The Chinese Interest in Special Drawing Rights:

At the recent BRICS conference in China, a joint declaration was made by the five involved nations addressing the imminent need for reforming the current international monetary system, stating that they “welcome the current discussion about the role of the SDR (special drawing rights) in the existing international monetary system including the composition of SDR's basket of currencies”. This discussion on the SDR has been rekindled for the second time in a serious way, since the unfolding of the global financial crisis. What is interesting is that the first time that the issue of the SDR was brought up, was by the governor of the People’s Bank of China (PBOC) – Zhou Xiaochuan in a speech in early 2009, when he said that the SDR “serves as the light in the tunnel for the reform of the international monetary system”.  It would be unwise to assume that the Chinese interest in the SDR is limited to the reforming of the international monetary system.

It is common knowledge today that the Chinese have amassed massive dollar reserves. China’s foreign exchange reserves of close to three trillion dollars are the biggest in the world. Meanwhile, the dollar has been taking a serious battering in the exchange markets, and the ICE exchange’s dollar index is close to all time lows. This selling in the dollar can be expected to continue till the current quantitative easing programme of the US government comes to a close in June this year. The fall in the value of the dollar would be worrying the central bankers in China because the value of their reserves also declines simultaneously. The promotion of the SDR agenda by the Chinese is certainly no coincidence given the position of the dollar today.

The SDR is an international reserve asset that comprises of a basket of currencies that are revaluated every five years. The current basket comprises of four currencies – the dollar, the euro, the pound sterling and the yen. It goes without saying that the relative weight attributed to the dollar is the most in this basket due to its long time standing as the unofficial reserve currency of the world since World War 2. In fact, the very fact that the IMF created the SDR way back in 1969 meant that it recognized the dollar’s standing as the reserve currency of the world and the fragilities associated with it. The creation was aided by a seminal paper by an economist; Robert Triffin in 1960 titled “Gold and the Dollar Crisis”. Triffin had foresight enough to recognise the fact that a currency that acts as an international reserve currency for the world cannot be the official currency of a sovereign State (USA) at the same time without causing considerable headaches to the central bankers of the State. This has been labelled “Triffin’s dilemma”, whereby there is a conflict of interest between global and State monetary policies. The conflict arises, as has been observed lately, with the dollar flowing out of the United States, due to the heavy global demand, leading to massive current account deficits for the country. The current account deficit of the United States stood at 113 billion dollars in the fourth quarter of 2010, meanwhile China’s current account surplus jumped by 25% in the same year. These very palpable imbalances in the global economy can possibly be offset by the use of the SDR in a new international monetary framework.

China’s continued support for incorporating the SDR in a new framework stems from the desire to convert its vast amounts of dollar reserves to the SDR. The SDR is not a form of currency and it cannot be exchanged in the global financial markets. The SDR can be purchased from the IMF and thereafter exchanged in bilateral trades between countries that require it and countries that are willing to supply it. The incorporation of the SDR into the monetary framework of the world would entail that every country included in it would necessarily eventually hold most of their reserves in the form of the SDR. This would help in correcting imbalances since the interest paid on the SDR would be the same for every sovereign state, much like the way things work under the euro for the states in the Euro-Zone. It is debatable however whether such a global monetary system, the conception of which can be attributed to Keynes who envisioned a super-national currency the “Bancor” back in the early forties, could actually work. Seeing the mess that the Euro-Zone members are in mostly owing to a singular monetary policy instituted for 17 fiscally independent states may not embolden too many economists to support the execution of a broad based international reform which incorporates using the SDR as a global reserve. However, the use of the SDR along with a substitution account and a less ambitious scale of reform could certainly help ease out existing imbalances.

Another plausible reason why China wants to contribute and accelerate the SDR based reform agenda is its interest in increasing its influence in the global monetary system. It is natural that China wants to increase the Yuan’s global presence, and it has been aggressively executing this agenda by increasing the number of bilateral transactions with its currency. However, the fact that the Yuan is not fully convertible makes the case for incorporating it in the asset basket of the SDR (which China has been hinting at) a moot point. Until China allows its currency to fluctuate according to actual global supply and demand (which at this point would entail a sharp appreciation of the Yuan), there is no foreseeable way for it to be part of the global reform agenda without seeming hypocritical at the outset.

The increasing prominence of the BRICS countries on the global stage is impressive, and a change in the international system which currently gives the dollar centre stage is certainly warranted.  This change is also something that policy makers in USA should not be averse to given that there is serious need for the country to address its deficits. However, the process of multilateral dialogue to further the reform agenda cannot go forward with the current monetary system prevailing in China  and it certainly should not go forward without due attention being paid to the risk factors involved with reforming an already proven and resilient system. The other member nations of the BRICS should also be acutely aware of the reasons for China’s stance and cannot afford to get carried away with promoting the reform agenda, which is partly based on an inherent need for highlighting their global presence, without due introspection.

