Tag Archives: FX

The Relentless Rise of the Dollar and Fall of the Yuan

With sentiment at the Fed shifting toward a rate rise in June, and news today in the Wall Street Journal (see China loses resolve to revamp Yuan) that China is again worried about the pressure on the Yuan, we can all predict what is about to happen. 

The low interest rate the Fed promotes has been described as a response by the Fed to the lack of active policy by the US government to drive economic growth. The market distortion as a result of the low interest rate are frightening. There was a piece, albeit an opinion, in yesterday’s Financial Tines that explained the impact on savings (negative), retirement planning (disastrous), and debt (growing toward all time highs again).   But we will not change the government’s actions overnight, not until November that is, and even that is not guaranteed. So we are stuck between a rock and a hard place. The Fed wants to raise rates but has to avoid chocking off the meager growth that is limping along.

China has its own economic challenges. As it wrestles with the gradual transition from a manufacturing based economy to a consumer and services based economy, it is using the exchange rate to control its export competitiveness. Note that in recent times, in studying the UK’s transition between late 1950’s to the 1990’s, this effort won’t be easy or quick. But China is trying to move quickly, perhaps too quickly.  And despite the IMF signaling it’s faith that China was going to let the market drive the Yuan’s exchange rate, the People’s Bank of China (PBOC) continues to take action to stabilize its currency. 

Assuming the Fed increase interest rates in June, we will all hear that big sucking sound again as capital flies from emerging markets including China back to American shores and the powering dollar. This will trigger a fall in the Yuan and the PBOC will again start to leverage its foreign exchange reserve to stem the losses. That reserve has fallen from an estimated $4th to about $3.2tn in the last year or so. The question is, how far can that reserve go in defending the Yuan?

Sterling was ‘broken’ in the 1970’s and the U.K. Government had to go to the IMF for a loan – check out “Decline to Fall: The Making of British Macro-Economic Policy and the 1976 IMF Crisis, Douglas Wass, 2008”.  That was a low point for the UK. The pound was again ‘broken’, perhaps more famously, by George Soros during ‘black Friday’ when the UK was forced to leave the Exchange Rate Mechanism (ERM), a pegged exchange-rate system that preceded the single currency, the euro. 

Clearly the PBOC won’t use up all its reserves. So the question becomes: what is the level at which the market expects massive red flags? Perhaps a leading indicator to watch are the monthly reported FX outflows from the PBOC. As that ramps up, the red flags will start to fly. And they won’t be the party flags of choice- they will be the economic panic flags that none of us want to see.

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Fear Concerning Chinese Reserves Mount

If you didn’t notice, there are increasing concerns reported in the media about Chinese FX reserves.  It all started a year ago or so when the PBOC’s reported FX reserves showed a slowing of accumulation, and then a slow but progressive fall.  The figure peaked at around $4tn but has since been reported at just over $3tn.  It seems a lot, $3tn, but it has fallen quite fast and the use of the reserve has been in favor of helping the slow but inexorable fall of the yaun, especially against the dollar.  To help the Chinese authorities even changes the way their currency was valued, using a basket of currencies that should have muted the dollars’ rise.  Even that has not helped.  

The concerns by onlookers are mounting.  Every weekend, now almost every day, there are reports of one concern or another.  Last weekend I noted in the US print edition of the Financial Times: Scepticism rife as G20 tries to calm FX.  The G20, meeting in China, was trying to signal to the market that there was nothing untoward about the fall in Chinese FX reserves.  This was an important article since the point was that the G20 itself was voicing support for China – and if the G20 is that concerned, so should we.  In today’s US print edition of the Financial Times there is another article: Concerns grows over Chine’a forex reserves.  The good news is that the most recent data suggest that the outflow of China’s FX is showing signs of easing.  This is good news.  We don’t want China to attract negative market sentiment should it feel that the reserves might be inadequate.  That might lead to a run on the Chinese currency and this would cause turmoil in the markets, and then the global economy. We need to keep an eye on this data point – more so then we should care about the US trade imbalance with China (which is part of the root of the FX build up).

