The dismal decade (Part 8: Seven forces shaping 2030 #5)
Phuah Eng Chye (31 August 2024)
Force #5 – Monetary geopolitics and the Fed policy transition
This is my third article focusing on monetary issues in “The dismal decade” series. The first covered “De-dollarisation and currency landscape in 2030” and the second “Adversarial monetary policies”. The preponderance of monetary articles reflect my dissatisfaction with mainstream analysis and I wanted to take this opportunity to express my views.
The global monetary landscape is in a state of disorder. Analysis is complicated by three developments. First, the Goldilocks era of low global interest and inflation rates was an anomaly created by China’s willingness to purchase US debt to finance US consumption. Decoupling and de-dollarisation broke this relationship. The outcome is a transition to a higher global interest and inflation rate environment. Second, data trends were badly skewed by extraordinary events such as the pandemic, decoupling, Russian invasion of Ukraine and outsized government responses (unprecedented fiscal and monetary support, and comprehensive financial sanctions[1]). Erratic data patterns makes it difficult to gauge the underlying trends. Third, structural changes in global financial markets – the enlargement of central bank balance sheets, proliferation of investment funds and financial products and a relatively static banking system – has changed monetary channels and the transmission of effects. Thus there is a need to adjust the analysis of monetary behaviours, policy options and scenarios to take into account these developments.
US fiscal deficit, debt and dependency on foreign buyers
The starting point is to address the elephant in the room; namely the US fiscal deficit and debt. The size of the US economy and the dominance of its currency means there are significant global consequences arising in relation to how the US Treasury and Fed manages their fiscal position. In this context, the Congressional Budget Office (CBO)[2] projects the US budget deficit will reach a staggering $1.9 trillion for FY ending September 2024. Niccolo Conte notes “the cost of paying for America’s national debt crossed the $1 trillion dollar mark in 2023, driven by high interest rates and a record $34 trillion mountain of debt”. “Over the last decade, U.S. debt interest payments have more than doubled…At current rates, the U.S. national debt[3] is growing by a remarkable $1 trillion about every 100 days, equal to roughly $3.6 trillion per year…On average, the U.S. spent more than $2 billion per day on interest costs last year. Going further, the U.S. government is projected to spend a historic $12.4 trillion on interest payments over the next decade, averaging about $37,100 per American…the CBO forecasts that roughly 75% of the federal deficit’s increase will be due to interest costs by 2034”.
Guido Ascari, Giancarlo Corsetti, Tilda Horvath and Riccardo Trezzi notes “in the US, right now, nominal GDP growth is roughly equal to long-term yields. In this case, the debt/GDP ratio stabilises only if the primary deficit is close to zero. However, the current US primary deficit is around 4% of GDP (3.8% in 2023). Therefore, given potential growth and nominal yields, the fiscal correction needed to stabilize the debt/GDP ratio is around 4 percentage points of GDP. Let’s suppose that real GDP grows at a steady 2.5% going forward. This is substantially higher than the rates underlying the CBO projections, setting 2% for 2025 and 1.8% for 2026 onward. In our simulation, we raise overall growth by distributing add factors to each component of GDP. While higher GDP results in an improved debt/GDP dynamic, absent fiscal correction the path of the debt/GDP ratio remains explosive: the fiscal benefits of higher real GDP growth are more than offset by the fiscal stance. For growth to have a significant effect, we would need to raise it on a permanent basis to a staggering – and implausible – level above 4%”. At this point, even substantial spending cuts and deficit-stabilising measures are insufficient to stop the trend. “Fast-track consolidations would require politically unfeasible hikes in tax rates and spending cuts, with harsh consequences on the economy”. “In our best scenario analysis, stabilising the fiscal outlook will take years to accomplish, but also require significant action already in the short run, operating on both spending and taxation”. “With debt growing at a sustained rate, delaying action can only make the required correction larger…Large debt may give rise to instability driven by self-validating expectations of a crisis. As the recent experience in Europe suggests, attempts to stabilise the fiscal outlook when markets are jittery are often self-defeating”. They conclude “the model prediction is crystal clear: starting now, it will likely take at least a decade to fix the excessive deficit issue. A year or two of mild measures would hardly do anything. It follows that stabilisation would require some form of bipartisan consensus on sticking to a reasonable path of fiscal adjustment for some time, whichever party governs. The worrisome question is: how many politicians and market participants are aware of the real situation, and have the means and the will to act?”
Wolf Richter notes the US national debt spiked to $34.7 trillion currently from $23.3 trillion in January 2020 – a rise of $11.4 trillion over four years and five months. Domestically, US government funds hold $7.1 trillion (20.5%), US mutual funds $4.8 trillion (13.8%), US individuals $2.6 trillion (7.4%), banks[4] $2.2 trillion (6.3%), state and local governments $1.7 trillion (4.9%) and other US institutions $2.1 (6.0%). The Federal Reserve holds about $4.6 trillion (13.2%). “Under its QT program, the Fed has already shed $1.31 trillion of its Treasury securities since the peak in June 2022”.
Foreign holders own $8.0 trillion (23%) of US government debt. Wolf Richter points out “foreign investors have continued to add to their holdings of Treasury securities over the years, but the US debt has grown far faster, and so the share of the debt that is held by foreign entities has been declining for many years. In 2014-2016, foreign investors held over 33% of the debt. Their share is now down to 22.9%. In other words, the US debt financing has become far less dependent on foreign holders – and…even less dependent on China and Japan”. China and Hong Kong have whittled down their combined holdings from over $1.4 trillion in 2012-2017 to $992 billion. Japan has maintained its holdings between $1.0 trillion and $1.3 trillion over the past 12 years, and has regained its position as the largest US creditor. Purchases by US allies have offset China’s sales. The six largest financial centers – the UK (largest with $710 billion), Belgium, Luxembourg, Switzerland, Cayman Islands, and Ireland – recorded 9.2% yoy growth to $2.31 trillion in March 2024; more than tripled since 2011. Euro countries have increased their holdings from $500 billion in 2011 to $1.58 trillion (14.6% yoy growth). Other major buyers include Canada ($338 billion, +36.9%), Taiwan ($257 billion, +5.3%) and India ($234 billion, -2.2% yoy but up six-fold since 2011).
Sustaining foreign buyer support is an important aspect of managing the US government debt. Without foreign purchases, the burden of financing government debt would fall completely on US investors and the Fed. In this regard, there is insufficient domestic private capacity to absorb the full amount of US deficits. This potentially increases the burden on the Fed to purchase US government debt via QE or money printing. In anticipation of this, the Fed astutely reduced its holdings of government debt via QT by $1.33 trillion from its peak in June 2022 to $4.38 trillion in June 2024. In total, the Fed shed 41% of the $3.27 trillion in Treasury securities it added during the pandemic. This creates space for the Fed to reinitiate purchases of government debt when they are pressed to do so. Future QE exercises will be determined by how the Fed choses to respond to domestic recessionary or financial stress pressures and the interest rate level it sets (and whether this is attractive enough to foreign buyers).
As noted earlier, the foreign investor share of US debt has fallen to 22.9% from 33% during 2014-2016. It should be noted the earlier 33% share is skewed by international support following the 2008 global financial crisis. Thus, the decline to 22.9% may reflect a return to more normal levels. With its loss of status as a geopolitically ‘safe asset”, China has been continuously trimming its USD reserves while Global South economies have generally not been major purchasers.
This means the US has become more dependent on its allies to provide buying support. Japan is the largest holder but has exercised restraint in disposing its US government debt despite tremendous pressure on the yen. Other allies have significantly stepped up their purchases over the past two years to offset the China sales. This may explain why the USD’s and yuan’s share of global reserves have been relatively stable.
It is timely to revisit the logic of why foreign central banks should accumulate large FX reserves. This trend started after the 1997-8 Asian crisis when central banks found themselves unable to defend their currencies (dirty pegs) in the face of speculative attacks. Thus, Asian central banks built large reserves as an insurance buffer against future attacks – and it has generally worked so far. But is the insurance motive still valid in light of geopolitical conflict – given decoupling, sanction risks and de-dollarisation? For “adversarial” countries, the risks now considerably outweigh the benefits of maintaining high levels of USD reserves.
The recent USD debt purchases by the international financial centers, Euro countries, Canada, Taiwan and India comprise both official buyers (central banks and sovereign pension funds) and private sector buyers. A portion of the rise in foreign holdings of US government debt reflects a surge in long-USD carry trades. In particular, the central bank USD purchases marks a departure from the market-based philosophy of letting exchange rates float freely and may reflect geopolitical motivations. Generally, it is odd for central banks to purchase US government debt when the USD is appreciating as this would aggravate domestic currency weakness and turn into a source of inflationary pressure (e.g. imported energy costs).
It is my view that central bank balance sheets have generally grown so large that the central banks are no longer price takers but are in effect market makers. As market makers, central banks should manage their inventory size to stabilise exchange rates with profits as a secondary but nonetheless still relevant objective. Consistent with their role as market makers, the basics are that central banks should reduce their USD inventory when USD is strong and accumulate FX reserves when USD is weak.
Why USD is strong when fiscal deficits and debt are so high?
Conventional theory suggests currencies should depreciate when a country runs massive fiscal deficits. Despite record deficits and debt, the USD has instead strengthened against most currencies. Several arguments are provided.
- Some argue dollar strength[5] reflects US exceptionalism. Despite the US economy experiencing difficulties from time to time, the world finds “there is no alternative (TINA)” to USD as the world’s currency and safe asset. While the indispensability argument supports the dominant market share of USD, it doesn’t specifically explain why the USD has been so strong.
- Reinforcing the indispensability argument, the world has little alternative to US-denominated consumption and financing. Global demand is dependent on the US role as the N-1 country (the largest net importer) and most borrowings in the world are also denominated in USD. In this context, US monetary tightening tends to reduce USD global supply and heightens the importance of exports as a means of earning USD. Countries and firms unable to earn US-denominated revenue will face difficulty in repaying USD-denominated loans.
- In recent years, reindustrialisation incentives have resulted in substantial foreign direct investment inflows into the US. In addition, rising defence spending and higher energy prices also contribute to USD strength.