   

The Week of April 11th: Dollar Doldrums

Dollar Doldrums

Although Joseph Schumpeter strongly opposed Marx’s Manifesto to the world, he did agree with him on one account. Like Marx, he also proposed that capitalism would not survive – and he did not mince his words while stating this in his book ‘Capitalism Socialism and Democracy’ where he started a chapter with “Can Capitalism Survive? No, I do not think it can”. Looking at the current state of affairs at the epicenter of capitalism, one begins to wonder if there is some element of truth in this view.

The United States of America is the greatest bastion of capitalism, and the dollar reflects this capitalism’s vitality. The dollar is the most widely traded and widely held currency in the world. Ever since Bretton Woods, it has been assigned the role that precious metals fulfilled in the global monetary system that existed before World War 2. And so, the global phenomenon of the diversification of every investment portfolio with the dollar became a reality. This has ensured two things – the United States would never have to worry about bets against its currency, and that by this self fulfilling prophecy, the world actually has had an overall stable monetary exchange system based on trust. Or has it?

The dollar seems to be telling a story that nobody in the Federal Reserve would want to hear. The currency started this year with the weakest start since 2008. This weakness has continued unabated in the midst of strengthening commodity prices. Now analysts are wondering when equity markets will reverse their traditionally negative correlations with the dollar, due to the increasing pressures on businesses which have to buy commodities with the weakening currency. This inflection point does not seem far given that equity markets are range bound in the United States, and there is no stopping the rally in commodities.

The decline in the dollar would not really be very worrying if it were not for the other compounding worries for the US economy. The budget cuts that were recently passed are not fooling anyone, and the bond markets are certainly not manipulated too easily.  The yields on the 10 year T Note have resumed their upward movement, even though the Federal Reserve is not going to announce an interest rate hike any time soon. Equity analysts suggest that equity investors will really start to take notice of the yields if the 10 year yields touch 4% (currently touching 3.5%).

The fact that central banks across the developed world are increasing rates, a recent example being the European Central Bank hike of 25 basis points earlier this month, is certainly not going to make life easier for Chairman Ben Bernanke. Given that there has not been a substantial recovery in the housing market, and both Freddie and Fannie are still problem children for the economy (Treasury Secretary Geithner recently stated that it could take up to 7 years to wind down the two housing loan giants, which incidentally insure about 90% of all new home loans); he would once again be finding himself in a catch 22 situation that all central bankers worth their salt would be more than familiar with. A premature interest rate hike could cause further hiccups to this artificial cheap credit induced recovery, and not raising rates while other central banks are busy doing so would lead to further weakness in the dollar.  

The markets are actually being very clear about the fate of the dollar in the short to medium term for once. Gold and silver are at record highs, and there is no reason why they should not be. This indicates a flight for safety to physical quantifiable commodities from currencies like the dollar. Silver prices have increased by phenomenal amounts over the last few months while gold seems destined to touch $2000 per ounce in the long term. Keeping in mind the fact that gold prices were at $300 at the start of the last decade and are now hovering below $1500; this meteoric rise is indicative of a fundamental shift in perceptions about paper currencies backed by nothing but a promise.

The recent BRICS summit that concluded in China saw discussions about the possible inclusion of the Yuan in the IMF’s SDR currency basket. Although this is unlikely to happen until full convertibility of the Yuan becomes a reality, it certainly does indicate that such options are on the formal agenda now. The monetary system that exists in today’s brave new world full of uncertainties looks unsustainable and fragile. Unless one believes in economic determinism, the fact that the dollar has survived so many onslaughts in the past is no indication of its survival prospects in the future.

                                                                                

The Show Must Go On:

“Modern capitalism has no purpose except to keep the show going” – Joan Robinson

Few people are brave enough to predict the market we are in right now over the medium term. There are too many contradictions and doubts about the fundamentals that govern markets, and it comes down to herd mentality in such situations. Equity markets have not sold off, and this makes for a truly enlightening study on investor psychology. Nothing seems to matter but interest rates. All the other news flow is superfluous, even if it is related to revolutions and nuclear meltdowns.

The current situation in Japan is still not under control. The Fukushima nuclear plant continues to emit waves of nuclear radiation, as the market capitalization of TEPCO has fallen bellow $1 trillion. There are definitely some unaddressed supply concerns that the developed world will have to take note of as a result of the productivity slowdown in the aftermath of the Japan disaster. Meanwhile, the situation in the Middle East also remains far from solved, and yet investors seem confident that the crisis is on its last legs. Oil prices have stabilized just above $100 for now, an indication that investors perceive less risk to oil supply in the coming weeks. All this confidence is coming amidst Obama announcing that he is not ruling out arming the Libyan rebels. Seems a little bit like what America did to Afghanistan when Russia was in control? There is no end game in sight if one looks at the middle-east situation based on historical perspective

The S&P 500 closed on Tuesday near one of its favourite levels of resistance at 1320. This upward surge from 1279 (after the initial post-Japan sell off) has been driven by no fundamental news. The housing slide in America continues to be worrisome- with the Case-Shiller 20-City Home Price Index falling 3.1% from year ago levels. There are supply concerns faced by auto manufacturers as a result of the Japan disaster, and unemployment has not witnessed any great slowdown. Likewise in the case of the Eur/Dollar, the risk on trade for the dollar continues through to this week with the currency pair trading above the pivotal 1.4 level.

