From Credit to Money
by Adrian Ash, Editor, Bullion Vault | February 4, 2008
Print"...Wouldn't life be much simpler for everyone if the US raised interest rates and didn't spend more than it had overseas...?"
ONE U.S. DOLLAR used to buy nearly four Brazilian Reals at the start of 2003.
Today it buys fewer than half as many. Which you might think implies higher travel, energy and food costs to come for US consumers.
But it seems to bother the central bank of Brazil much more than it fazes the Federal Reserve.
The United States bought nearly one-fifth of Brazil's total exports in 2006 primarily transport equipment, base metals and raw food-stuffs such as soybeans, meal, and oils.
Then in March '07, George W.Bush signed a biofuels deal with Brazil, the world's largest producer of ethanol, worth at least $8 billion.
On the other side of the ledger, meantime, the US accounts for more than 16% of what Brazilians buy from abroad. So you'd expect a weak Dollar to make the perfect ingredient for low-inflation growth in Brazil. Right?
Yet two days after the US Fed slashed its key lending rate by 0.75% in January's "emergency" action, the Banco Central do Brasil called a "snap auction" of its own currency, the Real. And bidding only for greenbacks, the Banco sold Reals at a rate of 1.7879 per Dollar, claiming that the Dollars were needed to build up its currency reserves.
Which was an odd excuse for trying to suppress the Real's relentless rise vs. the greenback.
Brazil has grown its overseas trade so fast since the start of 2003 and most notably to China, which now buys well over 6% of Brazil's exports that its current account balance with the rest of the world went from a deficit worth 4.6% of its annual economic turnover to a surplus of 1.3% of GDP in 2006.
Hence the record $185 billion foreign currency reserves it's already got. And if it really fancied extending its reserves further with a bundle of super-cheap Dollars, it should have waited until Friday. Because by the close of business in Brasνlia following the Banco's auction, the Dollar had dropped another 2% of its value despite the central-bank's intervention. The Real has now risen by almost one-fifth vs. the US currency since this time last year.
"The bank resumed buying Dollars in early October after a two-month hiatus from the currency market," explains Reuters. "It had previously bought greenbacks daily for months, helping lift Brazil's reserves to an all-time high of about $185 billion."
"The yield differential is a factor supporting the real in these times of crisis," according to one forex analyst in Sao Paolo and Brazilian interest rates were kept on hold at 11.25% when the Banco do Brasil met last month.
So even without a weakening Dollar, you could now pick up an easy 7.75% profit per year, simply by selling Dollars for Reals. And that's exactly the situation which Brazil's central bank faces, only in reverse. It's earning less on its huge Dollar holdings than it pays out in yield on its own sovereign bonds. So too do most of the rest of the world's export-rich countries.
"Things just got a lot more complicated for the managers of China's economy" for example, as Stephen Green, an analyst at Standard Chartered Bank in Shanghai, noted after the Fed's first cut to Dollar interest rates in January. And the Beijing policy-makers were already in way up to the necks before Christmas, drowning in a flood of dollars sent to pay for 15.5% of what the US imports each year.
Yes, Canada tops the US-imports list with 16.4% of America's trade; Mexico comes third with 10.7%. But they both have a land-border with the USA. Whereas Chinese goods, on the other hand, have to cross 6,590 miles of sea to get from Shenzen to the Port of Long Beach just like the dollars that flow back to pay for them.
But the export firms that then collect all these dollars don't have much use for them back in the Middle Kingdom. And rather than simply selling them Yuan in exchange for these greenbacks which would only plug America's flood of cheap dollars straight into China's money supply the People's Bank tries to "sterilize" them before they cause any trouble.
"Sterilize" as in scrub clean. Because otherwise, all those Dollars might infect China's economy with something nasty...something like, say, inflation. The disinfectant, for what it's worth, is a regular issue of Chinese government bonds.
These soak up the cash flooding in from the States. Trouble is, they cost much more in interest than the dollars they sterilize bring in.
"The trend is clearly accelerating as the reserves continue to grow faster than GDP," says Hong Liang, China economist for Goldman Sachs. She reckons the People's Bank of China is now losing some $4 billion per month trying to cover the gap between what it pays on its own government bonds and what it earns on the mountain of US Treasuries it's built up.
Just last month, the PBoC sold off some 5 billion Renminbis' worth of short-term notes in one day, sucking cash out of the economy to "sterilize" the money coming in from the US. But by issuing short-dated notes rather than longer-term bonds because the buyers prefer cash, which is what they got in the first place the Bank finds its obligations mounting each.
"It has more than a trillion RMB's worth [$137bn] due to mature over the course of this month alone," according to The Telegraph enough to keep any central bank busy, even before you figure in the $4bn lost on interest-disparity and the on-going loss of value in the US Dollar.
