China, Japan to launch yuan-yen direct trading

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Trade between Asia’s two largest economies is about to get a whole lot easier. China’s central bank confirmed Tuesday that the country will allow the direct trading of its currency against the Japanese yen starting Friday.

VIDEO: CHINA, JAPAN TO LAUNCH YUAN-YEN DIRECT TRADING CCTV News – CNTV English.

This makes the yen the first major currency besides the US dollar that can be directly traded with the RMB. The move is part of efforts made by China and Japan to strengthen cooperation in trade and financial markets. And it’s a huge step forward for the internationalization of the yuan.

After some excitement in the Asian markets yesterday. The People’s Bank of China confirmed on Tuesday that China and Japan will start to directly trade their currencies in Shanghai and Tokyo from June 1. The move will shore up trade and financial ties between Asia’s two biggest economies, and also marks another step to raise the yuan’s international role.

Japanese Finance Minister Jun Azumi, who announced the decision in Tokyo, stressed the cost benefits behind the move.

Azumi said, “By conducting transactions without using a third country’s currency, it will bring merits of reducing transaction costs and lowering risks involved in settlements at financial institutions. It will also contribute to improving convenience of both countries’ currencies and reinvigorate the Tokyo market.”

The step eliminates the US dollar’s monopoly position to set the exchange rate between the two currencies, and follows a deal struck by the leaders of the two countries in December.

Experts say it’s an important move towards the internationalization of China’s yuan currency.

Professor Ding Zhijie, dean of School of Banking & Finance, UIBE, said, “It raises the convertibility of the yuan. And I believe the yuan trading will be accepted by more Asian economies as well as the international markets. It will also push forward the internationalization of the yuan.”

Several banks in the two countries, including Bank of Tokyo-Mitsubishi UFJ and Bank of China, will start the direct trading.

Huang Jiaying, trade with Bank of China said, “The move will likely make the yuan accepted by more Japanese investors as well. It will also help boost the possibility of the yuan becoming an internationally-settled currency, which is an important move of propelling the yuan to become an international reserve currency.”

And Japan, which in March pledged to buy about 10 billion US dollars of Chinese government debt, is the first economy to connect with China’s yuan. The move is likely to strengthen ties with its biggest trading partner.

Japan, China to shore up yen/yuan trade

Japan and China will start trading their currencies directly in Tokyo and Shanghai from June 1 in a move that shores up trade and financial ties between Asia’s two biggest economies and also marks another baby step to raise the yuan’s international role.

The step eliminates the use of the dollar to set the exchange rate and follows an agreement struck by the leaders of the two countries in December, which also involves Japan buying Chinese government debt and efforts to forge a free trade pact between China, Japan and South Korea.

“This is part of China’s broader strategy to reduce dependence on the dollar. The yen has been chosen because of large trade flows between the two countries,” said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong.

“Volumes of currency trading on shore are small, but this could lead to an expansion of trading with other currencies. It would be easier for China to expand into other Asian currencies.”

Japanese Finance Minister Jun Azumi, who announced the decision in Tokyo, stressed the cost benefits of the move.

“By conducting transactions without using the third country’s currency, it will bring merits of reducing transaction costs and lowering risks involved in settlements at financial institutions,” Azumi told reporters after a cabinet meeting.

The People’s Bank of China noted benefits for mutual trade, but also tied the decision to China’s drive to boost the use of the yuan as a settlement currency for trade and financial transactions.

“Developing the direct yuan/yen trading will help form the direct yuan/yen exchange rate and reduce the trading cost for entities and promote the use of the yuan and yen in bilateral trade and investment as well as help strengthen financial cooperation between the two countries,” it said in a statement.

A separate statement issued by the China Foreign Exchange Trade System said it will provide a market-making system for direct yuan/yen trading.

Until now yen-yuan rates were calculated on the basis of their respective rates against the dollar, so the move is expected to narrow trading spreads, lower transaction costs and allow more trade deals to be settled directly.

For Japan, which in March pledged to buy about $10 billion of Chinese government debt, becoming the first major economy to do so, the move could strengthen ties with its biggest trading partner.

Despite sometimes rancorous political ties between the two neighbours, Japan’s economic fortunes are increasingly tied to China’s economic growth and consumer demand.

Dealers in Shanghai said the near-term effect would be probably higher trading volumes and lower costs.

“Direct yuan-yen trading is likely to cut trading costs, boosting yuan-yen trading liquidity,” said a dealer at a foreign bank. “Most yuan trading against the yen now goes through the dollar, because traders refer to dollar-yuan value to price yen-yuan.”

But some played down the broader impact.

“From what I can see, it doesn’t actually include any opening up of the capital account at all. It just allows a direct cross to be traded rather than actually increasing the amount of flow that can happen onshore to offshore,” Dominic Bunning, currency strategist at HSCB in Hong Kong, said.

“It seems to be more of a technical issue rather than a major development.”

The move to facilitate yen-yuan trading and the debt deal are part of Beijing’s long-term efforts to elevate the yuan’s status as an international currency, which so far have mainly centred on China’s promotion of the yuan to settle trade.

Beijing has struck agreements with several nations from Malaysia to Belarus and Argentina on the use of the yuan in trade and other transactions. It has expanded a pilot programme started in 2009 into a nationwide one allowing firms to settle their trade in yuan.

The result has been a relative surge in the use of the currency. More than 9%of China’s total trade was settled in yuan in 2011, up from just 0.7% in 2010.

Few argue against the idea that the yuan will one day become a reserve currency, given World Bank predictions that China will overtake the United States as the world’s top economy before 2030. But to achieve that the yuan would need to become fully convertible and Beijing has yet to indicate any timetable for reaching that stage..- Reuters

Related post/stories

• Demise of US dollar as world currency
• Crossover: Investors’ reaction to Yuan-Yen direct trading 2012-05-30
• China and Japan to start direct currency trading 2012-05-30
• China-Japan direct currency trading to boost economies, trade 2012-05-29

Euro, death approaching soon ?

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Death of a currency as eurogeddon approaches

It’s time to think what hitherto markets have regarded as unthinkable – that the euro really is on its last legs.

They need to wake up fast; it’s happening before their very eyes. In its current form, the single currency may always have been doomed, but it has been greatly helped on its way by an extraordinarily inept series of policy errors. Photo: AFP

 By Jeremy Warner, Associate editor – Telegraph

The defining moment was the fiasco over Wednesday’s bund auction, reinforced on Thursday by the spectacle of German sovereign bond yields rising above those of the UK.

If you are tempted to think this another vote of confidence by international investors in the UK, don’t. It’s actually got virtually nothing to do with us. Nor in truth does it have much to do with the idea that Germany will eventually get saddled with liability for periphery nation debts, thereby undermining its own creditworthiness.

