Global reset – Monetary decoupling (Part 1: Sterilisation and QE)
Phuah Eng Chye (19 June 2021)
One important aspect of the global reset is the decoupling of monetary relationships. Narratives such as currency manipulation or China’s dumping of US treasuries are simple and popular but they offer misleading perspectives on the inter-dependent relationship between US and Chinese monetary policies and on the significant consequences from the decoupling of this relationship.
A proper perspective requires analysis of the impact of large-scale sterilisation and quantitative easing (QE) which has enlarged central bank balance sheets disproportionately. Large central bank balance sheets have led to a tightening of the linkages between monetary policies and markets around the world. They have injected new growth dynamics that overcame previous demand and liquidity constraints to accelerate globalisation, expand financial markets and accommodate the rise of China and other economies. In the process, it also introduced new distortions and risks to monetary policies.
The mechanics of sterilisation and QE
Sterilisations and QE needs to be analysed within the context of the reserve currency framework. The US is the dominant reserve currency. It doesn’t need to sterilise capital inflows (maintain forex reserves). Thus, the US focuses on its managing domestic monetary conditions and has the privilege of effectively dictating monetary policy to other countries. Other countries have to adjust their monetary policies to manage the spillover effects of US policies.
Persistent US deficits (current account, fiscal or savings) effectively creates USD-denominated capital inflows into other countries. Foreign central banks have three tools – its balance sheet, interest rates and exchange rates – to manage the impact of these capital inflows on domestic monetary conditions. Central banks can sterilise the impact of inflows by accumulating foreign exchange (forex) assets. Sterilisation enlarges the central bank balance sheet and dampens the pressure on currency appreciation. The central bank can opt not to use its balance sheet and instead allow domestic interest rates to fall or the domestic currency to appreciate. At some point, the interest rate and currency price adjustments will trigger an unwinding of carry trades and cause capital flows to reverse direction. Generally, central banks strive to maintain stability in interest rates, exchange rates and financial markets rather than to target specific levels.
In QE, a central bank monetises domestic fiscal deficits by purchasing government debt; in effect printing money. This enlarges the central bank balance sheet. For most central banks, balance sheet expansion through QE is constrained by the threat of heavy capital outflows that can contract domestic market liquidity and trigger a run on the county’s currency. Countries with trade, fiscal or savings deficits are particularly vulnerable to these risks.
This balance-of-payments constraint doesn’t apply to the US because it is the issuer of the dominant reserve currency. As mentioned earlier, persistent US deficits generate an outward flow of USD into other countries. These countries may react by sterilising to prevent their currency from appreciating or to keep their domestic economy from overheating. Sterilisation, or the purchase of US government debt, relieves the pressure on the Federal Reserve (Fed) to conduct QE. In this regard, the US deficits are financed by foreign central banks. Hence, sterilisation by foreign central banks can significantly ease the US balance-of-payments constraints and accommodate the US to run persistent deficits for a lengthy period.
As the size of policy interventions is disproportionately large, it matters whether the US deficit is financed by foreign central banks (sterilisation) or by the Fed (QE). In simple terms, the difference is that sterilisation expands global liquidity while QE expands local liquidity. The consequences of large sterilisation and QE exercises on monetary and economic conditions over the past three decades are summarised as follows.
Post-1998 Asian crisis (Sterilisation without QE). The crisis exposed the frailties of Asian economies. Asian central banks started to accumulate sizeable USD reserves as a buffer or insurance against the volatility of capital flows. The Asian sterilisation was criticised as currency manipulation to prevent currency appreciation. On the other hand, Asian countries blamed the US for not controlling its savings deficit. Large sterilisation gave rise to the global savings glut hypothesis that US inflation rates stayed low due to the cheap Asian exports (from cheap currencies) and US interest rates stayed low due to Asian reinvestment of its saving in USD debt. In other words, Asia was financing the US fiscal and trade deficits. If the Asian central banks did not undertake sterilisation, the predicted outcomes based on accounting identities would be (1) the Fed would have to undertake aggressive QE to finance the US fiscal and trade deficits; (2) the USD would be weaker and interest rates higher; or/and (3) US deficits would shrink and this would cause US and global economic growth to contract.
In my view, this is not a sufficient explanation as to why the huge expansion in global USD liquidity didn’t have severe repercussions on the US balance of payments. Broader factors should be considered. There is a tendency to underestimate the overwhelming demand for global liquidity which was subsequently filled by the USD as the only viable candidate currency. This included the rapid growth in emerging economies led by China, the global shift from bank intermediation to market intermediation and the transition from a physical to an information economy. Emerging countries adopted many features of the Western capitalism model. They deepened their markets, set up sovereign wealth funds, nurtured their asset management industry, adopted global rules and standards, and strengthened governance and professionalism for listed companies. The expansion of USD liquidity, which assured USD supremacy, was a critical development strengthening global connectivity among governments, firms, intermediaries, investors and markets.
