In order to hold down the currency they needed to buy dollar assets, typically US Treasury Bill or Bonds (How did this make it to subprime?  It happened through lower interest rates and the reverse of crowding out; although internal regulatory failures and private capital allocation should not be excused).  This imported capital distorts local capital market by providing cheap capital and lower volatility, both of these factors encouraged leverage and we now understand that the great moderation certainly did not include financial assets (and only included the real economy to a small degree).  The truth is that if someone wants to build up reserves rapidly they need to hold debts and to do this someone must borrow. 

I have said in that past the we – the U.S. – doesn’t have any option to respond to fix the RMB exchange rate.  I should be more precise, we have no good unilateral option to affect the exchange rate.  Consider the following:

We could respond aggressively.  Claim that if you want to benefit from a global world, engage in a balanced way or we won’t engage with you.  This ultimatum would likely be taken as a bluff and simply end up damaging our creditability because the affects, at this point, of trying to unwind the system would be incredible disruptive.  It doesn’t seem to me to be a realistic option; people rarely shoot themselves to hurt an enemy (although they do it more often than I think they should so this should be totally ruled out).  And if protectionist sentiments show up and political pressure appears a weaker form of this foolishness may emerge. 

At the opposite end of an aggressive response would be a passive response.  Imagine we say, ‘fine, hold down your exchange rate and we’ll give you government debt for it; good luck trying to trade out of the debt.’  Funnel the capital in and take the stuff (the goods for paper trade).  This could happen through FX movement, outright default, or relatively higher inflation.  This extreme form of passivity would engender serious global conflict through massive instability.  This is also not a realistic, or at least a very unattractive, option in the extreme.  Although in a more mild sense it seems inevitable because it hard to imagine getting the total current ‘value’ for the reserve being held by China. 

Or we admit that changing the exchange rate is out of our hand (although pointing out to China that it in their own interest with regards to long term domestic and international stability might help) and then run responsible fiscal policy (not right now given we are entering a period of paradox of thrift/severe contraction) which would (eventually) force the reserve holders to buy non government debt; if they wish to really accumulate an extreme amount of debt.  This would mean that if they wanted to finance private consumption or private investment they would be taking the credit risk.  If they were pushed into a position of having to buy risky debt it would keep the pressure of excess dollar creation away from the banking system (admittedly they could start using deposits but there are problems with this as well) or they would have to look for dollar debt of other sovereigns which may help share the ‘burden’ of being the marginal borrower and running up debt. 

In my view at the end of the day we can’t force them to change their policy; they will focus on domestic stability and are not interested in much else (personal view).  We can positions ourselves more robustly so that when imbalances unwind that we can handle shifts in a better way.  We can also try to shine light on the reality that their domestic stability is a function of global stability and that although it is hard to see holding down their currency for too long will expose their system to risk that they will import from a gyrating world.  They have gotten a taste of this in 2008 and will get more in 2009.  Hopefully the pieces connect that they realize that being a major global economic power means that you can’t grow at the expense of global imbalance or if you do that it is only short term gains for long term pain.

China’s addiction to subsides

I would be nice if the world came out of this crisis understanding that resolving global imbalances is the key to global stability and thereby sustainable growth.  Coordinated behavior would be ideal (fiscal stimulus, floating currency, open trade and a larger IMF) but on an individual level it seems that emerging countries will take the view that they need to hold more reserves (run a current account surplus) like they did after 98; in order to ensure national stability. 

This desire for stability is global but China, in my view, has established it as the number one priority.  The puppeteers of the Chinese economy believe – correctly – in two source of instability: (1) slow growth (<8%) which would not absorb the urbanizing population and (2) inflation which would destroy the real income of the population and break down the pricing mechanism.  Their policies are situated to optimize stability.  Notice that they let their currency appreciate when they started to have inflation pressures.  It is my view that they are taking a very narrow sighted and costly view of stability by ensuring domestic stability at the cost of global imbalances (and thus global instability). 

Holding down their exchange rate appears to be a great strategy to gain a competitive advantage in order to accelerate development and enhance your growth rate.  If this is the case why doesn’t everyone do it?  First exchange rates are by their nature relative; not everyone can be undervalued.  Second if you hold down your exchange rate you will have to accumulated the overvalued currency; overvalued suggests that the buyer will take a real loss on this in the future at some point.  If the foreign assets (FX reserves) are small the country may be able to move out before they fall but in China’s case they will either lose when the FX rates equilibrate or if they try to buy real assets they will end up pushing the prices up and receiving poor future returns.  It seems very unlikely they get anywhere near what they put in [note: this doesn't mean it was a bad trade, they develop much more quickly than they otherwise would have]. 

What if the real exchange rate equilibrates through higher inflation in China and thus they don’t have any nominal losses (maybe even gains) on their foreign assets?  This is a good question.  Let me first explain why.  For China to buy FX they need to get the RMB to sell.  To do this they must borrow, use tax revenue, or print it.  The amount of FX is much too high to come out of the tax base so it leave the borrowing (sterilize interventions) or printing (unsterilized).  Now china has a very high saving rate (largely corporate) and they have in part funded this through increasing reserve requirements (increased borrowing from the banks).  It’s hard to imagine always being able to fund this domestically (firms have good and bad times…and how much do they want to save) and the reserves have a limit of how high they can be raised (and you’re messing with monetary policy).  So eventually China will have to let the FX appreciate or print money.  If they print money then expect inflation to accelerate.  So back to the question…this could happen but it hard to see it happening in a controlled way.  The FX would flip from undervalued to overvalued and capital flight ensue.  They have built up their reserves quickly but the fall would be faster.  Given that they desire stability this would be an unwise path but this could happen as a product of taking the short sighted path of gaining export share in order to maintain economic growth.  (Also the capital formation has not been a function of an equilibrium and thus it seems less likely than is typical that the capital is invested efficiently which could lead to longer term problems). 

Ignoring the crux of the story which is optimizing stability and ignoring what should be the crux which is global imbalances, holding down your exchange rate in order to gain export share and accumulating reserves is a large give away.  From the US perspective it is more complicated than just receiving free stuff (trading paper for goods)….(more on this to come).