No, what this is about is the markets starting to bet on what was previously a minority view – a complete collapse, or break-up, of the euro. Up until the past few days, it has remained just about possible to go along with the idea that ultimately Germany would bow to pressure and do whatever might be required to save the single currency.

The prevailing view was that the German Chancellor didn’t really mean what she was saying, or was only saying it to placate German voters. When finally she came to peer over the precipice, she would retreat from her hard line position and compromise. Self interest alone would force Germany to act.

But there comes a point in every crisis where the consensus suddenly shatters. That’s what has just occurred, and with good reason. In recent days, it has become plain as a pike staff that the lady’s not for turning.

This has caused remaining international confidence in the euro to evaporate, and even German bunds to lose their “risk free” status. The crisis is no longer confined to the sinners of the south. Suddenly, no-one wants to hold euro denominated assets of any variety, and that includes what had previously been thought the eurozone safe haven of German bunds.

Investors have gone on strike. The Americans are getting their money out as fast as they decently can. British banks have stopped lending to all but their safest eurozone counterparts, and even those have been denied access to dollar funding. The UK hardly has anything to boast of; it’s got its own legion of problems, many of them not so dissimilar to those of the eurozone periphery.

But almost anything is going to look preferable to a currency which might soon be assigned to the dustbin of history. All of a sudden, the pound is the European default asset of choice.

What we are witnessing is awesome stuff – the death throes of a currency. And not just any old currency either, but what when it was launched was confidently expected to take its place alongside the dollar as one of the world’s major reserve currencies. That promise today looks to be in ruins.

Contingency planning is in progress throughout Europe. From the UK Treasury on Whitehall to the architectural monstrosity of the Bundesbank in Frankfurt, everyone is desperately trying to figure out precisely how bad the consequences might be.

What they are preparing for is the biggest mass default in history. There’s no orderly way of doing this. European finance and trade is too far integrated to allow for an easy unwinding of contracts. It’s going to be anarchy.

It’s worth stressing here that for the moment the contingency planning is confined to officialdom. This week, for instance, we’ve had the Financial Services Authority’s Andrew Bailey admit that he’s asked UK banks to plan for a disorderly breakup of the euro. He’d be failing in his duties if he hadn’t. Europe’s political elite, as ever several steps behind the reality, still regards the prospect as unimaginable.

They need to wake up fast; it’s happening before their very eyes. In its current form, the single currency may always have been doomed, but it has been greatly helped on its way by an extraordinarily inept series of policy errors.

First there was the disastrous suggestion from Angela Merkel and Nicolas Sarkozy that if Greece didn’t buckle under it might be chucked out. Markets reacted logically, which was to sell bonds in any country that looked vulnerable and chase “safe haven” assets, thereby making it much harder for governments to fund themselves.

The blunder was compounded by attempts to underpin confidence in the banking system by forcing banks to mark their sovereign debt to market. This may only have recognised the reality, but it also destroyed the concept of the “risk free asset”, forcing banks for the first time to apply capital to their sovereign debt exposures. Unsurprisingly, they stopped buying sovereign bonds, again making it harder for governments to fund themselves.

But perhaps the biggest sin of the lot was effectively to render all credit default swaps (a form of insurance against default) on sovereign debt essentially worthless, or void, by making the Greek default “voluntary”.

This has made it impossible to hedge against eurozone sovereign debt purchases, and thereby destroyed the market. Worse, it’s made investors believe that the euro cannot be trusted, that it’ll repeatedly find ways of reneging on contract. That’s the point of no return. This is no longer a serious currency.

Changing the international monetary system

 

Image via Wikipedia

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THINK ASIAN By ANDREW SHENG

ON Oct 5, 2011, the Triffin International Conference celebrated the 100th year of birth of Robert Triffin, a Belgian economist who was trained in Harvard, worked in the US Fed, taught in Yale and then returned to Europe to help work on European monetary integration.

He was of course famous for the Triffin Dilemma, defined as the inconsistency between the domestic needs of the reserve currency country and the external needs of the world that uses the reserve currency. Put in another way, Triffin identified that the reserve currency country would have to run a current account deficit in order to provide the world with greater liquidity.

Over the long term, running cumulative current account deficits becomes a large debt overhang that is called the Global Imbalance.

Triffin wrote about the Dilemma in the late 1960s, when the United States was struggling whether to maintain its peg to gold, which it abandoned in 1971. This removed the anchor of the Bretton Woods system of fixed exchange rates, which had been in existence since 1947.

The succeeding Bretton Woods II, or non-system as some critics call it, has become a system of flexible exchange rates, plagued by financial crises every decade in the 1980s (Latin America), 1990s (Mexico and East Asia), 2007-9 (US subprime) and today, the European debt crisis.

Today, there is sufficient awareness that the shift from a unipolar world to a multipolar global financial system carries with it great risks and unknowns. The unipolar world of dominance by the US dollar had a lot of advantages, as long as the US remained the unchallenged hegemonic power. The US dollar became not only the standard unit of account for global trade, but also the deepest and most liquid market and an important store of value.

The price of oil, gold and other important commodities are all measured in US dollars. The US Treasuries market is the most liquid and efficient clearing system, which is one fundamental reason why the dollar remains superior to the euro, which does not have a single eurobond market, being divided into different national (German, French, etc) bond markets.

According to the BIS (Bank for International Settlements) April 2010 survey data, the US dollar today still accounts for 85% of global foreign exchange trading, compared with 39% for the euro, 19% for yen and 13% for sterling (because FX transactions are paired, total turnover sums up to 200%). By contrast, the Hong Kong dollar accounts for only 2.4% and the yuan 0.9% of turnover.

Because of its dominance in international trade and payments, the US dollar still accounts for nearly two thirds of total foreign exchange reserves. China alone reputedly holds roughly US$2 trillion in US dollar assets in the foreign exchange reserves and holdings by Chinese banks and state-owned enterprises.

In 2009, People’s Bank of China Governor Zhou Xiaochuan called for the use of the SDRs (International Monetary Fund’s Special Drawing Rights) as a possible global reserve currency. The logic for a globally issued reserve currency as opposed to a nationally issued reserve currency is impeccable. Nationally issued reserve currencies are subject to the Triffin Dilemma, because countries, however strong, will sooner or later go into deficit.

In other words, the whole global financial system is stable when the national reserve currency country is strong, but it will go into crisis, when the national reserve currency country goes into crisis. This is the current state of affairs.

The four reserve currency countries (US, euro area, Britain and Japan) accounting for just under 60% of world GDP are all in deep trouble. The US is running a current account deficit in excess of 3% of GDP and a fiscal deficit over 9% of GDP in 2011. At the end of 2010, the US had a gross foreign liability of US$22.8 trillion or 157% of GDP. Thank goodness that most of the debt is in US dollars, so that it can devalue its way out of debt.