What to do? The PBoC has now lifted its interest rate eight times since the start of 2006, but still the economy grew by 11% last year and consumer inflation hit an 11-year high. It's also told Chinese banks to keep 15% of their cash deposits in the PBoC's vaults, taking them out of circulation in an attempt to cap lending.
Indeed, it's even forced the banks "to hold at least part of their new required reserves in the form of dollars at the PBoC since August," reports Michael Pettis, finance professor at Peking University's Guanghua School of Management. At least that saves the Beijing policy-wonks the trouble of arranging auctions and paying out more in interest on Renminbi-denominated bonds!
But it also transfers the loss of wealth inherent in the tumbling Dollar onto China's private banking-sector, forcing lenders to share the pain with the State...and doing nothing to release the upwards pressure on the value of the Chinese currency itself, according to Pettis.
"It seems to me that forcing banks instead of the PBoC to hold dollars says nothing about pressure on the currency," he writes in his blog. "I would argue that the total net inflows are exactly the same except for one thing commercial banks have been asked to assume part of the PBoCs normal functioning (i.e. to buy dollars so as to maintain the countrys foreign currency regime), and as they assume this function the resulting purchases of dollars are whisked off the PBoC balance sheet.
"But nothing real has changed, except that now banks, instead of the PBoC, will be forced to assume the foreign exchange losses."
Surging inflation...soaring interest rates...a merry-go-round of bond auctions and redemptions that costs $4bn per month in the meantime...
Wouldn't it just be simpler if the US raised instead of cutting its interest rates, thus cutting back on its consumptive excesses? And wouldn't the problem of sterilizing all those sick dollars vanish if the world had only one kind of money?
Why don't we just do away with all the different currencies of the world, and settle on one single form of cash to buy, sell, invest and light our cigars with? As it is, the Babel we live in where 143 different kinds of currency either change hands or act as a way of measuring prices around the globe keeps finding itself in no end of trouble.
"The Rupee rose on Friday," reports LiveMint, the Wall Street Journal's Mumbai offering, "as investors bought the Indian unit for its higher yields after a hefty interest rate cut by the US Federal Reserve.
"But concerns weighed that the Indian central bank would intervene against the local unit, as it is widely suspected of doing in recent months."
"There was some suspected intervention against the Singapore Dollar at 1.4270," added a currency trader in the tiny Asian state to Reuters last week, "so I guess players are wary." Across the Pacific, the Argentine Peso has meantime lost more than 10% of its value against the US Dollar over the last four years thanks to "continued central bank intervention" says the newswire elsewhere.
And as the world's stock markets have tumbled this month, the central banks of the Philippines, Malaysia and Turkey are also rumored to have stepped into the open market, dumping their own currency and buying the US Dollar in a bid to support it and thus keep their export-economies cheap to foreign customers.
Put another way, as Benn Steil of the Council of Foreign Relations said at a recent meeting (or so the Washington Post reports), "the United States is exporting inflation worldwide" by forcing these sovereign nations to print up mountains of their own currency with which to buy the ailing greenback.
Countries like China and the Middle Eastern petro-kingdoms peg their currencies to the Dollar the world's No.1 reserve currency, and still top dog after all these years. So they "thus [peg themselves] to US monetary policy" too.
And US monetary policy, quite clearly, is inflationary right now. That makes monetary policy inflationary everywhere from Abu Dhabi to Beijing. Even those of us lucky enough to sit outside the "Dollar Zone" can expect rates to slide in tandem.
Slashing almost a third off the cost of borrowing dollars inside eight days and then offering to lend US banks $60 billion in 28-day loans every two weeks makes for quite the game of "follow my leader", don't you think?
Ah, but over in the dozy spires of pan-global political day-dreams, abolishing sovereign currencies and anointing one, single money in their place would smooth the wheels of commerce and boost world GDP overnight. Apparently.
"Annual transaction costs of $400 billion [would] be eliminated," reckons Morrison Bonpasse, editor of The Single Global Currency (2007 edition) published by Munich University. "Global currency imbalances will [also] be eliminated," he adds, along with "all Balance of Payments problems...currency crises...currency speculation...and the need for foreign exchange reserves (with a current annual opportunity cost of approximately $470 billion)."
Indeed, "worldwide interest rates will be lower than the current average due to the elimination of currency risk" and you've just got to love cheaper money!
So what's not to like? "National currencies and global markets simply do not mix," wrote Ben Steil in the policy-wonk's favorite glossy, Foreign Affairs, last May.
"Together they make a deadly brew of currency crises and geopolitical tension and create ready pretexts for damaging protectionism. In order to globalize safely, countries should abandon monetary nationalism and abolish unwanted currencies, the source of much of todays instability."