- Decoupling has led Western firms to withdraw investments in China. While some of this has been deployed to “target” host countries (e.g. Japan, India), a significant amount was reinvested (with leverage) in US and Western assets. This explains the buoyancy of asset prices in the West. In this context, a significant proportion of offshore USD is held by Western MNCs and financial intermediaries which regard the USD and other Western currencies as safe havens. They would minimise exposure to Chinese-denominated assets to reduce exposure to geopolitical risks.
- The most important development is that the Fed is tightening monetary policy – raising interest rates and draining excess domestic liquidity (via QT) – which offsets external balance pressures on the USD. Taking a cue from the Fed, Western central banks began tightening their balance sheets from April 2022 onwards. As at August 2024, ECB’s total assets have fallen to €6.45 trillion; down by 27% from the peak of €8.84 trillion, and at the lowest level since August 2020. In USD terms, the ECB has shed $2.66 trillion in assets, while the Fed has shed $1.78 trillion. Together, they’ve removed nearly $4.4 trillion in QE liquidity. This has led to a global shortage of USD liquidity which has been aggravated by a massive carry trade arbitrage as investors borrow in currencies with lower interest rates and invest in the higher yielding USD.
These trends assist the US to concomitantly run massive deficits and maintain a strong USD. It reflects the USD global consumer and currency hegemony is still intact. The USD dominance is backstopped by whole-hearted backing from its allies, Western intermediaries and MNCs, and the advantage of its sophisticated financial infrastructure that allows it to sustain remarkably high levels of leverage.
Jason Choi, Duong Dang, Rishabh Kirpalani and Diego Perez note the US public debt has exceeded “100% of GDP. Coupled with rising interest rates, this has raised concerns about the sustainability of US public debt and the government’s ability to meet its obligations. One argument mitigating these concerns is the US’s role as a global safe asset and reserve currency supplier. The potential loss of this exorbitant privilege in the event of a default imposes substantial costs, incentivising the US to continue servicing its debt”. They estimate the “convenience yield[6], reflects the additional liquidity and collateral properties of US debt valued by investors…saves the US government 0.7% of GDP in interest payments annually on a debt stock of 120% of GDP”. In addition, the current foreign holdings of US currency amounting to $1 trillion provide seigniorage revenues to the US government estimated to contribute 0.16% of GDP annually, assuming a 4% interest rate…Combined, these benefits save the US government approximately 0.9% of GDP annually due to its status as a safe asset issuer”. “The special status increases the maximal sustainable debt by approximately 22% of GDP. Most of this increased capacity arises from the convenience yield channel: an economy without the non-pecuniary benefits of US debt can sustain 18% less debt”. “The analysis suggests that maintaining the US’s special status in global financial markets is crucial for debt sustainability. Efforts by other countries to establish competing safe assets could pose challenges to the US’s dominant position, impacting its debt management strategies”.
How long can the co-existence of large US fiscal deficits and a strong currency be sustained?
Leaving aside black swan events (financial crisis or war), various scenarios will play out depending on how the Fed resolves policy tensions between the domestic and international fronts. On the domestic front, the Fed currently follows a crowding out strategy which allows it to conduct QT. By keeping interest rates high, the central bank outbids the private sector (e.g. Paul Volcker in the 1980s[7]) and other countries for USD liquidity. In this circumstance, government spending “crowds out” the private sector. In addition, the high interest rates attracts foreign investment in US government debt and this results in a strong USD. At the moment, the US economy is in a sweet spot and is yet to feel the full impact of higher interest rates due to lag effects[8]. Once the full impact materialises (falling consumer spending, rising unemployment, mounting losses from high interest rates and/or bank deposit flight), a recession will likely ensue and the pressure on the Fed to lower interest rates will mount.
The Fed will then have a choice between staying on the crowding out path or shifting onto the liquidity trap path. Even if it sticks to crowding out, it should be noted the US economy is no longer in a position to tolerate higher interest rates. In the 1980s, the US debt-to-GDP ratio was around 30%. Today, it is above 120%.The large debt and projected interest expense will dissuade the Fed from raising interest rates much higher from current levels of around 5%. As the US economy eventually enters into a recession and as the government’s debt servicing cost rise, the question then is whether the Fed can withstand the pressure to stick with its higher-for-longer stance.
This suggests a high likelihood that the Fed will soon begin easing interest rates with the restart of QE to potentially follow. On the liquidity trap[9] path, the size of QE (the quantity of government debt the Fed needs to buy) will depend on its interest rate target. The higher the target interest rate, the less debt it needs to buy while the lower the target, the more debt it needs to buy. If the Fed opts for extreme zero-bound interest rates (as in Japan), it would probably end up having to mop up US government debt. This scenario comes closest in leading to liquidity trap conditions.
The tendency is to analyse US monetary policy solely within a domestic setting (impact on inflation, employment and GDP growth). This time, international considerations may weigh more heavily on the Fed’s policy decisions. First, the Fed needs to maintain US interest rates at a level above other countries to entice foreign buying of US government debt. Second, US interest rates are a major determinant of dollar strength. Lowering US interest rates risk triggering an unwinding of carry trades which would weaken the dollar and result in a vicious downcycle. This would erode international support from US government debt and possibly trigger deleveraging in Western markets. The carry trade dynamics could also change if other countries such as Japan and China, for their own reasons, begin to raise interest rates.
At the moment, the Fed benefits from “interest rate” illusion where the market persistently believes interest rates are due to fall sharply and soon but the regulators keep maintaining interest rates at high levels. This has allowed the US economy to enjoy the best of both worlds – high interest rates, a strong currency and steady economic growth. The illusion is beginning to crack as some of the trends cited in the earlier section are starting to reverse.
Recent developments hint the endgame is approaching. Generally, European economies are under greater pressure and as their central banks try to normalise their monetary operations and lower interest rates, this would impose constraints on USD leverage and liquidity creation. In Japan, the latest attempt to exit the QE trap by raising domestic interest rates triggered an unwinding of global carry trades and has made markets more jittery. The changing monetary conditions suggests a confrontation is developing between markets and governments which would jeopardise the current “stability”. This confrontation is less concerned with inflation and unemployment but more with exchange rates and corporate profits. My view is that the Fed is likely to want to avoid extreme scenarios; search for a middle path of moderate QE with an interest rate target range of between 3% to 4% and tolerate some weakness in the dollar. Despite their efforts, my view is that the co-existence of large US fiscal deficits and a strong currency is unlikely to be tenable beyond 2025-6.
Monetary geopolitics
The geopolitical dimensions of monetary policy are becoming increasingly important. Currency and monetary policies[10] have unfortunately become part of the arsenal of soft power tools weaponised in “whole-of-society” asymmetric warfare. Capital thus no longer flows freely in search of the best returns or the lowest risk. Instead, the new patterns of capital flow are dictated by geopolitical loyalties reinforced by sanctions, controls, suasion and public and political pressure.
International policy debate is centered around the global imbalances – in effect, China’s dominance in manufacturing[11] and US dominance in finance. Though it is not explicit, rebalancing of China’s dominance of manufacturing would also necessitate a rebalancing of US’s dominance of finance. Global rebalancing thus has ramifications related to respective vulnerabilities from reducing their respective dominance.
Brad Setser points out “the link between financial self-reliance and geopolitical power has long been debated. The unbalanced Sino-American trade relationship has created asymmetric financial ties which generate potential sources of leverage for both parties and will not quickly disappear. Absent a clarifying major crisis, it will be difficult to definitively determine which party has greater leverage…Both parties thus worry about the possibility that financial interdependence can be weaponized yet find it hard to extricate themselves from the inevitability of financial interdependence absent a clean break from an entrenched pattern of trade imbalances…China’s government owned far more US bonds than the American government owned Chinese bonds, and China’s economy relied far more on US demand than the US economy relied on Chinese demand. Yet is also important to note that in a crisis, countries don’t need access to external finance so much as access to real goods and services. China’s leverage in an economically interdependent relationship may stem less from the large stock of financial assets under the control of China’s state and more from the difficulties of finding alternatives to Chinese parts and final assembly. China’s importance to the global supply of advanced manufactures has increased enormously over time. In a crisis over Taiwan, China would likely lose access to its reserves – and the G7 countries would see their supply of new cell phones disappear”.
Overall, monetary policy conduct is constrained within the framework of the impossible trinity[12] or trilemma. The trilemma refers to the hypothesis that countries cannot pursue a monetary policy independent of the US, maintain a fixed exchange rate target and allow the free flow of capital all at the same time. The trilemma thus suggests monetary policy conflicts needs to be eventually resolved by convergence of interest rates or an exchange rate adjustment. Hence, as US interest rates rise, other countries are compelled to respond by either raising their interest rates to minimise the carry trade arbitrage, allowing the domestic currency to depreciate, or to intervene by selling down forex reserves (providing it has sufficient reserves to mount a successful defence). It should be noted China is able to preserve a fair degree of policy independence and is better positioned to resist convergence towards US monetary policy due to capital controls and its large FX reserves.
While the trilemma is entrenched in a unipolar, globalised monetary setting, it is unclear how the theory operates in a multipolar, fragmented monetary setting. During the Goldilocks era, price trends converged with inflationary pressures generally mild across the major economies. However, the linkages between US and Chinese monetary policies have been loosened by decoupling (US intention to reduce trade and investments with China) and de-dollarisation (China’s intention to reduce use and investments denominated in USD). As geoeconomic fragmentation deepens, the likelihood of monetary policy divergence increases. For example, price trends have diverged with the West facing inflationary pressures while China is having to cope with deflation. This leads monetary policies to diverge because Western policies focus on combating inflationary pressures whereas China focuses on neutralising deflationary pressures.
Geopolitical conflict is giving rise to a monetary policy tug-of-war and accentuating the policy tensions between domestic and external objectives. When monetary policies diverge, the pressure is for monetary policies to align within a sphere and for policies to diverge between spheres. Deliberately or otherwise, US and China are crafting monetary policies to neutralise or curb each other’s influence and to reshape international ecosystems around their currencies. Longer-term, geopolitical conflict is congesting liquidity within spheres and damaging international monetary adjustment mechanisms. Cross-border capital flows between the West and China are likely to dwindle while funding and carry-trade leverage will be much lower than in the past. In other words, the global savings glut is evaporating.