The euro area as a whole has a smaller current account deficit of 0.5% of GDP, but if you look deeper, there are deep imbalances within the eurozone. Germany, the Netherlands and a few are in surplus, whereas the smaller countries like Greece, Portugal, Ireland and Spain all have net foreign liabilities exceeding 50% of GDP, an indicator of crisis using the Asian crisis experience as rule of thumb.

Britain has a fiscal deficit of 8.8% of GDP and gross debt of 81% of GDP. Its one advantage relative to the Euro is that it can devalue its way out of debt.

Japan, on the other hand, has a net foreign surplus of 50% of GDP, being a major net lender to the rest of world, since it runs a current account surplus of 2.3% of GDP. Its vulnerability is, however, its large domestic gross debt of 220% of GDP, growing larger every year with fiscal current account deficit of 8.3% of GDP in 2011. This means that the domestic debt is vulnerable to bubble implosion, because if interest rate rises, the debt becomes unsustainable.

In sum, the reserve currency countries are in a double trap. They have to run loose monetary policy to keep interest rates low, so that their fiscal debt will not run out of control. But their central banks also know that exceptionally low interest rates are distorting not only global financial markets, they also have very distortive impact on their domestic resource allocation.

This is the liquidity debt trap that Japan got into in 1990 when its asset market bubble burst following the sharp rise in the yen exchange rate. Japanese GDP growth never fully recovered after that. Reserve country status has not been a privilege, but a curse.

The emerging markets are struggling because the present international monetary system has become unstable and unsustainable. How should this essentially unipolar system be reformed to a multi-polar system where yuan plays a role will be the subject of the next column.

l Tan Sri Andrew Sheng is president of the Fung Global Institute.

China’s US$3.2 trillion headache

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ENTER THE DRAGON By YAO YANG

WHILE the downgrade of US government debt by Standard & Poor’s shocked global financial markets, China has more reason to worry than most: the bulk of its US$3.2 trillion in official foreign reserves more than 60% is denominated in dollars, including US$1.1 trillion in US Treasury bonds.

So long as the US government does not default, whatever losses China may experience from the downgrade will be small. To be sure, the dollar’s value will fall, imposing a balance sheet loss on the People’s Bank of China (PBC, the central bank). But a falling dollar would make it cheaper for Chinese consumers and companies to buy American goods.

If prices are stable in the United States, as is the case now, the gains from buying American goods should exactly offset the PBC’s balance sheet losses.

The downgrade could, moreover, force the US Treasury to raise the interest rate on new bonds, in which case China would stand to gain. But S&P’s downgrade was a poor decision, taken at the wrong time. If America’s debts had truly become less trustworthy, they would have been even more dubious before the agreement reached on Aug 2 by Congress and President Barack Obama to raise the government’s debt ceiling.

That agreement allowed the world to hope that the US economy would embark on a more predictable path to recovery. The downgrade has undermined that hope. Some people even predict a double-dip recession. If that happens, the chance of an actual US default would be much higher than it is today.

 Reason to worry: China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. — AP

These new worries are raising alarm bells in China. Diversification away from dollar assets is the advice of the day. But this is no easy task, particularly in the short term. If the PBC started to buy non-dollar assets in large quantities, it would invariably need to convert some current dollar assets into another currency, which would inevitably drive up that currency’s value, thus increasing the PBC’s costs.

Another idea being discussed in Chinese policy circles is to allow the renminbi to appreciate against the dollar. Much of China’s official foreign reserves have accumulated because the PBC seeks to control the renminbi’s exchange rate, keeping its upward movement within a reasonable range and at a measured pace.

If it allowed the renminbi to appreciate faster, the PBC would not need to buy large quantities of foreign currencies.

International experience

But whether renminbi appreciation will work depends on reducing China’s net capital inflows and current account surplus. International experience suggests that, in the short run, more capital flows into a country when its currency appreciates, and most empirical studies have shown that gradual appreciation has only a limited effect on countries’ current account positions.

If appreciation does not reduce the current account surplus and capital inflows, then the renminbi’s exchange rate is bound to face further upward pressure. That is why some people are advocating that China undertake a one-shot, big-bang appreciation large enough to defuse expectations of further strengthening and deter inflows of speculative “hot” money. Such a revaluation would also discourage exports and encourage imports, thereby reducing China’s chronic trade surplus.

But such a move would be almost suicidal for China’s economy. Between 2001 and 2008, export growth accounted for more than 40% of China’s overall economic growth. That is, China’s annual gross domestic product (GDP) growth rate would drop by four percentage points if its exports did not grow at all. In addition, a study by the China Centre for Economic Research has found that a 20% appreciation against the dollar would entail a 3% drop in employment more than 20 million jobs.

There is no short-term cure for China’s US$3.2 trillion problem. The government must rely on longer-term measures to mitigate the problem, including internationalisation of the renminbi. Using the renminbi to settle China’s international trade accounts would help China escape America’s beggar-thy-neighbour policy of allowing the dollar’s value to fall dramatically against trade rivals.

But China’s US$3.2 trillion problem will become a 20-trillion-renminbi problem if China cannot reduce its current account surplus and fence off capital inflows. There is no escape from the need for domestic structural adjustment.

To achieve this, China must increase domestic consumption’s share of GDP. This has already been written into the government’s 12th Five-Year Plan. Unfortunately, given high inflation, structural adjustment has been postponed, with efforts to control credit expansion becoming the government’s first priority. This enforced investment slowdown is itself increasing China’s net savings, i.e., the current account surplus, while constraining the expansion of domestic consumption.

Real appreciation of the renminbi is inevitable so long as Chinese living standards are catching up with US levels. Indeed, the Chinese government cannot hold down inflation while maintaining a stable value for the renminbi. The PBC should target the renminbi’s rate of real appreciation, rather than the inflation rate under a stable renminbi. And then the government needs to focus more attention on structural adjustment the only effective cure for China’s US$3.2 trillion headache. – Project Syndicate

● Yao Yang is Director of the China Center for Economic Research at Peking University.

Stupid central banker tricks

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By Paul R. La Monica

The euro has rallied against the dollar despite worries about Greece as investors bet on ECB rate hikes. Click chart for more on currencies.

NEW YORK (CNNMoney) — Greek debt crisis? What Greek debt crisis?

The European Central Bank is meeting this Thursday and is widely expected to raise interest rates by a quarter of a percentage point to 1.5%. That would be the second rate hike by the ECB this year.

 Sure, the austerity vote in Greece is good news since it could mean the worst-case scenario fears about a euro meltdown may not be realized.

But this isn’t the end to the difficulties in Greece. Doesn’t it seem just a bit odd that the ECB is contemplating more tightening at a time when there are still legitimate worries about the problems spreading to Portugal, Ireland, Italy and Spain? Moody’s downgraded Portugal’s debt to junk status on Tuesday.

The sovereign debt woes could be disastrous news for banks in France and Germany — the two big euro zone nations that actually have somewhat healthy economies.