Post-2008 Global financial crisis (Sterilisation + QE). In response to the crisis, policy-makers coordinated a massive round of fiscal and monetary stimulus. The combination of QE and sterilisation took global central bank balance sheets up another level. China continued to build its sterilisation reserves aggressively and paused after 2013. As the global economy stabilised, central banks attempted to normalise their balance sheets but with patchy results. Lyn Alden relates “the Fed, in particular, did three major rounds of quantitative easing, but those ended in late 2014. Between 2014 and 2015, as the Fed shifted to tighter monetary policy by putting an end to QE, the dollar quickly strengthened, resulting in the third major dollar bull run. Several emerging markets subsequently encountered a severe recession from 2014-2016”. “A combination of looser fiscal policy and tighter monetary policy than the rest of the developed world from late 2014 to the present has been a recipe for a strong dollar, while it lasts”.
2016 Trump presidency (Normalisation). With the global economy on a stable footing, central banks focused on normalising or downsizing their balance sheets. This coincided with the introduction of America First policies – comprising tariffs, sanctions and other actions – which can be said to have triggered the global reset. Lyn Alden notes “in 2016, the dollar reached a peak… weakened significantly throughout 2017, and the world encountered global synchronized growth…In early 2018, the Fed began quantitative tightening (reducing the size of its balance sheet), and the dollar began re-strengthening. From peak to trough, the dollar only had a 12% drawdown from its peak, and never achieved one of those massive 40% dollar declines like the previous two cycles. By mid-2018, global growth began to slow in the US and the rest of the world. The dollar weakness was a fake-out, in other words. It was still a strong dollar period. By summer 2019, the Fed began cutting interest rates in the face of slowing economic growth. In September 2019, the overnight lending rate in the US banking system spiked, leading the Fed to begin supplying repo liquidity, and then eventually to buying T-bills and expanding its balance sheet, which marked the end of quantitative tightening”.
Lyn Alden explains “this was an example of the system correcting itself, or more specifically, forcing US policymakers to correct it. A strong dollar contributed to slowing global GDP growth, including in the United States, which led the Fed to cut rates. And, with foreigners not buying enough Treasuries for years due to the dollar being so strong, the US domestic balance sheets became increasingly stuffed with Treasuries and couldn’t keep buying more, so the Fed had to shift from quantitively tightening to quantitative easing to begin buying a ton of Treasuries, which floods the system with liquidity. The dollar began weakening again from there, as expected. However, the COVID-19 pandemic hit in early 2020, which halted global trade and contributed (along with a structural oil oversupply issue) to a collapse in oil prices. The dollar quickly spiked, foreigners began outright selling Treasuries and other US assets to get dollars, causing the Treasury market to become very illiquid and ceasing to function effectively…the Fed cut rates to zero and performed massive quantitative easing, and the US federal government performed massive fiscal stimulus”.
Lyn Alden points out from 2015, “foreigners have been buying very little U.S. government debt compared to what they used to, which means that domestic sources have had to buy most of it instead. The U.S. government increased its debt levels by $4.6 trillion from 2015 through 2019, but foreigners only bought $700 billion of that, and almost all of that was private investors during a brief period in the first 2/3rds of 2019…Large U.S. government debt and deficits, combined with a relative lack of foreigners buying those Treasuries for the past five years, eventually contributed to the September 2019 spike in overnight lending rates (the repo spike, where interest rates shot up dramatically until the Federal Reserve intervened). With $4.6 trillion in new U.S. treasuries issued from Q1 2015 to Q3 2019, and about $3.9 trillion of that funded domestically, it means that about $3.9 trillion in dollars were sucked out of the U.S. financial system and converted into Treasuries over a five-year period. That’s a big dollar liquidity drain…Foreign holdings of U.S. treasuries peaked in August 2019 and turned down, just weeks before the repo spike that occurred in mid-September. Leading up to the repo spike, U.S. domestic balance sheets were stuffed full of Treasuries (especially T-bills) and couldn’t buy much more, resulting in a dollar liquidity shortage and an excessive supply of Treasuries. Large banks (primary dealers of Treasuries, the ones who serve as middlemen) ran into post-crisis lows for cash as a percent of total assets during the week of the repo spike: Within a day of the liquidity shortage and repo spike, the U.S. Federal Reserve stepped in to begin expanding the monetary base to borrow and buy some of the excess supply of Treasuries. The Fed has been the main buyer of U.S. Treasuries since that time. So, rather than sucking existing dollars out of the system as they were from 2015-2019, newly-issued Treasuries are now being funded by newly-created dollars, which means less or no liquidity drain”.
Frances Coppola argues the repo rate spike was due to the fact that since mid-2018 “the entire market has become dependent on funding from just four big banks. If those banks reduce lending to the market even slightly, the market suffers a heart attack…possibly as other banks do not have the scale and non-bank cash suppliers such as money market funds (MMFs) hit exposure limits…The four banks collectively are acting as lender-of-last-resort to the market. They are effectively doing the job of a central bank. But they are not a central bank, they are commercial banks driven by their own profit motives – and those motives can be in conflict with the needs of the market. Furthermore, they are ultimately dependent on the Fed for cash liquidity. And the Fed has been blindly pursuing a monetary policy that diminishes the cash available to banks”. Hence, the large US banks have become prudent and are positioned to squeeze other players to exploit liquidity shortages. This implies a shifting of the burden on the central bank to underwrite market liquidity.