Progress on de-dollarisation
A key feature of monetary geopolitics has been the weaponisation of the USD-based international financial system and this has strengthened the resolve of the Global South to pursue de-dollarisation. Kate Mackenzie and Tim Sahay calls the current global financial system a “dysfunctional system in which money flows out of the countries that need it most and into the coffers of the wealthiest. In 2023, the private sector collected $68 billion more in interest and principal repayments than it lent to the developing world. International financial institutions and assistance agencies extracted another $40 billion, while net concessional assistance from international financial institutions was only $2 billion – even as famine spread. The result is that as developing economies make exorbitant interest payments to their creditors, they are forced to cut spending on health, education, and infrastructure at home. Half of the world’s poorest countries are now poorer than they were before the pandemic”.
Kate Mackenzie and Tim Sahay explains the global financial system was inherently hierarchal with “interest rate decisions made by the five central banks in the top tier create shockwaves for countries lower down. After 2021, rising interest rates attracted foreign and domestic capital toward the top. Lower-tier economies were hit by currency depreciation, surging dollar outflows to import costly commodities (thus fueling their inflation), and soaring borrowing costs. The IMF estimates that capital outflows from emerging markets exceeded $300 billion between late 2021 and July 2022 when the Fed began its current hiking cycle. Currencies of G20 countries, not just the G77, were sold off and weakened against the dollar in 2021–2023. Even top-tier countries such as Japan are now upset about the strong dollar and are remonstrating at the G20”.
Kate Mackenzie and Tim Sahay notes changes to the global financial order are afoot. “In their own geoeconomic sphere, the Gulf kingdoms have established themselves as lenders of last resort…Over the last sixty years, Saudi Arabia, the UAE, Qatar, and Kuwait have disbursed an estimated $363 billion to countries, most of which are in the Middle East North Africa region. The largest recipients were Egypt, Iraq, Pakistan, and Jordan…In contrast, the IMF has, over the same period, given out $162 billion (in constant 2020 USD) in loans to those same countries”. “China’s liquidity provision – PBOC currency swap lines and emergency loans by Chinese state banks to countries in the Belt and Road Initiative – has surged in the last decade…warned that China’s becoming a major liquidity provider could lead to a less transparent global financial architecture. But looking at the present global financial safety net suggests coherence has long been in short supply”. It was “found that for countries that did not have active loans with the IMF, the bilateral swaps with China functioned as a substitute for going to the IMF – a very useful service indeed”. In addition, “several formal alliances have been created out of dissatisfaction with the IMF, including the Arab Monetary Fund, the Chiang Mai Initiative by ASEAN countries and China, Japan and Korea, the Eurasian Fund for Stabilization and Development, the European Stability Mechanism, the Latin American Reserve Fund, and the BRICS contingent reserves…Despite a lending capacity almost as large as the IMF, they have only disbursed about $1.5bn in loans in the first ten months of the Covid crisis and activated $550m worth of currency swaps. The IMF provided $88bn in the same period”.
Robert Greene notes China’s Cross-border Interbank Payment System (CIPS) “was launched in 2015 and now counts over 100 direct participants and over 1,300 indirect participants globally, meaningfully improved the efficiency of cross-border renminbi transactions relative to previous channels. Average daily CIPS transactions reportedly increased by 50 percent in 2022 after Russia invaded Ukraine, and they increased by about another 25 percent in the first three quarters of 2023”. “The IMF allowed Argentina’s government to use renminbi credit made available by China’s central bank, the People’s Bank of China (PBOC), to facilitate the partial pay down of IMF loans, and an IMF official indicated that renminbi IMF debt repayments could become increasingly commonplace”.
Fernando Broner, Sergio L. Schmukler and Goetz von Peter notes the growing role of the Global South “in international financial investments, not just as holders of bank deposits and reserves in the North…China has become an important lender in Africa, Asia, and Latin America, and the renminbi has become more widely used. Russia has deepened its economic ties with China. The Gulf countries have recycled some of the petrodollars by investing in other emerging markets and developing economies”. “By 2018, South-to-South investments and those between the South and the North had risen to 8% and 26% of global investments respectively”. “Portfolio investment and international reserves involving the South grew faster than FDI, which in turn grew faster than bank loans and deposits. Despite this growth, the weight of the South in portfolio investment remained smaller in magnitude than that in other investments. In contrast, South-to-North reserves accounted for a hefty 73% of the global total in 2018. In 2001, the South had mainly been a destination of FDI from the North and a source of loans and deposits and international reserves to the North. By 2018, the South had grown substantially as a source of FDI to both the North and the South and as a destination of loans and deposits from both the North and the South…these results are not driven by the growing heft of China. China is not unique when it comes to the financial integration of the South….In fact, Africa is the region with the fastest growth in portfolio investment and FDI, and Eastern Europe and Central Asia is the region with the fastest growth in loans and deposits”.
Financial deepening is progressing in the Global South. Previously driven by the banking industry, financial sector development is now largely driven by SWFs, pension funds and domestic asset management companies. These funds play an important role in safeguarding national savings, facilitating maturity transformation, and anchoring local-currency financial product and capital market development. Jodi Vittori and Lakshmi Kumar note “sovereign wealth funds (SWFs) have existed for more than a century, typically as state-sponsored financial institutions to manage a country’s budgetary surplus, accrue profit, and protect a country’s wealth for future generations. Yet, for economies of the Organisation of Economic Co-operation and Development (OECD), SWFs only burst into public consciousness in the mid-2000s, when widespread concerns arose that SWFs with large amounts of capital could control strategically important assets and threaten the national security of countries where they deployed their investments…In the 1990s, SWFs held $500 billion in assets, but by 2020, they had more than $7.5 trillion in assets under management (AUM), equal to about 7 percent of the global AUM of $111.2 trillion. Globally, prior to 2010, there were only fifty-eight SWFs. Today, however, SWFs have become an increasingly fashionable type of state-owned entity to set up, and there are currently 118 operating or prospective SWFs. In the African continent alone, prior to 2000, there were only two SWFs. Since 2000, sixteen new SWFs have been set up”. However, they expressed concern “that SWFs have been established not just in countries with strong rule of law and civil liberty protections but also in countries marked by high corruption risks, insecurity, violence, and weak or absent rule of law” and these assets should be protected by adequate transparency requirements.
Gita Gopinath asks “given the reshaping of trade relations, has the currency composition of trade finance changed during 2022-23? The answer is not much for U.S.-leaning countries, but there have been more visible changes for China-leaning countries. For the China bloc, the USD share of trade finance payments has declined since early 2022. At the same time, the RMB share has more than doubled, from around 4 percent to 8 percent…For China, the share of RMB in all cross-border transactions of Chinese non-bank entities with foreign counterparts was close to zero 15 years ago but has risen to reach around 50 percent in late 2023. In contrast, the USD share has been on a declining trend, falling from around 80 percent in 2010 to 50 percent in 2023. The increasing use of the RMB may have been supported by the Cross-Border Interbank Payments System (CIPS)”. China’s “share of gold in total FX reserves has increased from less than 2 percent in 2015 to 4.3 percent in 2023. During the same period, the value of China’s holdings of U.S. Treasury and Agency bonds relative to FX reserves has declined from 44 percent to about 30 percent. This reflects both net purchases and valuation effects”.
Gita Gopinath points out there are “costs from financial fragmentation. It would limit capital accumulation – because FDI would be reduced – and affect the allocation of capital, asset prices, and the international payment system. Financial fragmentation could also lead to weaker international risk sharing, resulting in higher macro-financial volatility for individual countries, and higher crisis risks due to idiosyncratic shocks. The global payment system could become fragmented along geopolitical lines with the emergence of new payment platforms with limited or no interoperability. This could lower efficiency, and lead to fragmented standards and regulation…In addition, FX reserves could be re-aligned to reflect new economic links and geopolitical risks. A global system with multiple reserve currencies could have several benefits, including a larger pool of safe assets and more opportunities for FX reserve diversification. But the stability of such a system would be at risk without strong policy coordination among all reserve currency issuing countries – including through a network of swap lines. This would not be possible if the world is divided along geopolitical lines. The estimates of the economic costs of fragmentation vary widely and are highly uncertain. In a mild scenario with low adjustment costs, losses could be as low as 0.2% of world GDP, while in an extreme trade fragmentation scenario with limited ability of economies to adjust, losses could be as high as 7 percent of global GDP. As for foreign direct investment, fragmentation in a world divided into two blocs centered around the U.S. and China with some countries remaining non-aligned could result in long term losses of around 2 percent of global GDP. Some countries could benefit from fragmentation in its mild forms. But if fragmentation worsens, they could be left with a larger slice of a much smaller pie. In short, everyone could lose”.
De-dollarisation is a slow-moving process but geopolitical events have catalysed “adoption” momentum. Yu Yongding points out the freezing of Russia’s $300 billion in forex reserves on 28 February 2022 “forced China to re-examine the safety of its foreign exchange reserves and overseas assets”. “This has seriously undermined the international credibility of the US and shaken the credit foundation of the Western-dominated international financial system. Which country can be sure that the US will not freeze its foreign exchange reserves similarly in the future? The US’ weaponisation of foreign exchange reserves has exceeded the worst estimates of economists about the security of China’s foreign exchange reserves. The value of China’s foreign exchange reserves will not only suffer losses due to US inflation, dollar depreciation, and falling treasury bond prices or defaults but they may be wiped out instantly for geopolitical reasons”. So far, the US has not imposed a comprehensive oil and gas embargo on Russia but China’s continued purchases of Russian oil and gas could provide US an excuse “to act against China’s foreign reserves or impose sanctions on Chinese financial institutions”. “The possibility of the United States freezing and seizing China’s overseas assets cannot be ruled out”.