But the ECB, unlike the Federal Reserve in the U.S., only has one mandate: inflation. (The Fed is charged with watching prices as well as employment.)

And even though commodity prices have come back from their peaks earlier this year, they are still somewhat alarmingly high. Crude oil, for example, has crept back above $95 a barrel. So that may be all that ECB president Jean-Claude Trichet needs to justify bumping rates up a bit.

Still, will the move backfire?

Another ECB rate hike would further widen the gap between interest rates in the euro zone and here in the United States. (They’ve been near zero since December 2008.) The general rule of thumb in the land of paper money is that the higher the interest rates are, the stronger the currency.

Europe cited as scariest risk to economy

But that’s a problem from an inflation standpoint. With oil and many other commodities denominated in dollars, the weaker the greenback gets, the more likely it is for commodity prices to go higher.

“An ECB rate hike means a higher euro going forward,” said Brian Gendreau, market strategist with Financial Network Investment Corp., a Segunda, Calif.-based advisory firm.

“It seems paradoxical that Europe, with its very serious problems, has a currency that’s strong and rising but that’s a reality. That means the trading bias is in favor of a lower dollar and higher oil prices,” Gendreau added.

It makes you wonder if David Letterman needs to expand his stupid tricks franchise and create one specifically for central bankers.

Other currency experts wondered if the ECB should just leave well enough alone since crude prices have pulled back in the past few months after surging due to Arab Spring-inspired supply disruption fears.

“I don’t think the ECB would be doing the right thing with a rate hike. Oil prices are high but inflation pressures have abated quite a bit,” said Kathy Lien, director of currency research for foreign exchange brokerage GFT in Jersey City.

Lien said the ECB needs to pay more attention to slow growth in Europe — even if it’s not officially one of that central bank’s particular mandates.

“Price stability is the top priority but the more important question is should the ECB be doing this during a fragile point of negotiations with Greece?” she said. “Raising rates makes financing more difficult for people in Europe.”

What makes matters more vexing is the fact that it’s not as if the ECB won’t have other opportunities to raise rates soon if inflation does in fact pick up.

The ECB will meet again on August 4 and has another meeting scheduled for September 8. Wouldn’t it be more judicious to wait for at least another month or two to see how the situation in Greece plays out before rushing to raise rates again?
http://i.cdn.turner.com/money/.element/apps/cvp/4.0/swf/cnn_money_384x216_embed.swf?context=embed&videoId=/video/news/2011/06/13/n_trichet_intv2.cnnmoney
“I am a little puzzled by why the ECB seems so intent on raising interest rates right now. It’s not going to ease any of the problems in the peripheral euro countries,” Gendreau said.

Still, some think that the ECB rate hike may be a non-event. That’s because the euro has already rallied against the dollar this year despite all the negative headlines about Greece, Portugal, Ireland, etc.

“The speculation about a rate hike has been in the cards for a couple of months,” said Ian Naismith, co-manager of The Currency Strategies Fund (FOREX), a Sarasota-Fla. Based mutual fund specializing in foreign exchange investments.

Naismith pointed out that just because the ECB is likely to raise rates on Thursday does not mean that this is the beginning of a long cycle of rate hikes. The key is going to be whether Trichet signals that he’s still worried about inflation and that more rate increases are on the way.

“Nothing is etched in stone,” Naismith said.

Let’s hope so. The ECB does seem strangely hell bent on rate hikes even though Europe is still in the midst of major financial upheaval.

But the last thing Greece, other troubled European nations and the rest of the world for that matter, need is for the ECB to make matters worse with ill-timed policy decisions.

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The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks. 

US Dollar’s Share Of Global Reserves Continues To Slide, Reserve Status Questioned

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Dollar’s Share Of Global Reserves Continues To Slide, Reserve Status Questioned

Jimmy Geithner and Bennie Bernanke have contributed to the dollar’s decline – Getty Images North America.

WASHINGTON – APRIL 21: Treasury Secretary Timothy Geithner (L) and Federal Reserve Chairman Ben Bernanke applaud during the unveiling of the new $100 note in the Cash Room at the Treasury Department April 21, 2010 in Washington, DC. According to the Treasury Department, the U.S. government evaluates advances in digital and printing technology to redesign currency and stay ahead of counterfeiters. The new note will be put into circulation in Feburary 2011.

Further confirmation that the U.S. dollar is gradually losing its reserve status came today from an International Monetary Fund report on global holdings of foreign exchange reserves by central banks.  The greenback, and the euro, lost share vis-à-vis the Japanese yen, the Australian, and the Canadian dollar, pointing to a “slow, gradual diversification” of reserve holdings.

With Christine Lagarde recently appointed General Manager in replacement of the disgraced Dominique Strauss-Kahn, the IMF released its latest “Composition of Official Foreign Exchange Reserves” (COMFER) which lists reserves held at central banks in 33 “advanced economies” and 105 “emerging and developing economies.”  China, one of the largest holders of foreign reserves, is not included in the sample. (Read IMF Appoints Lagarde To Fix A Disgraced institution).

Attesting to the continued global loss of confidence in the U.S. dollar, the greenback’s share of the world’s reserve continued to slide in the fourth quarter of 2010, the latest data show.  Interestingly, the trend can be explained entirely by valuation effects, with the trade-weighted dollar depreciating 4%% in that time frame.

The U.S.’ share of allocated reserves fell in the first quarter to 60.69%% from 61.53% from Q4 2010.  Central Bank reserves move slowly, but the slide in the greenback’s share, which Nomura suggests would be even steeper if China was included in the sample, has been very pronounced if one takes a longer-term window.

A year before the latest data, Q1 2010, the greenback’s share stood at 61.64%, while in Q1 2001, ten years before, it stood at 72.3%.  While USDs dominance was unquestioned a few years ago, it is anything but rare to speak of a move toward a multi-currency system, with the dollar still a primus inter pares [first among peers]. (Read Central Banks Dump Treasuries As Dollar’s Reserve Currency Status Fades).

Emerging and developing nations aggressively accumulated foreign reserves in the first quarter, as their high-growth economies attracted massive capital flows from so-called advanced economies.  While rich nations added $65.5 billion in reserves, $1.6 billion of those in U.S. dollars, emerging markets added $366.3 billion, $65.8 billion of those in dollars.  Regardless, EM central banks also sought further diversification, with the Japanese Yen as the main destination.

Emerging market central banks accumulated $6.6 billion in new JPY reserves in the first quarter, taking their allocation up to 2.9%.  “While the increase appears small, it signifies that the yen has recently found favor amongst EM central banks as an alternative safe haven,” noted Nomura.

“Other” currencies, as denominated by the IMF, made up 20% of emerging market reserve accumulation in the first quarter.  With the Canadian and Australian dollars as some of the biggest beneficiaries, the share of “other” currencies climbed up to 5.8%, from 5.1% in Q4 2010.