Meanwhile, the Euro-zone continues to battle credit downgrades and risk aversion in the bond markets, even as equity markets remain calm. The Dax is nearing its key 7000 mark, and the FTSE is near 6000. Both these levels are important in assessing how much optimism is priced into the markets, and as they are crossed, the risk on trade is definitely on. Predictably, following from the pattern of equity markets in America and Japan (Nikkei comfortably above 9000), the European equity markets are not bothered by socio-economic fundamentals.

The yields on the 10 year German bonds (bunds) are within 3 basis points of the most in 14 months. This makes sense since there is clearly going to be an ECB rate hike in the very near future (next meeting is on April 7^th). The other concerns in the Euro zone are of course the credit ratings of Portugal and Greece which were downgraded once again by S&P to BBB- and BB- respectively. Now Portugal’s rating is one notch above junk status. Does not seem like thrilling news for equities at the outset does it! Furthermore, there are also political concerns in the Euro zone , with the governments in France and Germany facing political uncertainty. Merkel and Sarkozy have both lost in regional elections held recently in their countries. There seems to be a resurgence of socialist political power in the Euro zone and perhaps befittingly so given that austerity is being promoted by the right wingers.

So what does one do in a situation, where we remain in a bear market in the sense that with every jolt to the economic structure of the world, there is a knee-jerk reactionary sell off, and commodities remain expensive? Equities seem destined to remain in a sideways trend for some time to come, and as I have been pointing out all through this year, June is the key month for the markets. Given that low interest rates are probably the sole drivers of the equity markets as of today, QE3 is looking all the more probable.

 

The Week of March 14th: Speculation and the Yen

There is a common misconception about currencies and their values which goes somewhere along the lines of - the stronger the currency, the stronger the economy. This is an incorrect view which does not consider the fact that export dependant nations necessarily need to keep their currencies weak. Even the dollar is not an exception to this rule, and one of the unstated objectives of the massive quantitative easing programs being carried out by the Federal Reserve is to weaken the dollar. This is done through creating extra supply of dollars and hence affecting the balance of payments which further affects the exchange rates.

Currently there has been a great amount of discussion in the currency markets about the sharp appreciation of the yen following the massive natural disasters that hit the country last week followed by the reactor meltdowns. The increase in the value of the Yen seriously undermines the potential for a recovery in the equity markets which have been rocked by the recent spate of disasters afflicting Japan. The Nikkei fell by over 10% on a single day this week, wiping off billions in value from the equity markets. The Japanese have always been a strong and resolute people, but even they will not be able to dig themselves out of this hole if their currency continues to strengthen. The rise in the Yen has been attributed to speculative activity by traders. The Yen touched 76.375 to the Dollar on the 16^th of March, a move that gained momentum after some heavy options book selling. This was the strongest the Yen has been since the aftermath of the Kobe earthquake when the Yen hit 79.75 to the Dollar.

Fundamentally speaking, the appreciation of the yen can be attributed to risk aversion following the earthquake. The Japanese have had to repatriate their foreign assets home in order to fulfill the needs of disaster relief and reconstruction activity. This risk aversion has been strong over the last few months in any case. The happenings in the Middle East do not make the case against risk aversion strong. Furthermore, reports from hedge funds suggest that equity hedges of up to $20 billion over January-February to insure against the weakness in Japanese equities have lead to further currency appreciation.  .

Historically the Yen has been strengthening against the Dollar in the very long term. In the late sixties, it took over 350 Yen to purchase a Dollar, and these days it is hovering around 80 Yen to the Dollar. The most recent highs for the Dollar were reached at the peak of the asset bubble in June 2007 when 124.14 Yen would buy one dollar. Since that peak, the Yen has been in a long term appreciation trend against the dollar. This trend does not seem likely to reverse in the long term despite many possible central bank interventions.

The G7 have agreed to get their feet wet in the currency markets to curb the current appreciation. The exact amount of intervention has not been clarified, and indeed it does not matter. The main effect of intervention is the effect of the announcement in the minds of currency traders. Much like interest rate announcements, such an explicitly announced intervention will be priced into the market without the need for actual significant amounts of intervention. As I type this, the Yen has weakened to 81.76 to the Dollar.

The interesting effects of currency intervention could be the creation of extra liquidity in the Japanese economy. The Bank of Japan might not absorb the extra liquidity that will be generated by the current increases in supply of the currency. The economy has been in a veritable deflationary spiral for decades, and might just benefit from the series of disasters that have struck it recently in that there might actually be some inflation in Japan at the end of the current rounds of quantitative easing. Albeit unlikely given that monetary expansion has not worked so far, this would truly be a turn around moment for an economy which has more or less stagnated since the collapse of its massive asset bubble in 1991.