Yu Yongding notes “China’s holdings of $3.3 trillion in foreign exchange reserves (excluding Hong Kong’s $496.8 billion and Taiwan’s $548.4 billion) far exceed “the second, third, and fourth largest foreign exchange reserve holders in the world are Japan, with $1.3 trillion; Switzerland, with $1 trillion; and India, with $569.9 billion”. However, this comes at a cost. “Since the rate of return on foreign exchange reserves is extremely low, if the proportion of foreign exchange reserves in overseas assets is too high, the overall rate of return on overseas assets will inevitably be too low. Of China’s $9 trillion in overseas assets, reserve assets account for 37 percent of the total; of these reserve assets, US Treasury bills account for 32 percent”. “Because of the safety and liquidity requirements of foreign reserves, an overproportion of foreign reserves in overseas assets will inevitably lead to lower income from overseas assets. Not only that, a large proportion of China’s foreign exchange reserves is borrowed through the introduction of foreign capital rather than earned through the trade surplus. Compared with the investment income of foreign reserves, the debt cost of borrowed foreign exchange reserves is extremely high”. China thus suffers negative investment returns despite possessing $2 trillion in net overseas assets. “China’s balance of payments and overseas investment position is in stark contrast to that of the United States…the latter will have nearly $200 billion in investment income in 2021 despite being a $15 trillion net debtor”.
Yu Yongding argues there are two principal purposes for restructuring China’s overseas asset-liability structure and balance of payments structure. “First, to improve the structure of China’s overseas assets-liabilities and to increase the return on its net overseas assets. To this end, China should reduce the share of foreign exchange reserves in its overseas assets. Second, to improve the safety of China’s overseas assets, especially its foreign exchange reserves. Under current conditions, China should reduce its stock of foreign exchange reserves to at least the internationally recognised level of foreign exchange reserve adequacy. How much foreign exchange reserves should a country hold? In general, this depends on the size of the country’s imports (or exports), the size of short-term foreign debt, the size of other securities liabilities, and the broader money supply (M2)”. For its existing stock of foreign exchange reserves, China should consider “increasing holdings of other forms of assets while reducing US Treasuries holdings. In the past, arguments have been made in favour of currency diversification of China’s foreign exchange reserves (towards the Euro and Japanese yen) due to concerns about the depreciation of the US dollar. However, under the current geopolitical conditions, such diversification may not be sensible”. China should also accelerate “the construction of financial infrastructure – such as settlement, clearing, and messaging systems – that is independent of the US. Make full use of China’s technological reserves and strength in the field of digital technology to improve the cross-border payment system that adapts to the new trend of digital trade”.
Robin Brooks observes that despite near-record levels of goods exports in 2023, China’s accumulation of official foreign exchange (FX) reserves was essentially zero. He thinks this indicates that “first, China could be stockpiling dollar-invoiced commodities to reduce the current account surplus, thereby reducing upward pressure on reserves. Second, it is possible that what in the past counted as official intervention is now being channeled through state banks (i.e., is being classified as a capital outflow rather than official intervention). Third, net foreign direct investment (FDI) may be shifting against China. Empirically, it is the third channel that is most important”. “China’s outward direct investment straddles the nexus between financial interdependence and rising trade tensions. This is because China is likely diversifying its manufacturing base, shifting production to third countries where exports will not automatically be subject to U.S. tariffs. This is apparent in China’s outward investment flows, which show a rise in outflows to countries across Asia and – on a smaller scale – to countries in Europe. This shift is consistent with China financially decoupling from the U.S. and diversifying manufacturing supply chains at the same time”. “Unfortunately, data transparency is poor, which means it is hard to disentangle if this shift is due to foreign businesses pulling back or China’s outbound direct investment. Our reading of the data is that it is primarily the latter, consistent with China trying to financially decouple from the US”.
Alexandra Prokopenko points out US can impede de-dollarisation by expanding secondary sanctions; such as the 2023 secondary sanctions on financial institutions working with Russia’s defense sector. “Some Chinese banks have stopped accepting Russian payments entirely, while the average processing time for such payments rose to eighteen days. In March 2024, Chinese exports to Russia fell (by 16 percent year-on-year) for the first time since 2022. The trend continued in April with a drop of 13.5 percent”. Nonetheless, “regional banks – of which there are more than 4,500 in China – still work with Russia and the transactions have become more layers sometimes with as many as five other banks involved”. By the end of 2023, 557 banks and companies – including 159 non-residents from twenty countries – had signed up with Moscow’s SWIFT alternative, the System for Transfer of Financial Messages (SPFS) and negotiations are ongoing to allow Chinese banks to join. In 2023, at least twenty-three Russian banks signed up for China’s Cross-Border Interbank Payment System (CIPS). “The average number of daily transactions via CIPS increased 50 percent in 2022, and was up 25 percent in the first nine months of 2023… CIPS is even being used by third countries to make payments to Russia”.
Global Times notes a Bloomberg report that “the latest sanctions introduced by the US in mid-June (2024) forced the Moscow Exchange to halt trading in US dollars and the euro”. As a result, “the Chinese yuan’s share on Russia’s foreign exchange market reached 99.6 percent in June” from 53.6 percent of Russia’s exchange trading volume in May. However, Global Times caution that “rapidly expanding the use of the yuan in the international market may introduce new challenges to the management of China’s foreign exchange reserves…If other countries ditch the dollar too quickly, it could result in fluctuations in the valuation of dollar assets, placing strain on China’s reserve management… In short, the internationalization of the yuan is a delicate process that necessitates China’s careful navigation of the international political and economic environment, bolstering domestic economic reforms and financial stability, facilitating multilateral trade and investment, along with the implementation of a cautious strategy. After all, the primary goal of the yuan’s internationalization is to facilitate greater integration of China into the global economy, rather than to displace others”.
There are operational hurdles to overcome in the fledging non-USD alternative financial network. Robert Greene adds “the usage of BRICS local currencies for cross-border trade payments is disincentivized by inadequate financial infrastructure” such as the payment-versus-payment, or PvP, arrangement[13]”. “The rand is the only BRICS currency eligible for settlement by the world’s dominant PvP arrangement, which is controlled by a Switzerland-incorporated company that counts major global banks as shareholders and through direct central bank relationships facilitates PvP transactions using central bank liabilities. This PvP arrangement reportedly accounted for over 40 percent of global spot foreign exchange trading volume in recent years, and it can be used to facilitate trading of the rand against seventeen currencies, including the dollar”. In contrast, “the real and the rupee, local systems regulated by the Brazilian and Indian central banks are able to facilitate PvP foreign exchange settlement, but only against the dollar. The renminbi’s ability to be transacted through PvP arrangements is also limited; it can be transacted through a Hong Kong-based PvP arrangement for which a British commercial bank facilitates settlement against the dollar, the euro, or the dollar-pegged Hong Kong dollar. In addition, small, Chinese-government-run PvP arrangements exist for some renminbi pairs with emerging market currencies, including the Russian ruble. Despite these arrangements, data from a 2022 report suggested that around 20-40 percent of renminbi foreign exchange transactions may be exposed to settlement risk”.
Operational challenges – such as differences in law, language, transparency, counterparty creditworthiness, intermediation capacity and transaction frictions (i.e. bid-offer spreads, liquidity depth, holding and funding costs) – are surmountable and should be mostly resolved by 2030. The most difficult challenge relates to the ability to ensure Global South countries are creditworthy and that they comply with international standards in terms of macroeconomic, financial and information requirements; that there is adequate oversight and that conditionalities are agreed to and enforced in distressed economies. Generally, there is a need to build confidence in the quality of non-Western “safe assets” as this is crucial to minimising liquidity leakages.
Pepe Escobar reports that at a recent BRICS+ meeting, proposals were put forward to create an international currency “that can be issued in a de-centralized way, and then recognized and regulated at national level”. It was proposed the new international currency be anchored in gold (40%) and BRICS+ currencies (60%). “The Unit organizers employ a distributed ledger: a technology that ensures transparency, precluding capital controls or any exchange rate manipulation. This means that connection is available to all open DEX and digital platforms operated by both commercial and Central Banks around the world. The endgame is that everyone, essentially, may use the Unit for accounting, bookkeeping, pricing, settling, paying, saving and investing. No wonder the institutional possibilities are quite enticing – as the Unit can be used for accounting and settlement for BRICS+; payment and pricing for the Eurasian Economic Union (EAEU); or as a reserve currency for Sub-Saharan Africa…the Unit has already received backing by the BRICS Business Council”.
De-dollarisation is spearheaded by the internationalisation of yuan. Global Times note “the yuan overtook the yen as the world’s fourth most active currency in global payments in November 2023”. Based on the Society for Worldwide Interbank Financial Telecommunication (SWIFT) data, “the yuan accounted for 4.61 percent in global payments in June, with the US dollar at 47.08 percent, the euro at 22.72 percent and the pound at 7.08 percent”. “In the first quarter of 2024, the yuan cross-border payment system processed 1.871 million transactions, up 36.37 percent year-on-year, amounting to 40.49 trillion yuan, an increase of 60.83 percent year-on-year, according to…the People’s Bank of China (PBC)…Cross-border yuan settlements of trade in goods accounted for 24.4 percent of all goods trade cross-border settlements in the first nine months of 2023, the highest level in recent years”.
Kandy Wong reports Renmin University’s yuan internationalisation index[14], which tracks global usage of the Chinese currency, grew 22.9% in 2023. “The report gave an average internationalisation score of 6.27 for the yuan last year, while the US dollar stood at 51.52 in the same period and the euro earned a 25.03 on the index…The yuan ranked higher on the index than the British pound and Japanese yen, which scored 3.76 and 4.4 respectively”. Tu Xinquan commented “cross-border financial settlement platforms established by various provinces have effectively attracted many financial institutions, improving the efficiency of corporate payments and receipts, expanding investment and financing channels, and advancing the internationalisation of the yuan.” The Renmin University report warned though “that the yuan’s internationalisation faced challenges ahead, including pressures from the Chinese economy, persistent geopolitical risks, a relatively low rate of return for yuan assets, and the Chinese currency’s relatively weak exchange rate against the US dollar. Blockchains and big data technology should be used for stabilising and protecting supply chains from risks…The service quality should be improved for partners in the Cross-border Interbank Payment System, while more support should be given to trade activities under the Belt and Road Initiative and the Regional Comprehensive Economic Partnership”.
At the moment, there still exists a yawning gap between China’s share of global trade and yuan’s share of global currency use and holdings. While it is true that China can leverage off its trading relationships to increase international usage of yuan, ultimately China needs to wean itself and other countries off dollar dependence by replacing USD-denominated financing, consumption and intermediaries. Towards this end, Chinese intermediaries need to expand their presence in international finance and build up the yuan-denominated ecosystem. From a macroeconomic perspective, China also needs to be willing to run a current account deficit and supply as much yuan as demanded by the rest of the Global South.