Euro share of global reserves crawled up a couple of percentage points to 26.6%, despite being shunned by EM central banks (where its share fell to 28.2%).  With the euro gaining 5.8% against the dollar in the first quarter, the data indicates EM’s actively selling euros.  “It is likely that central banks sought to rebalance their reserve portfolios in the wake of EUR strength and corresponding USD weakness. That is, they sold EUR and bought USD and other currencies to counter the sharp change in valuation,” explained Nomura’s analysts.

The IMF’s most recent COFER continues to support the thesis that the U.S. is losing its reserve status.  Central banks are sticking to “relatively stable allocations of major currencies,” namely the U.S. dollar and the euro, yet they are gradually moving away, adding yen and “other” currencies.  While the greenback will continue to play a predominant role in world trade, there can be no doubt that slowly, but surely, central banks will rely less and less on it.

US dollar died, debt default is unimaginable, “playing with fire”, creditors say

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The Day the Dollar Died

UD debt default is unimaginable

By Emily Kaiser  SINGAPORE,Agencies

SINGAPORE - Allowing a brief US debt default to force government spending cuts is a “horrible idea” that could destabilize the world economy and sour already tense relations with big creditors, government officials and investors said on Wednesday.

A growing number of US Republican lawmakers think a technical debt default might be a price worth paying if it gets the White House to accept deep spending cuts. This idea, once confined to the party’s fringe, is seeping into the mainstream, Reuters reported on Tuesday.

“How can the US be allowed to default?” said an official at India’s central bank. “We don’t think this is a possibility because this could then create huge panic globally.”

Indian officials say they have little choice but to buy US Treasury debt because it is still among the world’s safest and most liquid investments. It held $39.8 billion in US Treasuries as of March, according to US data.

The US Congress has balked at increasing a statutory limit on government spending as lawmakers argue over how to curb a deficit which is projected to reach $1.4 trillion this fiscal year. The US Treasury Department has said it will run out of borrowing room by August 2.

If Washington cannot make interest payments on its debt, the Obama administration has warned of “catastrophic” consequences that could push the still-fragile economy back into recession.

“It has dire implications for the economy at a time when the macro data is softening,” said Ben Westmore, a commodities economist at National Australia Bank.

“It’s just a horrible idea,” he said.

‘WOULDN’T HAPPEN’

The Republicans’ theory is that bondholders would accept a brief delay in interest payments — maybe a couple of days — if it meant Washington finally addressed its long-term fiscal problems, putting the country in a stronger position to meet its debt obligations later on.

But interviews with government officials and investors show they consider a default such a grim — and remote — possibility that it was nearly impossible to imagine.

“It just wouldn’t happen,” said Barry Evans, who oversees $83 billion in fixed income assets at Manulife Asset Management. “They would pay their Treasury bills first instead of other bills. It’s as simple as that.”

As for China, Washington’s largest foreign creditor with $1.14 trillion in Treasuries as of March, a default could fray political and economic ties.

Yuan Gangming, a researcher with the government think tank Chinese Academy of Social Sciences, smelled some political wrangling behind the US debt debate as the 2012 presidential election draws nearer and said Republicans “want to make things difficult for Obama.”

But with time running short before Treasury exhausts its borrowing room, Yuan said default was a real risk.

“The possibility is quite high to see a default of the US debt, which would harm many countries in the world, and China in particular,” he said.

China warns U.S. debt-default idea is “playing with fire”

By Emily Kaiser

(Reuters) – Republican lawmakers are “playing with fire” by contemplating even a brief debt default as a means to force deeper government spending cuts, an adviser to China’s central bank said on Wednesday.

The idea of a technical default — essentially delaying interest payments for a few days — has gained backing from a growing number of mainstream Republicans who see it as a price worth paying if it forces the White House to slash spending, Reuters reported on Tuesday.

But any form of default could destabilize the global economy and sour already tense relations with big U.S. creditors such as China, government officials and investors warn.

Li Daokui, an adviser to the People’s Bank of China, said a default could undermine the U.S. dollar, and Beijing needed to dissuade Washington from pursuing this course of action.

“I think there is a risk that the U.S. debt default may happen,” Li told reporters on the sidelines of a forum in Beijing. “The result will be very serious and I really hope that they would stop playing with fire.”

China is the largest foreign creditor to the United States, holding more than $1 trillion in Treasury debt as of March, U.S. data shows, so its concerns carry considerable weight in Washington.

“I really worry about the risks of a U.S. debt default, which I think may lead to a decline in the dollar’s value,” Li said.

Congress has balked at increasing a statutory limit on government spending as lawmakers argue over how to curb a deficit which is projected to reach $1.4 trillion this fiscal year. The U.S. Treasury Department has said it will run out of borrowing room by August 2.

If the United States cannot make interest payments on its debt, the Obama administration has warned of “catastrophic” consequences that could push the still-fragile economy back into recession.

“It has dire implications for the economy at a time when the macro data is softening,” said Ben Westmore, a commodities economist at National Australia Bank.

“It’s just a horrible idea,” he said.

Financial markets are following the U.S. debate but see little risk of a default.

U.S. Treasury prices were firm in Europe on Wednesday, supported by a flight to their perceived safety on the back of the Greek debt crisis and worries about a slowdown in U.S. economic growth.

Marc Ostwald, a strategist with Monument Securities in London, said markets were working on the assumption that the U.S. debt story “will go away.” But nervousness would grow if a resolution was not reached in the next five to six weeks.

‘WOULDN’T HAPPEN’

The Republicans’ theory is that bondholders would accept a brief delay in interest payments if it meant Washington finally addressed its long-term fiscal problems, putting the country in a stronger position to meet its debt obligations later on.

But interviews with government officials and investors show they consider a default such a grim — and remote — possibility that it was nearly impossible to imagine.

“How can the U.S. be allowed to default?” said an official at India’s central bank. “We don’t think this is a possibility because this could then create huge panic globally.”

Indian officials say they have little choice but to buy U.S. Treasury debt because it is still among the world’s safest and most liquid investments. It held $39.8 billion in U.S. Treasuries as of March, U.S. data shows.

The officials declined to be identified because they are not authorized to speak to the media.

Oman is concerned about the impact of a default on the currency reserves of the sultanate and its Gulf neighbors.

“Our economies are substantially tied up with the U.S. financial developments,” said a senior central bank official, who spoke on condition of anonymity.

“It just wouldn’t happen,” said Barry Evans, who oversees $83 billion in fixed income assets at Manulife Asset Management. “They would pay their Treasury bills first instead of other bills. It’s as simple as that.”

Monument’s Ostwald called the default scenario “frightening” and said bondholders’ patience would wear thin if lawmakers persisted in pitching this strategy in the coming weeks.

“This isn’t a debate, this is like a Mexican standoff and that is where the problem lies,” he said.