2021 Biden presidency (QE). The Biden administration inherited a policy quandary and its options have been worsened by the pandemic. It is nonetheless responding vigorously and has launched a massive fiscal stimulus with plans for additional spending. In the absence of sterilisation, these large US fiscal deficits are mainly being financed by QE. The QE stimulus has already seeped into asset prices. Equity indices are at all-time highs and funds are seeking alternatives such as newly-minted and retail-favoured assets (IPOs, SPACs, Reddit stocks and crypto assets) as well as traditional assets such as commodities and housing.
QE has created so much liquidity that the Fed had to intervene to mop it up. Wolf Richter notes in early 2021, the Fed is engaging in reverse repos: “so with one hand, as part of QE, the Fed is buying $120 billion a month in Treasury securities and MBS. With the other hand, the Fed took back $351 billion via overnight reverse repos, undoing nearly three months of QE.” “This is the first time that I have seen Wall Street banks clamoring for the Fed to back off QE as the banking system is creaking and straining under the huge pile of reserves. And apparently, from the response disclosed in the minutes, the Fed is figuring out that you can push QE only so far before something big is going to go haywire with unforeseen consequences”.
Over the past two decades, sterilisation and QE programmes have enlarged central bank balance sheets around the world. Asian (ex-Japan) central banks enlarged their balance sheets after the 1998 Asian financial crisis. The Fed and ECB enlarged their balance sheets after the 2008 crisis and is now on course for another massive expansion in response to the pandemic. One key difference to note is that the global economy has shifted from a phase of QE with sterilisation into a phase of accelerated QE in the US and EU without sterilisation.
The outcome of QE without sterilisation is that domestic liquidity is expanding rapidly against a backdrop of stagnating global liquidity. There are several important implications. First, how are economies with trade or savings surpluses, in the absence of sterilisation, to deal with the threat of capital inflows created by USD liquidity. In recent years, some European countries and Japan favoured letting interest rates fall, even to negative levels, to stem capital inflows.
Second, the lack of sterilisation implies falling levels of global liquidity. This, in turn, implies higher asset price volatilities, higher incidence of asset price “sudden stops”, the withdrawal of intermediation capacity, higher hedging costs and deleveraging. Combined with the increasing incidence of supply bottlenecks and a strengthening Yuan, cost-push inflationary pressures are growing. Hence, there are rising risks that unexpected movements in USD and interest rates could trigger market dislocation and financial contagion. A more detailed analysis of large central bank balance sheets is required.
Frances Coppola (10 December 2019) “The blind Federal Reserve”. Coppola Comment. https://www.coppolacomment.com/2019/12/the-blind-federal-reserve.html?m=1
International Relations Committee Task Force (2006) “The accumulation of foreign reserves”. European Central Bank. https://www.ecb.europa.eu/pub/pdf/scpops/ecbocp43.pdf
Joshua Aizenman, Hiro Ito, Gurnain Kaur Pasricha (8 April 2021) “Central bank swaps in the age of Covid-19”. Voxeu. https://voxeu.org/article/central-bank-swaps-age-covid-19
Lyn Alden (11 April 2020) “The global dollar short squeeze”.
Lyn Alden (6 December 2020) “The fraying of the US global currency reserve system”.
Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society. http://www.amazon.com/dp/B01AWRAKJG
Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”. http://economicsofinformationsociety.com/global-reset-two-whales-in-a-pond/
Scott Sumner (18 February 2020) “Currency manipulation: Reframing the debate”. Mercatus Center at George Mason University. https://www.mercatus.org/publications/monetary-policy/currency-manipulation-reframing-debate
Wolf Richter (20 May 2021) “Fed drains $351 billion in liquidity from market via reverse repos, as banking system creaks under mountain of reserves”. Wolf Street. https://wolfstreet.com/2021/05/20/fed-drains-351-billion-in-liquidity-from-market-via-reverse-repos-as-banking-system-creaks-under-mountain-of-reserves/
 See Scott Sumner for a review of the theoretical debate on currency manipulation.
 See International Relations Committee Task Force for a conventional perspective on forex accumulation.
 “Carry trades” are highly leveraged trades that seek to exploit the differential between domestic and international interest rates and account for a major proportion of global capital flows.
 Repo rates spiked due to the liquidity stress in the FX and currency swap markets. Joshua Aizenman, Hiro Ito and Gurnain Kaur Pasricha describes how the Fed reinforced swap arrangements and established a financial institution and monetary authoritie’ repo facility in response to the acute strains in the offshore dollar funding markets during Covid-19.
 In other words, given the absence of large-scale sterilisation, the Fed QE is expanding the supply of safe assets will alleviate the supply shortages and cause US interest rates to rise.