My 2030 scenario is that most of the teething problems for a non-USD network would have been ironed out. This means de-dollarisation is likely to achieve critical mass at the end of this decade and the yuan would be positioned to begin competing with the USD in the next decade. In tandem with this, the emergence of a competitive non-USD network by 2030 would severely weaken Western sanctions power. In any case, the power of comprehensive financial sanctions is over-rated; as evident from Russia’s experience. At the end of the day, currencies are merely government IOUs and reserve assets are an accounting entry. Repudiating an IOU can hurt a borrower as much as it does a creditor. The country with the most physical assets to collateralise will be in a stronger position. Debtors that repudiates IOUs (via sanctions) will lose trust and will find it either more difficult or more expensive to borrow in the future. In this context, sanctions undermine the USD hegemony which is dependent on international willingness (including adversaries) to recognise USD debt as a safe asset. The US should recognise that as de-dollarisation progresses, it will have the effect of reducing the number of buyers for US debt and this would cap future US consumption. In this context, currencies should be viewed as an information medium that facilitates payment, credit and investment. Currencies will lose relevance once their customer base shrinks.
The global feast-famine cycle
US monetary policy is the Pied Piper for the global feast-famine cycle. An expansive US monetary policy sets in motion a global economic up-cycle (feast) by boosting US aggregate demand, increasing supply of USD-denominated financing at lower interest rates and weakening the USD. When US monetary policy tightens, it induces a global economic down-cycle (famine) by moderating US aggregate demand, decreasing the availability and increasing the costs of USD-denominated financing, and strengthening the USD. During the down-cycle, vulnerable economies are hit by cross-border deleveraging and may face a run on their balance of payments as governments and private firms find difficulty in servicing and repaying their USD-denominated debt. Western MNCs, intermediaries and investors are usually well positioned to take advantage because of their financial strengths and access to USD-denominated liquidity and financing. In past famine cycles, the West levied pressure on crisis-stricken countries to undertake market reforms which allowed their firms and investors to swoop in to buy distressed assets (i.e. fire-sale FDI).
The global feast-famine cycle is aggravated by speculative attacks on countries. In September 1990, hedge funds gained prominence when George Soro’s Quantum fund successfully forced the Bank of England to withdraw sterling from the European Exchange Rate Mechanism (ERM I) and its drastic devaluation on Black Wednesday[15]. During 1994-5 the Fed doubled short-term interest rates over a period of 12 months. This subsequently triggered Mexico’s Peso crisis, the Orange County bankruptcy and the demise of Kidder, Peabody & Co. By 1997, rising US interest rates and a strong dollar provided an opportunity for hedge funds to launch speculative attacks on the Asian currency pegs. Thailand was the first domino to fall when it forced to devalue the Baht in July 1997. This was followed by Indonesia and South Korea which also abandoned their dollar pegs. Their attention then switched to Malaysia, Hong Kong and China. However, China, Hong Kong and Malaysia launched a coordinated counter-attack by imposing draconian capital controls which effectively ended the attacks. The 1997-8 crisis was a wake-up call for Asian countries which spent the next decade reforming their financial, regulatory and governance systems. During this period, the Asian central banks accumulated massive amounts of forex reserves to deter future currency attacks.
Given past run-ins between funds and governments, Mandy Zuo and Ralph Jennings highlight Chinese suspicions of the geopolitical motivations of US monetary policy. They note comments by Chen Wenling, formerly with the State Council, that “the nation must steel itself in the midst of a finance war”. “China should remain on guard, as it remains at a disadvantage in terms of financial competition with the US…[We are] always in a state of being contained, suppressed and harvested…The status of the US dollar is still there, and the strength of the US is still there. Any increase or decrease in interest rates by the Federal Reserve will have an impact on us. Describing foreign investors’ retreat from China in the past year as evidence of a finance war, while their bearish sentiment toward China is the result of a public opinion war”. Chen Wenling also said “Hong Kong must strengthen its status as a global financial centre. Ensuring the safety of US-listed Chinese company assets should be another priority for Beijing in the two sides’ financial wrangling…Washington has been pushing Chinese firms to delist from the New York Stock Exchange, and she pointed to the delisting of five state-owned Chinese companies, including energy and chemical giants PetroChina and Sinopec in 2022. And after the US presidential election later this year, more companies could be forced to delist”. She expects foreign investors to likely flock back to China due to interest rate trends and voiced concerns that “anticipated interest rate cuts by the US Federal Reserve could lure a large amount of money back to China and potentially trigger fresh turbulence in the domestic financial market. We must prevent large-scale malicious speculation to harvest China’s high-quality assets or [the injection of US capital] causing trouble in the Chinese stock market”.
These apprehensions are widely shared in the Global South. Robert Greene notes “senior BRICS policymakers have expressed concerns over the macroeconomic impacts of dollar dominance on emerging markets. These concerns have grown louder in response to unprecedented increases in advanced economies’ interest rates…means that emerging markets “run a serious risk of becoming permanently more prone to currency depreciation and higher inflation.” A recent Chinese article “stated that recent U.S. monetary policy choices created a dollar tide that seizes the wealth of other countries and forces developing countries to bear the huge economic losses and financial risks brought about by the hegemony of the dollar. A paper published by India’s central bank in 2023 argued that there is an inherent defect of the dollar’s global role, whereby the weakening of the U.S. economy results in disorder and disproportionate losses outside the United States”. Thus, several notable Global South economies face severe dollar shortages and high inflation. “Dollar shortages in Argentina and Ethiopia were so severe at times in 2023 that black market exchange rates were reportedly nearly double the official rates. In Egypt, the banking system’s net foreign assets (a measure of foreign currency shortages) hit a record deficit in June 2023…High and increasing debt levels in these countries, against the backdrop of rising advanced economy interest rates, make it difficult to successfully address dollar shortages by issuing debt in dollars, as there is little investor appeal…exacerbating inflation, as the scarcity of dollars constrains the ability to import food and energy and thus drives up prices”.
The recent global feast-famine downcycle is taking place in a global landscape altered by decoupling and de-dollarisation. Western central banks have generally tightened monetary policy and raised interest rates over the past 20 months. The higher interest rates has triggered capital outflow from emerging economies (particularly China) to the West. USD liquidity shortages in the Global South has weakened their currencies, markets and economies. In the meantime, USD-denominated liquidity has congested within Western equity and bond markets.
As a matter of comparison though, the impact of Western central bank tightening on the global economy seems milder than in past decades. First, the magnitude of the US interest rate shock is relatively smaller as interest rates are far from the double-digit levels of the 1980s. It is possible there is more damage caused by a strong USD and cross-border deleveraging. Second, Western economies remain sheltered by large-scale fiscal spending and global aggregate demand has not, till now, been severely affected. Third, the post-2000 regulatory and governance reforms are paying off. Middle-income economies are generally better prepared with substantial FX reserves, strengthened prudential and risk management rules and oversight, and are backstopped by their wealth management institutions. Lastly, Global South exposure to the West has also been diluted by trade, financing and investment diversification. The shrinking size of G7 economies has diluted the impulse from the feast-famine cycle. Given the roughly equal size of the West relative to the Global South economies, it is likely the effects are no longer one-directional but are two-way; i.e. a recession in the Global South will dampen growth in the West.
Overall, the recent global feast-famine cycle is likely to behave differently from past cycles. Despite higher Western interest rates, growth in the Global South remains relatively resilient due to growth in intra-Global South trade. Even if the Fed was to lower interest rates, it will not trigger a “feast” upcycle because decoupling means that the recovery in cross-border trade and capital flows will be muted for “adversarial” economies. Allies may not benefit as much as well because a weaker USD will benefit US exports possibly at their expense.
2030 scenario: The Fed policy transition
The Fed policy transition from QT-high interest rates to QE-low interest rates is likely to be the most pivotal monetary event of this decade. Certainly, Western investors have been baying for the Fed (and other central banks) to cut interest rates to foster a supportive environment for equity and bond markets. Otherwise, as the narrative goes, “higher-for-longer” interest rates would lead to a hard landing which presage a deep recession and a sharp equity and bond market sell-off.
In this context, US monetary policy choices are constrained by fiscal dominance. Macro Butler defines fiscal dominance as “a condition whereby the amount of debt in an economy reaches a point where monetary policy actions must allow federal debts and deficits to be serviced and funded cost-effectively. By default, such monetary policy decisions will often come at the expense of traditional employment and price goals”. He points out the Fed has forced a negative real rate regime (Fed Funds less CPI) upon lenders and investors for the better part of the last 20+ years. “This has already caused localized recessions affecting people’s finances, especially in commercial real estate and regional banks…Simultaneously, the sharp increase in interest rates has profoundly affected long-duration treasuries…However as Fiscal Dominance is here to stay, the next crisis will inevitably a sovereign debt crisis. In a recession, tax revenues plummet while spending surges due to social programs like unemployment and wage security. This mean that the current deficit could balloon the deficit from $2 trillion to potentially $3, $4, $5, or even $6 trillion annually. Such a debt spiral, where new debt issuance is needed to pay off existing debt, erodes confidence in US bonds and undermines the value of the dollar through inflation. This constant manipulation by central banks perpetuates a soft default scenario, where future dollar repayments are worth less than initially lent, driving the US into a cycle of increasing inflation and debt. The only apparent solution seems to be maintaining negative real interest rates on treasuries indefinitely to sustain nominal GDP growth, despite it being based on inflated values rather than real economic expansion…Make no mistake, this cannot go on forever and will end when the US Treasury is unable to issue more new debt to pay back the old debt”.