Instability being a bad thing the kind of thing that knocks the S&P lower by 7% inside one month, for instance it should be abolished, right? The beautiful stability of Western Europe's economies just goes to prove how remarkable a single currency could prove.
"Spanish and Italian manufacturers are clearly struggling in the headwinds of weaker global growth, the strong Euro, high oil prices and eroding demand in domestic markets," said Jacques Cailloux, economist at Royal Bank of Scotland in London, to Dow Jones newswires today after the Eurozone's Purchasing Managers Index for January showed a slight rise overall.
"Against this, French and German manufacturers continue to do well, at least for the time being, but German producers have failed to fully make up the pace lost last autumn."
Why the disparity? According to most Spanish, Italian, Portuguese and Greek politicians, the cost of borrowing Euros is too high. According to the latest inflation data for the 14-nation currency zone, however, it's still way too low.
"Annual inflation in the Eurozone jumped to a new high of 3.2% in January, the European Union's statistics bureau Eurostat estimated on Friday," reports the China Daily.
"The figure, including new Eurozone members Malta and Cyprus for the first time, was the highest since the single currency was introduced to world markets as an accounting currency in 1999. It rose from 3.1% in the previous two months and stayed well above the two percent ceiling preferred by the European Central Bank (ECB) for the fifth consecutive month."
Spain's minister of finance, Pedro Solbes, said last week that "there's significant debate" inside the European Central Bank about whether or not to cut interest rates as the global slowdown looms over Europe. But then, he faces re-election in March and no one seemed to mind too much about interest-rates being too low during the Spanish real estate bubble that began bursting last year.
Property prices nearly tripled in Spain between 1997 and 2007, thanks to a wave of British ex-pats in search of a perma-tan and the sudden collapse in borrowing costs that preceded the birth of the Euro in 2000. Mortgage rates went from 11% in 1995 to below 6% and then 5% as the single currency delivered the hope of German-style monetary policy and German-style interest rates.
Across the sea in Ireland, house prices trebled in just seven short years after the introduction of the Euro. But not even a peak of just 4.0% in the Eurozone's cost of money could keep the bubble inflating forever.
Now "Spanish banks are issuing mortgage securities and asset-backed bonds on a massive scale to park at the European Central Bank," reports the London Telegraph, "using them as collateral to raise money at favorable rates from the official credit window in Frankfurt.
"The rating agency Moody's said lenders had issued a record 53 billion [$77bn] of mortgage- and asset-backed bonds in the fourth quarter of 2007, yet almost none of the securities have actually been placed on the open market. Most have been sent directly to the ECB for use in 'repo' operations."
So for all its tough talk on inflation, the European Central Bank is still feeding the growth of credit and money supplies in Europe. Any wonder the broad M3 money supply is swelling at a three-decade record rate? Any surprise that consumer-price inflation is surging beyond the ECB's grasp...?
And does anyone really imagine this isn't a problem?
"Living in a credit era," wrote Robert L.Smitley in his 1933 classic, Popular Financial Delusions, "we cannot go back to a currency era without massive upheavals. The cause of the great boom was credit expansion to an abnormal degree the same cause as that for all booms under a credit system."
The world's central bankers all know this too well. Few of them, if any, believe a return to cash-only possible, let alone desirable. So if the world's consumers and investors choose to shut down the credit markets both as borrowers and lenders and pile into cash instead, then the world's central banks will just have to destroy cash in the hope of forcing a flight back into credit.
How else, we wonder here at BullionVault, would you characterize a cut of 125 basis points in the rewards paid on Dollars inside eight days...?
The panic starting last August a panic that closed the West's mortgage markets almost entirely can be beaten by central banks buying mortgage-backed bonds themselves if need be. The stock-market panic of January a panic that knocked almost one-tenth off the value of equities worldwide can be reversed by historic cuts to interest rates and a fresh flood of short-term loans to the banks.
Or so the central banks think. But the panic they're then causing as a direct result a panic revealed by the surging Gold Price since August might prove worse than the flight into cash that they're fighting:
A complete loss of faith in all official currency.
Might that lead to the one, single money that day-dreaming economists think can cure the world's evils? Whatever comes when the dust settles, you can be sure the world won't turn to using gold coins again.
Yes, Ben Bernanke's depression theories might be disputed and yes, his current credit-inflation panic looks absurd. But history would seem to make clear that during the 1930s deflation, those nations which abandoned the Gold Standard soonest turned the corner the fastest and began to recover.
The "barbarous relic" of tying the supply of money to a real quantity of Gold Bullion can't make a comeback for as long as "deflation" and "depression" are still blamed on gold hoarders.
But that doesn't mean you can't hoard a little real wealth in the meantime. You might want to consider it if you're losing your faith in government money.
Copyright © 2008 Adrian Ash
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