China’s Quantitative Tightening In Focus

On August 10th I blogged (see The Coming Yuan and the Falling Dollar) about a recent Economist article that attempted to explore what would happen “if” the Chinese yuan achieved global currency reserve status.   I thought the Economist article was poorly titled: there is no “if” here in my mind; it is more a discussion of ‘when’.  Thus I felt the excellent analysis was simply couched incorrectly and I didn’t feel there was enough analysis of what might happen along the way.

In my blog I explore the relationship between the now trade-debtor status the U.S. enjoys along with the trillions of dollar denominated debt held by China.  China clearly needs to both support the dollar enough to preserve some semblance of global economic order (else its own holdings fall in value) while at the same time lower its dollar denominated debt (and/or demand for same) and most likely use some of its burgeoning exchange surplus.  Lastly I suggested that big banks must be playing currency and trade games to play out various scenarios.  This journey is going to be a challenge, and probably quite painful for many.
I noted today a really thought provoking article on CNBC that basically explores this scenario: China’s ‘QT’ [quantitative tightening] is the real global economic threat.  The article suggests that China, in its attempt to shift its debt-laden construction driven economy into a consumer driven market economy, will have to de-lever much of its debt: this means dollar denominated debt.  To ensure a ‘managed’ exchange rate China can defend its currency, when needed, by selling some its vast dollarised FX reserve.  In other words China has all the cards: though not all cards are aces.  Selling US debt won’t be easy: who else can afford it?  What happens to US interest rates if no one wants the U.S. debt?  The U.S. will be less able to live beyond its means.  The pressure on those U.S. rates will be UP, just at a time the fragile US economy might not want such increases.  

So this global re-balancing act is fraught with risks.  I stick to my point in my blog: smart bankers are working on some scenarios in order to figure out how to navigate the changes that must come.  The ‘Fed must be working on the same analysis.  Only trouble is, the ‘Fed may not have as many cards left to play.  

In my ongoing studies of UK monetary policy between the wars, and how war debts and inflation were ‘managed’ globally, it is clear from this vantage point that Britain knew it was sliding into deep financial trouble: Britain was bled dry by the war, financially.  Many allied nations owed each other vast sums in war debts; global trade was kaput and no one had any capital to buy food or raw materials needed to kick start trade.  I get the feeling that at the time the U.S. basically ‘stuck it’ to Britain, due in part to innocence (no economist had lived through such globally complex issues before) but also deliberately in that an opportunity had arisen for the U.S., and the dollar, to usurp Brtain and sterlings’ hegemony.  

The U.S. had no interest in collapsing and reconciling reciprocal war debts, that would have enabled Britain to contribute more usefully in reconstruction in mainland Europe.  This decision tied the hands of the financially strapped UK.  It paralysed progress and facilitated wild inflationary and currency swings due to the resulting global monetary instability  Of course the resulting failure of monetary policy and lack of coordination led to disastrous economic results and conditions that contributed significantly to a positive environment for polical crisis in Germany.  The result was World War Two and after that, a cleaner changeover in the order from sterling to the U.S. dollar.

We don’t have world wars to contend with, that is for sure.  But there are growing similarities between the siutation of the UK Treasury and UK economy in the 1920’s and the Fed and U.S. economy in 2010’s.  Only now it is China that is in the 1920 shoes of the U.S., and the U.S. that it is in the 1920 shoes of the UK.  Thankfully the similarities are only that, and not even universal or completely consistent in every way.  But the similarities are interesting enough that observed behavior of nations might follow.  Will China ‘stick it’ to the U.S. economy?  I don’t think so, at least not deliberately.  But deliberately China will do what it thinks it needs to do to push the yuan to currency reserve status.  And so the same ‘innocence’ we saw in the 1920’s may yet repeat.