Michael Lebowtiz notes “a recent article co-authored by Stephen Miran and Dr. Nouriel Roubini, aka Dr. Doom, accuses the U.S. Treasury Department of using its debt-issuance powers to manipulate financial conditions. They liken recent Treasury debt issuance decisions to stealth QE…usurping core functions of the Federal Reserve…The authors claim that recent Treasury debt issuance patterns were intentionally implemented to boost economic activity and support the financial markets, thus easing financial conditions…to stimulate the economy into election season”. “They assert the Treasury has purposely issued less long-term debt in favor of more short-term bills. The authors hypothesize its actions equate to an approximate one percent cut in the Fed Funds rate”. They explain increasing the proportion of short-term debt has a Portfolio Balance Channel effect by reducing duration risk which allows investors to absorb more Treasury debt and a Money Supply Channel effect as it require fewer reserves than bonds and this expands banking capacity to make more loans that stimulate the economy and financial markets. Whereas QE works by removing interest rate risk from the market and hiding it away on the Fed’s balance sheet, increasing the proportion of short-term debt, by limiting the production of interest rate risk at the source, has a similar net effect.
Michael Lebowtiz defends the Treasury actions, arguing it is in line with its primary goal to minimise funding costs. “Federal Deficits have been running well above average, forcing the Treasury to issue more debt than typical. Accordingly, the Treasury must carefully distribute its debt so they don’t overwhelm the demand for a specific maturity while not meeting the demand for another. Money market balances have been soaring, causing retail and institutional investors to clamor for Treasury bills. At the same time, longer-term bond investors have been shying away from bonds due to inflation and worries that yields will increase further. The Treasury doesn’t manage demand for its products; it only controls the supply. Given market conditions, it has made the most sense to meet the insatiable demand from short-term investors and try to limit the supply to longer-term bond investors choking on what could be deemed an oversupply of bonds. Again, shifting issuance amongst different debt maturities constitutes smart funding decisions, not manipulation…Had the Treasury Department ignored troubling market signals and its low-cost funding objective, it would have significantly raised borrowing costs and possibly introduced bond market turmoil that could have easily spread to the equity and currency markets. Recent Treasury debt issuance patterns are appropriate and will likely have and will save the nation significantly”.
Wolf Richter notes the Treasury is not only increasing the issuance of short-term Treasury bills in new debt, it is also “buying back older longer-term Treasury securities with the proceeds from issuing new Treasury securities”. Swapping the debt through buybacks puts “a big regular buyer into the harder-to-trade end of the bond market” and adds “a big relentless bid to a portion of the Treasury market where liquidity can be thin, and where an investor that needs to unload a pile of off-the-run securities could do so only at a substantial discount compared to on-the-run securities…kicked it off in April, at first with smaller weekly auctions (on Wednesdays) that then increased in size. In recent weekly auctions it bought back between $2 billion and $4 billion…These buybacks allow big investors, such as banks, to sell off-the-run long-term bonds at massive losses, but without further pushing down prices and pushing up yields, and without therefore further increasing their losses. This has the effect of propping up long-term bond prices and pushing down their yields – which then translates into lower interest rates in the economy”.
Wolf Richter notes “the effects of those two policies on the 10-year yield. The increased portion of T-bill issuance starting in the second half of 2023 took pressure off the 10-year yield, which had been spiking into October 2023 and briefly kissed 5%. The buybacks, which started in April, coincided with a decline in the 10-year yield of nearly 100 basis points, even as the Fed was pushing back against rate-cut mania. Since the Treasury Department started this shift last year, T-bills – bracketed by expectations of the Fed’s policy rates – have yielded above 5%, substantially higher than the 10-year yield, which has ranged from 3.8% to just under 5% over this period. So short-term, this strategy costs the government and taxpayers more money, but long term, if the bet works out, Treasury would reduce the effects of locking in the higher interest rates (interest expense!) on its incredibly ballooning debt for many years to come”. Nonetheless, he thinks “the primary objective is clearly to manipulate long-term interest rates lower to stimulate the economy since long-term interest rates matter to the economy much more than short-term interest rates. These lower long-term yields contribute inflationary fuel to the economy. They reduce mortgage rates. They encourage corporate leverage. They loosen financial conditions. This comes on top of the vast deficit spending, which also adds inflationary fuel to the economy. These efforts by Treasury to push down long-term interest rates are in direct conflict with what the Fed has been trying to accomplish since it began hiking its policy rates”.
According to Death Taxes and QE, “the marginal bid came almost exclusively from foreign non-official investors – which means foreign banks, foreign pensions, foreign insurance funds, and other bodies, but namely foreign hedge funds as part of the highly-leveraged, infamous basis trade: Buy the cash Treasury, short the corresponding Treasury futures, and – so long as volatility doesn’t cause the spread to explode in the meantime – net the difference when it’s time to deliver the security on the futures contract. It’s arbitrage and like most cases of arbitrage it’s highly leveraged (the hedge fund buys a Treasury, posts the Treasury in a repo trade as collateral and simultaneously uses the proceeds of the repo loan to finance that original purchase, putting up only a fraction of its own capital) and not risk-free”. However, “foreign buyers are vulnerable to foreign exchange risks should local currencies appreciate against an investment currency…recent TIC data points to Europe providing the overwhelming marginal bid for the all-important U.S debt. The FX risks to Treasuries are inherently that the dollar weaken significantly against it’s G7 peers, i.e. EUR/USD and GBP/USD up, USD/CAD and USD/JPY down, etc. Since FX hedging costs are higher than the interest income so long as the yield curve is inverted, it does not make sense to hedge these investments in a FX swap (as it would lock in a loss on the investment)…Less about the direction of yields, but more about dealers widening bid-ask spreads as their balance sheet becomes overwhelmed…at the end of the day there must be an end investor willing to hold the sold securities in exchange for cash. Dealers are only willing to do so because they can easily finance the purchases in the repo market. If there were enough end investors in March 2020, then the dealers would have just sold the securities and there would not have been any liquidity issues. But there were almost no end investors, dealer warehousing capacity was maxed out, and the Fed swooped in to buy it all. Similar to 2020, these funding stresses will likely pull away capital and hence balance sheet from equity long/short strategies which could spill over into a broader equity selloff…The difference between now and 2020 is that lowering the overnight rate (hello rate cuts!) could only further deteriorate the dollar’s exchange rate. FX traders know that interest rate differentials are the dominant force driving foreign exchange – rate cuts would exacerbate the negative carry held by those foreign investors, giving them even more reason to puke the trade onto some foreign dealer’s balance sheet, who struggles to get rid of it but at a steep discount, etc”.
Death Taxes and QE point out “American relative value (RV) hedge funds have been the marginal buyer for Treasuries as part of a cash-futures basis trade, but there are binding constraints that would limit their firepower. Crucial to a basis trade are dealers willing to hold the security on their balance sheet, which incurs regulatory costs at a time when they are already chock full. The costs are then transferred from the dealer, who is acting more like a custodian, to his investor – costs such as wider bid-ask spreads, higher repo rates and larger swap spreads that inevitably disincentivize the trade. Regulators would have to suspend leverage ratios (exactly what they did in 2020) to remove these inherent costs, and perhaps cut rates to reduce the dealer premium (less negative swap spreads). Of course, when all else fails, the Fed could step in as the end investor of last resort and announce temporary liquidity support like the BoE did in 2022 (and not unlike the Fed itself did in September 2019)”.
Ostensibly, the Fed held back on initiating a policy transition as it was waiting for data to confirm that US inflationary pressures were finally subdued and employment was normalising. But the challenges go beyond this. First, the Fed needs to keep interest rates high enough to ensure there are sufficient buyers for the ever-expanding supply of US government debt. Second, it is fine if the Fed can manage an orderly retreat that results in a soft landing. But there are risks the orderly retreat could turn into a rout; particularly if it inadvertently triggers a sharp market sell-off.
In this context, it should be noted that interest rate movements have double-sided effects. Rising interest rate increases investor income from government debt and raises tax revenues. Investors tends to reinvest their interest income in government debt. However, higher rates increase debt servicing costs, capital losses and funding mismatch risks. Falling interest rates have the converse effects of reducing debt servicing costs, providing capital gains and reducing funding mismatch risks. However, there are constraints. If US interest rates fall too quickly and by too much, it might trigger sales among holders seeking to “take profits”. In relation to this, US interest rates also cannot drop below the levels in Europe, Japan and China if the US wishes to continue attracting foreign capital.
The most likely triggers for a Fed policy transition are (1) data confirming the economy has entered into a recession; (2) the Fed thinks that private and international purchases of US government debt have reached a saturation point; or (3) if there is a market crisis. These situations would compel the Fed to lower interest rates and, depending on circumstances, inject liquidity by restarting QE.
In the background perhaps, the Fed is mindful of the geopolitical consequences and this may have affected the timing of its policy transition. The high interest rates and strong dollar helped the US attract global capital to finance in its reindustrialisation as well as its fiscal deficits. In the meantime, maintaining higher interest rates assists in exerting carry-trade selling pressure on the yuan, weakening China’s economy and market, and hindering the progress of de-dollarisation. It would be timely to initiate the policy transition when the new plant capacity comes onstream. By lowering interest rates, the Fed can engineer a sharp dollar devaluation to restore US export competitiveness.
But there are drawbacks associated with the policy transition. Lowering US interest rates risk unwinding the carry trade; and in the process weakening the USD and strengthening the yuan. It increases the difficulty of finding foreign buyers for US debt and poses a threat to the leveraged markets and inflated asset prices in the West. The geopolitical consequences are to relieve the pressure on China’s economy and markets, and narrow the gap between US and China’s standing in terms of global share of nominal GDP and currency usage.
In addition, there are no certainty that the Fed can maintain low interest rates if the USD weakens too much. In such a situation, foreigners could turn sellers and this would require the Fed to intervene through QE to mop up US government debt and possibly to maintain domestic interest rates at a level higher than they wish. The Fed needs to carefully manage the policy transition to avoid risks that could inadvertently trigger a sharp market sell-off.
There may also be over-expectations of the potency of lower interest rates to revitalise the domestic and global economy. In my view, recent government intrusions on private sector activities has been too extensive and intrusive and has damaged “animal spirits”. In fact, markets seems to have more than fully priced in any lowering of interest rates many months earlier as the market kept rising to new record levels. The markets are priced to perfection and it would not come as a surprise if markets actually fall when interest rates are cut. A surprise scenario where the Fed is forced to backtrack and raise interest rates higher – either due to a resurgence in inflation, to attract buyers for US government debt or in response to a crisis – cannot be ruled out.