Yuan Gangming, a researcher with the Chinese Academy of Social Sciences, a government think tank, smelled some political wrangling behind the U.S. debt debate as the 2012 presidential election draws nearer and said Republicans “want to make things difficult for Obama.”

But with time running short before the U.S. Treasury exhausts its borrowing room, Yuan said default was a real risk.

“The possibility is quite high to see a default of the U.S. debt, which would harm many countries in the world, and China in particular,” he said.

(Reporting by Kevin Lim and Jong Woo Cheon in Singapore, Suvashree Dey Choudhury in Mumbai, Aileen Wang and Kevin Yao in Beijing, Abhijit Neogy in Delhi, Marius Zaharia in London and Umesh Desai in Hong Kong; Editing by Dean Yates and Neil Fullick)

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The untold story of Malaysia foreign exchange controls

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Book reveals how Malaysia beat currency speculators in 1997/98 crisis

By Thean Lee Cheng, Starbiz

Nor Mohamed (left) and Wong at the book launch

KUALA LUMPUR: Former Prime Minister Tun Dr Mahathir Mohamad toyed with the idea of exchange controls as early as May 1998 but was met with resistance from within the National Economic Advisory Council, the Cabinet and the central bank.

This was revealed in Notes to the Prime Minister, a new book that chronicles one of the biggest challenges and triumphs in Dr Mahathir’s 22 years as Malaysia’s Prime Minister.

Notes to the Prime Minister: The Untold Story of How Malaysia Beat the Currency Speculators was launched yesterday in Kuala Lumpur by Minister in the Prime Minister’s Department Tan Sri Nor Mohamed Yakcop. Tun Dr Mahathir was not present as he was advised by doctors to rest at home.

The book, published by MPH Publishing, is based on 45 sets of notes written between Oct 3, 1997 and Aug 21, 1998 by Nor Mohamed when he became Dr Mahathir’s unofficial and unpaid economic adviser.

The Asian financial crisis, which first engulfed Thailand in the middle of 1997, hit Malaysia soon after. Selective capital controls were imposed on Sept 1.

The book is written by veteran journalist Datuk Wong Sulong, the former business editor and group chief editor of The Star.

In an excerpt from the book, Dr Mahathir told Wong that he decided on foreign exchange controls “after Nor Mohamed explained to me how currency trading works … millions and millions of ringgit can be transferred from a domestic account to a foreign account by a stroke of a pen … I realised that foreign currency trading can be stopped by stopping this balance transfer.

“But I must say it was not as easy as that. We needed to do a lot of background work and monitoring and Bank Negara (needed to) set up many committees to do that to ensure that the controls were effectively implemented. (Tan Sri) Dr Zeti (Akhtar Aziz, then deputy governor of Bank Negara) did a lot in that respect and also in the economic recovery.”

Notes to the Prime Minister is not only a valuable lesson on how Malaysia took unorthodox steps to solve the Asian financial crisis but it is also a story of how two Malaysians met halfway around the world and came up with the Malaysian solution to the Asian financial crisis.

It is an intriguing story of how Nor Mohamed, then chief executive officer of Mun Loong Bhd, was summoned by Dr Mahathir to meet him in Buenos Aires, Argentina, on Oct 2, 1997. The first set of those notes was written a day later, on Oct 3.

Prior to this unique flow of notes, Nor Mohamed was a Bank Negara adviser.

His expertise in foreign exchange landed him and then Bank Negara governor Tan Sri Jaafar Hussein in trouble. Both of them resigned to take responsibility for Bank Negara’s speculation on foreign exchange losses that went into billions of ringgit in the early 1990s. Nor Mohamed joined the private sector after that.

Said Nor Mohamed at the launch: “We learn in history that sometimes the lives of individuals and the fate of nations hinge on a millimetre’s difference in the trajectory of a bullet, a road not taken on a whim, or the random stray of a shrapnel.

“In my case, my fate was sealed … by the turn of a head Tun Dr Mahathir’s … It was a sunny afternoon in September 1997, when the PM’s motorcade was speeding along the streets of Kuala Lumpur.

“At one junction, as the motorcade slowed, Tun Dr Mahathir turned his head to look out. And he saw a forlorn-looking man walking towards a row of shops for lunch. That forlorn-looking man was me!”

Nor Mohamed was summoned a few days later to go to Argentina. In April 1998, Nor Mohamed resigned from Mun Loong to concentrate on being Dr Mahathir’s unofficial adviser.

During that period of assessement, Nor Mohamed went to Singapore to observe the operations of Central Limit Order Book (CLOB), a board on the Singapore Stock Exchange which dealt with a great number of Malaysian shares. Dr Mahathir felt that Malaysia’s currency crisis could not be solved as long as CLOB exists.

Dr Mahathir, aware that his adviser was unemployed, asked: “Do you have money to go down to Singapore?” Nor Mohamed laughed and assured him that the trip would not cost a lot of money. The rest, as they say, is history.

As for Wong, who shares a deep liking for Nor Mohamed, he was asked by his friend to write the book.

“I felt a sense of excitement and a heavy responsibility. These notes had never seen daylight and it shed a new light (on more than just the economic and political aspects of this country). You have to tell a story as honestly as possibile, but not technically, because it has to appeal to the average reader. So that was my dual challenge.”

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Capital controls: From heresy to orthodoxy

The Renminbi’s Journey to the World

As China’s currency becomes more popular internationally, the country will have less need to hold US dollar assets.

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BEIJING – Recently, HSBC bank released an upbeat survey predicting that China’s currency, the renminbi (RMB), will become one of three global settlement currencies (alongside the dollar and euro) sometime this year. It seems that the RMB’s internationalization has been progressing without anyone really noticing. The key remaining questions concern whether or not the RMB will become an important international currency anytime soon, and whether it is poised to pose a serious challenge to the US dollar’s domination of the international monetary system.

China has made progress in the use of the renminbi (RMB) as a settlement currency [GALLO/GETTY]

An international currency is used and held beyond the issuing country’s borders, and plays the role of unit of account, medium of exchange, and store of value for residents and non-residents alike. Certainly, there are many potential benefits for China to be gained from the RMB’s internationalization:

·        Elimination of exchange-rate risks to which Chinese firms are exposed;

·        Greater funding efficiency for Chinese financial institutions, thus strengthening their competitiveness in global financial markets;

·        A boost to China’s trade with its neighbors, owing to the reduction in transaction costs;

·        Less need for China to hold US dollar assets and risk capital losses on the country’s foreign-exchange reserves;

·        Eventual status as one of the world’s major reserve currencies, which would provide China more freedom to maneuver in domestic and international economic policy.

China’s enthusiasm for RMB internationalization since 2009 partly reflects its frustration with the lack of progress in reforming the international financial architecture, and with the state of regional financial cooperation. Chinese officials believe that RMB internationalization is a way for China to set its own agenda without being overly constrained by external conditions beyond its control.