While falling US interest rates and a weaker dollar will relieve global debt servicing pressures, elevated geopolitical conflict limits the scope for cross-border investments and re-leveraging that is needed to combat the global recession. After all, the West is likely to continue to frown on investments into China. At the same time, it is doubtful China will re-invest in USD debt.
2030 scenario: Comparisons between Japan and China’s currency battles
In an earlier article, I argued that Japan’s error in forsaking the global contest for technological supremacy during the 1990s may have contributed to its economic stagnation and that China should not repeat its mistake. Michael Pettis recently provided a refutation. “Most economic historians would argue that Tokyo in the late 1980s and 1990s, like Beijing today, found it politically difficult to address its deep, demand-side imbalances and instead hoped to accelerate supply-side reforms by focusing on the development of new technology. At the time, Tokyo expected that technological advancement would lead to large enough technological breakthroughs and productivity gains for the overall economy that Japan would be able to rebalance its economy towards a greater role for domestic demand without slowing the growth of the supply side. It would be growth in supply that would drive even faster growth in demand. In fact, Japan’s technological push was quite successful. It maintained and even expanded its technological lead in many of the most important industries of the 1990s. For example, economist Noah Smith…pointed out that in the period after 1990, Japan created the digital camera industry, 3G, camera phones, the [lithium]-ion battery industry, the hybrid car industry, service robots, and high-performance ceramics”.
Michael Pettis points out that “in the end, supply-side policies failed to drive both rebalancing and rapid growth. The consumption share of Japan’s GDP bottomed out at 63.3 percent in 1991 (compared to 53.4 percent for China in 2022), and it took seventeen years for the consumption share to rise by 10 percentage points. In 2008, it had reached 73.8 percent (still below the global average). During that time, Japan’s share of global GDP dropped from 15 percent to 7.9 percent. I am not arguing that an intense supply-side focus on developing new technology won’t make a difference for China and will fail. It is certainly possible that such a focus could help China avoid – or at least reduce – a long and difficult adjustment associated with boosting a very weak demand side of the economy. But it is foolish to suggest that such a focus must inevitably work, and even more foolish to claim that China is the first country to try this approach. Many countries have tried to resolve demand imbalances with technology-driven supply-side measures – most notoriously the Soviet Union in the 1960s and Japan in the late 1980s and early 1990s – but it has always proved far more difficult than expected. The important lesson is that ignoring the problems of its historical precedents won’t make China’s success any more likely”.
Following this macroeconomic logic, overinvestment in manufacturing is leading China down Japan’s path to economic stagnation. In the absence of massive consumption-based stimulus, aggregate demand shortfalls will sink the Chinese economy into a deflationary spiral. Trends such as a prolonged property and equity market downturn, an industrial fall-out due to excess capacity, trade war tensions with the West, and domestic capital flight in search of higher yields and international opportunities is taking its toll on the Chinese economy. In 2024, signs are emerging that China’s economy is losing growth momentum and that deflationary pressures – such as anaemic demand, and weak inflation and monetary readings – are increasing. The weak economic and profit trends, wide interest rate differentials, and Western deleveraging of China have prompted currency speculators to pile pressure on the Chinese yuan.
Until recently, PBOC weathered the selling pressure by mostly following its Asian crisis playbook by defending the yuan[16] as the last line of defence (rather than the equity market). Unlike in the Asian crisis, PBOC is well prepared with its balance sheet fortified by high levels of FX reserves. It has focused on tightening controls to squeeze out short positions (short-selling and round-tripping), increasing physical delivery requirements and curbing outflows (repatriation, transfers, overseas investments).
In a sense, PBOC is facing the same plight as BOJ in the 1990s. One feature of Japanification was the low domestic interest rates which enticed the legendary “Japanese housewives” and intermediaries into investing abroad. Their outflows enlarged the offshore yen funding base for carry trades. There are also broad similarities in relation to the deflationary economic conditions[17] between China now and Japan in the 1990s. China’s bond yields have also been falling and the low yields is enticing Chinese retail investors and institutions to invest abroad for higher returns. Foreign funds and intermediaries ran rings around BOJ attempts to control the speculative forex trades. Chinese financial intermediaries, like their Japanese counterparts, have limited sophistication and international presence.
But there are differences. First, unlike Japan, China maintains strict capital controls and is in a better position to control exchange rate volatility. Second, it has been perplexing as least to PBOC why bond yields have been falling when its currency has been weak. Third, the policy objectives differ. it was largely believed the BOJ tolerated these outflows as it helped to moderate the yen’s appreciation. Japan (eventually) opted for zero-interest QE to stimulate economic growth. In contrast, PBOC have been trying to stem selling pressure on the yuan which indicates its preference for a stronger and stable yuan. PBOC is also more focused on financial stability and is trying to establish an interest rate floor.
There are also differences between the yen and yuan carry trade. Winni Zhou and Summer Zhen notes “the yuan carry trade is similar, but with limitations because the currency is not fully convertible. A large proportion of yuan carry trades are by Chinese exporters parking cash in dollars. In another version, foreigners borrow yuan to invest in mainland markets. A third type of carry trade involves using the cheap offshore yuan to buy bonds denominated in dollars and other currencies”. “Until 2022, when the Federal Reserve started aggressively raising rates and Beijing moved to an easing bias to aid a struggling economy, Chinese interest rates had for years been higher than their U.S. counterparts. As dollar yields surged, Chinese exporters found they could earn as much as 5% a year if they retained their earnings in dollars, compared to paltry returns on yuan term deposits. Rampant dollar hoarding by exporters has been a major factor behind the yuan’s depreciation since April 2022. The yuan’s depreciation meant foreigners could trade dollar-yuan swaps onshore, earning a fat spread on these trades. Overseas investors could borrow cheap offshore yuan and convert those into U.S. dollars or other currencies to invest in stocks and bonds. The investors would benefit from conversion rates as the yuan depreciated, as well as the usual return on the assets”. “Macquarie estimated Chinese exporters and multinational companies have accumulated foreign currency holdings of more than $500 billion since 2022. Foreign companies have also been sending more of their earnings from China abroad instead of reinvesting in the country. Meanwhile, foreign holdings of onshore yuan bonds increased by 920 billion yuan ($128.12 billion) since the end of 2022 to a record high in June, official data showed. That is evidence of what traders call the reverse yuan carry trade, in which foreign investors profit from lending U.S. dollars and borrowing yuan via currency-hedged swap trades and then buying yuan bonds”.
Given these features, can China fare better than Japan in coping with currency speculators? I think Chinese regulators suspect that bond yields are being manipulated, abetted by domestic institutions, to lure locals into investing abroad. The domestic leakages or capital flight are an important source for round-tripping “short-yuan and long-USD” carry trades. Charlie Zhu and Helen Sun note “Chinese regulators intensified efforts to tighten…The People’s Bank of China effectively narrowed its interest rate corridor, placing a much higher floor on the costs banks pay to borrow overnight from each other. For longer-term bond yields…rural lenders to shorten the average duration of their bond holdings, joining the PBOC’s recent efforts to prevent yields from falling further. For stocks, the securities watchdog…restrict short selling and quantitative trading strategies”.
Chu Daye reports PBOC plans “to conduct treasury bond borrowing operations with primary dealers in the open market…The amount of lendable medium- and long-term treasury bonds held by these financial institutions is in the range of several hundreds of billions of yuan…The central bank will borrow treasury bonds without fixed terms and continue to borrow and sell the borrowed treasury bonds according to bonds market conditions”. “Experts said the move signals the central bank’s plan to address the overheated bond market to ensure its smooth operation and help stabilize the market by managing the expectations of market participants. As investors pour their money into the domestic bond market, yields have come under pressure. China’s 10-year treasury bond yield has dropped below the symbolic 2.3 percent level…The 30-year bond yield has slid below 2.5 percent, attracting significant market attention…China’s central bank has repeatedly warned about the risk of low yields on medium- to long-term treasury bonds…Pan Gongsheng, governor of the PBOC…emphasized the importance of maintaining a normal upward-sloping yield curve to preserve market investment incentives…the PBC is also aiming to limit speculative activities in the treasury bond market…The move by the central bank could reshape market expectations by increasing the supply of bonds available for purchase on the market, avoiding the risks from ultra-low bond yields…incorporating treasury bond trading into the monetary policy toolkit aims to serve as a channel to increase the monetary base and manage liquidity”.
William Pesek notes “bond bulls argue the rally is supported by underlying fundamentals – including slowing growth and deflationary pressures – and has room to grow…When bonds and stocks are added together, it amounted to just 31% of total social financing last year, with the rest dominated by bank loans. In the US, by comparison, the figure is more than 70%”. “In recent weeks, PBOC Governor Pan Gongsheng warned of bubble troubles as walls of capital flowed from shaky stocks and plunging property into bonds…SVB in the United States has taught us that the central bank needs to observe and evaluate the situation of the financial market from a macro-prudential perspective…At present, we must pay close attention to the maturity mismatch and interest rate risks associated with the large holdings of medium and long-term bonds by some non-bank entities. Entities in potential harm’s way include insurance companies, investment funds and other financial firms. That’s particularly the case as China flashes some Japan-like warning signs. Credit demand is weak due to the property woes. As a result, banks have to buy more bonds as money is trapped in the interbank market”.
William Pesek reports “at least four Chinese brokerages implemented new curbs on trading in domestic government bonds. One went so far as to suspend dealing in certain maturities”. “One recent step saw regulators prodding some of China’s biggest state banks to collect more details about buyers of sovereign notes. The idea is to tighten the leash on speculators. At the PBOC’s branch in Shanghai, officers are meeting with financial institutions to discuss bond market risks”. “This week, regulators counseled commercial banks in China’s Jiangxi province against settling their government bond purchases. Prodding institutions to renege on trades is a bold move to reduce risk”.
Michael Pettis notes “for much of 2024, markets have driven up bond prices as banks and investors aggressively bought up long-dated government bonds, after which the regulators have swooped in with a combination of measures to drive bond prices back down. These measures have been fairly heterodox. They include warnings to the smaller banks, outright prohibitions and cancellations of bond purchases, bank investigations, regulatory fines, and what some are calling quantitative contraction – with the PBoC borrowing long-dated government bonds from banks and selling them into the market to drive down prices. Last week, the measures intensified after bond yields plummeted another 10 basis points in late July. Regulators announced an investigation into four rural commercial banks for allegedly manipulating sovereign bond prices in the secondary market. This was widely seen as a warning to smaller banks who, after the large state banks sold long-dated government bonds into the market – encouraged, no doubt, by strong regulatory pressure – took advantage of these sales to buy up the bonds cheaply. This week, at least four brokers took steps to reduce bond trading, helping to drive down trading volume by nearly 50 percent from last week. They, too, were almost certainly pressured to do so by the regulators.