Thus far, China has made significant progress in the use of the RMB as a settlement currency, in the issuance of RMB-denominated bonds, and in signing currency-swap agreements with foreign central banks. RMB deposits in Hong Kong are growing exponentially.

Despite these achievements, however, RMB internationalization could still easily go awry. For example, various incentives have been provided to encourage enterprises to use the RMB to settle transactions. But, with an undervalued exchange rate and strong expectations for the RMB to appreciate in the future, foreign importers of Chinese products refuse to use the RMB to settle transactions, while foreign exporters are happy to accept RMB. As a result, even with the same trade balance, China ends up with more foreign-exchange reserves, though using the RMB as a settlement currency is supposed to reduce their accumulation.

Indeed, so far, RMB internationalization has shown a clear pattern of asymmetry – and not only as a settlement currency for China’s imports, but not for exports. RMB-denominated bonds meet strong demand, yet non-residents have no great incentive to issue them. And, while foreign lenders are happy to extend RMB loans, they are not welcome by foreign borrowers. Given strong expectations of RMB appreciation, internationalization will inevitably lead to a serious currency mismatch, with possibly detrimental consequences for China’s welfare.

A more fundamental problem for RMB internationalization is what it implies for China’s capital controls. Although the internationalization of a currency is not tantamount to capital-account liberalization, the degree of internationalization is conditional on capital-account liberalization. In fact, internationalization of the RMB has opened a new hole in China’s wall of capital controls. The big increase in RMB deposits in Hong Kong is a case in point.

When a currency endures a prolonged process of one-way appreciation, speculative capital aimed at exchange-rate arbitrage is bound to seek all chances to flow in. Hot money will increase currency appreciation pressure and complicate macroeconomic management. The profit-taking by speculators at the end of the game will lead to huge welfare losses to the recipient country, in this case China.

Fear of hot money was the main reason why China refused to de-peg the RMB from the dollar until July 2005. While China did decide to allow the RMB to appreciate gradually after that, it has relied on capital controls to prevent hot money from flowing in. The controls are leaky, to be sure, but they have worked (so far), which is why China has effectively maintained macroeconomic stability over the years.

The key objective of China’s capital controls is to prevent non-residents from holding domestic RMB-denominated assets that are unrelated to trade and long-term capital flows. But RMB internationalization encourages non-residents to hold more RMBs and RMB-denominated assets. As a result of RMB internationalization, RMB deposits held by Hong Kong residents have reached RMB370 billion ($57 billion), and the amount may reach RMB1 trillion by the end of the year.

One might wonder what difference there is between hot money and RMB deposits held by non-residents. The answer depends on why non-residents hold these deposits. The attraction of the RMB should come from China’s strong economic fundamentals and faith in its economy. If it comes from expectations of RMB appreciation, the success of RMB internationalization can be easily reversed and will cause more problems for China’s monetary authority to solve in the future.

Fortunately, China’s monetary authority has already noticed the subtlety of the distinction between legitimate demand for RMB-denominated assets and hot money. This means that the pace of RMB internationalization could become more measured than international investors have expected.

While internationalization of the RMB is necessary (and inevitable), it should be guided by market principles and pursued in a cautious manner. To get the sequence of policy adjustments right is vital. In any case, the RMB’s path to becoming a truly international currency promises to be a bumpy one.

By,Yu Yongding, currently President of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples’ Bank of China and former Director of the Chinese Academy of Sciences Institute of World Economics and Politics.

Copyright: Project Syndicate, 2011. www.project-syndicate.org

What’s wrong with the international monetary system?

WHAT ARE WE TO DO By TAN SRI LIN SEE-YAN
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President Johnson stated in 1968: “To the average citizen, the balance of payments, the strength of the US dollar, and the international monetary system are meaningless phrases. They seem to have little relevance to our daily lives. Yet, their consequences touch us all consumer and captain of industry, worker, farmer and financier.”

This is true when international financial arrangements are working well; and becomes even more evident when they are not. While not all would argue there is no life left in the international monetary system (IMS), almost all would agree the present system contains inherent contradictions which lead to frequent breakdowns.

Basic principles

Four basic principles underlie the IMS: (i) a country’s sovereign right to regulate internal demand to maintain stable conditions at home in terms of employment and domestic prices; (ii) free international movement of goods and capital and here, substantial progress has been made in meeting this goal; (iii) a system of mixed exchange rate regimes – from fixed exchange rate (eg China) to flexible exchange rate (eg US dollar, British pound and euro) to degrees of managed floats (eg yen and the ringgit); and (iv) a nation’s right to hold international reserves in the form of gold, US dollar and other major currencies. In addition, lines of credit are available from the IMF. The reserves available and potentially obtainable set a limit on the cumulative size of a country’s balance of payments (BOP) deficit, thus acting as a BOP constraint in domestic policy making. But there is no such corresponding limit for surplus nations. The system is asymmetrical; it “punishes” those in deficit and lets the surplus nations alone.

Most countries experience some trade-off between unemployment and price stability. As unemployment is lowered by policies to expand demand (as with the US stimulative packages), the higher is the price that has to be paid in rising inflation. The trade-off varies over time, and from country to country. The rationale behind this relationship centres on the tendency for money-wage increases to outstrip rises in productivity even under conditions of high unemployment. The current state of a jobless growth in the US with low inflation in the face of continuing high unutilised capacity shows no trade-off at this time. But as demand picks up and as growth picks up and unemployment trends down, inflation is bound to creep up.

G-20 finance ministers and central bank governors gather for a group photo during the IMF and World Bank spring meetings in Washington on April 15. — Reuters

What’s wrong?

First, there is the adjustment problem. The present IMS has no reliable mechanism to eliminate BOP dis-equilibrium (ie payments imbalances). This is fundamental. There are three possible ways of correcting a payments deficit: use of trade and capital controls; adjustment of exchange rate; and government policies working through internal changes in income and prices. All three go against the the principles underlying the system. So, when a country experiences a deficit, there is no assurance the deficit will be eliminated before its reserves are used up; or depending on the extent to which market forces are allowed to sufficiently depreciate the currency; or whether domestic policies are tightened enough to reduce demand.

Second, there is the problem of the exchange rate, which usually doesn’t react fast enough to correct imbalances. Destabilising capital flows exacerbate the problem. The IMS is also subject to massive (especially speculative) flows of funds which could complicate BOP adjustment. The flooding of cheap US dollar funds into emerging markets following QE2 (2nd phase of Fed’s quantitative easing) have led to capital controls and managed exchange rates limiting their appreciation. Of late, the size of speculative flows has become too large for even the larger emerging markets to cope. This is not the end. In the event QE2 exits, the impact of large capital withdrawals on the exchange rate can be just as destabilising.

Third, there is the problem of liquidity. The system has no arrangement to generate in an orderly and predictable way, increases in foreign reserves that are needed to meet demands of growing world trade. The creation of SDRs (Special Drawing Rights) in the IMF, as and when needed, is supposed to do the job; but in practice, increases in SDRs have been few and far between. By chance, the Fed’s recent expansionary program, including QE2, is now over-doing the job; indeed, these capital flows have become too large for orderly adjustments to take place.

Finally, there is the confidence problem. The system allows persistently large surplus nations to do virtually whatever they please in postponing real adjustment. Today, about two-thirds of global reserves is held in US dollar-denominated assets (especially Treasuries). China’s international reserves today amounted to about US$3.1 trillion, of which US$1.15 trillion is invested in US dollars. It has been estimated that Italy’s entire sovereign debt (principal plus interest until 2062) totalled US$3 trillion. In terms of oil, China’s reserves can buy 25 billion barrels of Brent crude, equivalent to 13 years of its net oil imports. Indeed, it could pay for the entire Nikkei 225 list of companies, with US$30bil in change. That’s how big China’s reserves are.

True, the Bretton Woods system had served the world economy reasonably well. In a sense, the system operated well in the 50s and 60s but was on borrowed time. The “tearless deficits” during this period left a legacy of a large and growing “overhang” of foreign dollar holdings, which frequently threatens a confidence crisis. Persistent US deficits had since led to a diminution in the quality of the US dollar in the eyes of most foreign holders.

Global payments imbalances require a co-ordinated global action to resolve. This is hard to come by. Of the four problem areas, I think the matter of speculative and exchange rate instability is serious. This involves two aspects: (a) threat imposed by the “overhang” of convertible claims against the reserve currencies (especially US dollar) where such claims are today touching 15% of global GDP (6% 10 years ago); and (b) the danger of private speculative runs against currencies under pressure, especially the greenback. They are inter-related. To top it all, the IMF practice of allowing nations to choose their own exchange rate regimes didn’t help the adjustment process. Fixed exchange rates operated uneasily alongside flexible exchange rates, including managed floats and permutations of these two major regimes, in the hope that somehow policies would be co-ordinated to converge and foster imbalances adjustment. Nothing like it will ever happen as each regime did its own thing to protect its national interest.

And so, until today, the four problems of adjustment, exchange rate, liquidity and confidence underlying the IMS persisted. One thing is clear: there is no political will to reform. The US, for which reform means the diminution of the dollar’s global role, is lukewarm. And Europe is distracted more than ever with protecting the status of the euro and the EU’s sovereign debt crisis. France, as chair of G-20, wants to find an IMS that more accurately reflects the new structure of the world economy. But the major emerging nations, especially the BRICS (Brazil, Russia, India, China & South Africa) want to move away from a virtual one-reserve regime to one based on multiple reserve currencies.

Are payments deficits good or bad?

For most, payments deficits are instinctively bad. But think about it. After all, the purpose of international trade is to obtain goods and services from abroad at less than can be produced (or not available) at home. Imports are the benefits of trade. A trade deficit means more goods and services are being received from abroad than are being given up. Surely that’s good from the deficit nation’s point of view. But this deficit has to be financed. So, the nation either loses reserves (uses savings) or borrows (living on credit), and this may prove uncomfortable as the deficit persists. In the end, the deficit country has to take corrective action, such as deflationary domestic policies (austerity measures), exchange controls, or devalue its currency. All of them conflict with one or more of its domestic economic goals. There is a cost to adjust.

The soft solution is to use reserves (“its function is to render exchange rate stability compatible with freedom for individual nations to pursue national economic goals”). While drawing down reserves or borrowing may reduce the conflict of objectives, it nevertheless increases the potential for future conflict.

That’s exactly what’s happening in the US. It has run persistent deficits for so long that its debt is now too high (close to 100% of GDP) and its liabilities to nations accumulating US dollar reserves (especially China and Japan) have grown so large that it can trigger off a confidence run on the greenback.

This has proved inconvenient at a time when the US continues to need expansionary policies to bring down its high unemployment. Surplus nations have the opposite problem since these surpluses are inflationary and reflect an inefficient utilisation of reserves in the form of involuntary foreign lending. It can be viewed as the mere hoarding of resources that might have enhanced future output and welfare if added on to domestic investments instead. To sum up, today’s mixed exchange rate regimes provide no mechanism for systematic and effective BOP adjustment that does not conflict with major goals of public policy.

IMS reform

Reform of the IMS is clearly needed. V. Lenin once said that “the surest way to destroy the capitalist system (is) to debauch its currency.” The IMS is at the heart of the world economy. When rules of the global monetary game are unclear, inadequate, some even obsolete, nations find it difficult to play; indeed, some may exploit them to their advantage.

This undermines the very fabric of the IMS. Some history. In 1944, Bretton Woods gave birth to the IMF and today’s US dollar-centred IMS. The Bretton Woods conference was dominated by two strong-willed economists, H.D.White (US) and J.M.Keynes (UK). The UK wanted a system in which global liquidity is regulated by a multilateral agency (IMF), while the US (for self-interest) preferred a US dollar-based system.

Because of its enormous political power, the US got its way. Keynes, for all his intellect and persuasiveness, failed to: (i) endow the IMF with the power to create a new global reserve unit as an alternative to the US dollar; and (ii) secure a global regime which forces surplus as well as deficit nations, and the issuer of the reserve currency as well as its users, to adjust. It’s a pity as Keynes’ failures haunt us to this day. Nations with chronic surpluses (Germany, China and Japan) and the US as dominant supplier of US dollar reserves, do not face the same pressures to adjust their imbalances as do deficit countries that are often bullied to do so.

In my view, what is needed is a tripolar IMS organised around the US dolar, euro and RMB (China’s yuan or renmimbi). Let’s face it, neither the euro nor the RMB are in any position today to challenge the US dollar. The world will be better off with a viable alternative to the US dollar. Their interplay forces on the reserve currencies a market discipline earlier and more consistently. This way, central banks seeking to accumulate reserves will have a choice, so that the US no longer has “so much rope with which to hang itself” (so says my friend Barry Eichengreen). Another view is to transform the IMF’s SDRs into an international reserve currency (IRC). The trouble is, the SDR is not market tradable. To be an effective IRC, the IMF will have to be accorded the role of a world central bank. This is unlikely; indeed, a non-starter, as it was in the Bretton Woods days.

At the recent G-20 finance ministers meeting in Paris, all central bankers acknowledged that global imbalances remain a critical problem, and that a solution will involve policy co-ordination. Yet, each played down its own role. Until a solution is found, the “accumulation of foreign exchange reserves is a powerful instrument of self-insurance.” There is no political will to reform only the will to congregate and obfuscate. In the Bretton Woods days, the might of the US called the day. Today, it’s nobody’s call. What a pity.

Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching & promoting the public interest. Feedback is most welcome; email: starbizweek@thestar.com.my