It seems that the regulators are aggressively intervening in the bond market mainly because they are worried that a bond bubble might lead to financial instability”.
Michael Pettis adds “continued weakness in the real estate market and the widespread perception that the economy is still slowing…lead to the reluctance of Chinese businesses to borrow to expand their production and of Chinese households to borrow for mortgages. In July, Chinese banks loans actually contracted (by RMB 77 billion) as Chinese households and businesses repaid more debt than they took out, the first time this has happened since 2005. This pessimism is also reflected in the stock market, another market that this year has seen heavy intervention by regulators, this time to get prices to rise. But while the regulators had succeeded for a while (the CSI rose from 3179 on February 2 to 3690 on May 20), they were unable to maintain the market, and it has dropped sharply since then (to 3326 by August 12). At the same time, as Bloomberg notes…share transactions in China shrank to their lowest level in over four years, as a local bond rally hit fever pitch in a weakening economy. This raises an obvious question: Will the regulators succeed in preventing banks from piling even more into long-dated government bonds and driving yields down further? Another way of asking this question might be to consider how, if they are indeed prevented from buying the long-dated bonds, Chinese banks can manage their deposit inflows and the weak real demand for their funds”.
William Pesek points out “authorities may have a harder time taming the market than many believe. Though heady demand for China’s government bonds dovetails with Beijing’s long-term agenda, it’s colliding with PBOC efforts to support the yuan. All in all, the recent flattening of the yield curve has limited Pan’s policy flexibility, fueling renewed speculation that more monetary easing is coming. This explains why the PBOC’s tug-of-war with bond vigilantes is only just beginning – and why the battle won’t be an easy one for China to win”. “Trouble is, this could damage the integrity of a market that Xi has been slow to develop. If counterparties in bond trades worry additional transactions might go awry, trust in Chinese bonds could wane even further. Too often in recent years, Xi’s regulators intervened in stock and foreign exchange trading, turning off global money managers. As such, it’s hardly surprising that foreign accounts are pulling record amounts of capital out of China’s economy”. These are “the worst capital outflows from China since at least 2016. The trend appears to have spooked Xi’s team so much so that regulators have moved to release less high-frequency data…because the data hasn’t been looking good, and it’s volatile…they probably don’t want the data to amplify capital outflows but it doesn’t solve the root of the problem”.
On the other hand, China surprised markets by easing interest rates. Reuters reported the PBOC “cut the seven-day reverse repo rate to 1.7% from 1.8%, and would also improve the mechanism of open market operations. That is the first cut to the rate since August 2023. Minutes later, China cut benchmark lending rates by the same margin at the monthly fixing. The one-year loan prime rate (LPR) was lowered to 3.35% from 3.45% previously, while the five-year LPR was reduced to 3.85% from 3.95%. The PBOC subsequently lowered the rates on its standing lending facility (SLF), a type of loan that it gives commercial banks to fulfill their temporary cash demands, by the same amount…The PBOC also made adjustments to its lending programme, saying collateral requirements for medium-term lending facility loans will be lowered from July. Analysts said that meant banks would need to hold fewer longer-term bonds for collateral needs and could sell or trade more, helping the central bank with its mission to put a floor under longer-term yields, rein in a bubble in bonds and get a steeper yield curve”.
The PBOC’s delicate balancing act reflects the tension in its monetary policy objectives. The PBOC faces pressures to lower interest rates to address deflationary pressures as the domestic economy is slowing, to expand yuan liquidity to fill in the gap left by the USD liquidity exodus and to support its de-dollarisation objectives. As a result, PBOC has so far resisted from raising interest rates to confront the carry trades that is pressuring the yuan. Instead, drawing on Japan’s experience, China’s regulators are intent on getting to the source of domestic leakages and disciplining the local institutions reckless or foolish enough to take on funding mismatch risks without understanding what they are getting to. Of course, imposing strict disciplinary measures will chill risk-taking. This is always the regulatory dilemma. Of course, market players will complain about over-regulation and its consequences of illiquidity and captive market problems. From my experience, the consequences of letting domestic institutions run loose on risks is a bad proposition and regulators should always ensure that markets are fair and orderly, and that the interests of depositors/investors are always safeguarded.
The August 2024 carry trade unwind
I think the Chinese regulators have also been looking ahead to and preparing for the potential consequences, given their jaundiced view of the American monetary situation, of the Fed policy transition. The sudden carry trade unwinding in August gave a hint of the shape of things to come.
Tyler Durden notes “the Bank of Japan has lifted its benchmark interest rate to 0.25% and outlined plans to halve its monthly bond purchases in a decisive, if doomed, move to normalize its monetary policy… With the Fed and all other central banks either set to move, or already moving rapidly in the opposite direction, the always confused BoJ’s shift to tighter policy will narrow an interest rate gap that has driven record weakness in the yen, marking a big shift for global currency markets”. Japan has caved “to government pressure to ease the pressure on the crashing yen”. BOJ’s “market intervention had the effect of squeezing a substantial volume of short yen positions out of the market, traders said, tamping down the so-called carry trade”.
William Pesek notes “ever since the Bank of Japan’s July 31 interest rate hike, the yen’s resulting surge has upended foreign exchange markets. Twenty-five years of holding rates at zero turned Japan into the globe’s top creditor nation, where for decades investment funds borrowed cheaply in yen to bet on higher-yielding assets worldwide. It became one of the globe’s most crowded trades, one uniquely prone to correction where sudden moves in the yen slammed markets virtually everywhere.
Wolf Richter points out “the yen has been rising from the ashes. In early July, the yen had plunged to ¥162 to the USD, its weakest level since 1982, despite repeated, large-scale, and costly interventions by the government. At that point, from June 2020, the yen had plunged by 34% against the USD, and by 54% since January 2012, when the Bank of Japan kicked off its crazed monetary policies under Abenomics…The BOJ had to choose between its currency – preventing it from collapsing further – and the stock market wealth that foreigners have piled up. Today, the yen rose to ¥147 to the USD. This is still a low level for the yen that has traded around the 110-range give or take over the past decade”.
The unwinding of yen-funded carry trades triggered a global market sell-off. The yen appreciated by 12.1% from a recent low of 161.6 on 10 July 2024 to 144.0 on 25 August 2024. The offshore yuan (CNH) appreciated by 2.5% from 7.29 on 22 July 2024 to 7.11 on 25 August 2024. The USD weakness was mirrored in Western equity markets. The Nikkei 225 fell by 25.5% from its all-time high of 42,224.02 on 11 July 2024 to 31,458.42 on 5 August 2024. This was followed by a 21.9% rebound to 38,364.27 on 23 August 2024. The DJIA fell by 5.3% from 40,842.79 on 31 July 2024 to 38,703.27 on 5 August 2024. This was followed by a 6.4% rebound to 41,175.08 on 23 August 2024.
In this context, modern financial markets are incestuous. A (large) group of loosely-knitted financiers that speak the same modern financial language support each other’s liquidity and leverage. Debt and equity is extensively unbundled and recombined to form several product layers. Complex portfolio strategies, with many trading legs, tightens the price linkages between different asset classes which results in tight coupling vulnerabilities. The August price shocks illustrate that the global carry-trade strategy comprise legs that involved being short yen and yuan (funding) and long Japanese equities, US equities and bonds, and Chinese bonds (investments). When the carry trade unwound, the price trends in those markets reversed. The lead action is in the currencies – namely the appreciation of the yen and the yuan. In particular, the PBOC have allowed the onshore and offshore yuan exchange rates to converge.
What is remarkable is how prices seemingly hit an air pocket but the Japanese and US equity markets were able to recover their poise so quickly. In fact, this has been a feature over few years. As compared with the past, none of major financial disasters that broke out in US, UK, Europe and Japan seem to have had a durable effect and seemingly disappeared without lingering ill effects. Undoubtedly regulators and market players are getting more skilled at intervention – establishing liquidity bridging facilities, buying enough time ensuring an orderly unwinding of leveraged positions and minimising potential losses among market players and institutions.
Though regulators have been able to smooth markets over, their policy dilemmas have just been deferred and remain intact. How does the Fed intend to finance the US fiscal deficits? How does the Chinese government intend to overcome its deflationary pressures? How is BOJ to exit its decades-old QE trap? For example, William Pesek notes a “big question mark is the BOJ’s outlook. Additional Japanese rate hikes could send the yen sharply higher, causing the carry trade to explode spectacularly. Carlos Casanova, economist at Union Bancaire Privée, thinks upcoming data will reinforce the Bank of Japan’s hawkish policy stance, despite persistent challenges. Therefore, we expect that the BOJ will implement one more 10-25 basis point hike in the fourth quarter. The BOJ’s pivot has led to market volatility and expectations of yen strengthening, which could erode imported inflation benefits and dampen tourism spending”.
The timing and magnitude of the Fed policy transition matters a lot to the global economy. In China’s case, the carry trade unwind and pending Fed interest rate cuts will shift the policy challenge from one of managing yuan weakness to managing yuan strength. Nigel Green notes estimates “that Chinese companies have amassed over US$2 trillion in offshore investments, a large portion of which is parked in US dollar assets. Since the onset of the pandemic, Chinese firms have been seeking higher yields abroad, finding greater returns in dollar-denominated assets than in domestic, yuan-denominated options”. However, if US interest rates are cut in the coming months, this could prompt “Chinese firms to shift their investments back home. Projections for how much capital might be repatriated vary but estimates range from $400 billion to $1 trillion. Even at the lower end of this range, the impact on the yuan could be significant, with some analysts predicting that the currency could appreciate by as much as 10% against the dollar”. “A stronger yuan could signal a broader rebalancing of economic power, particularly in the context of ongoing US-China tensions and the increasing importance of the Chinese economy on the global stage…A stronger yuan could also impact other currencies, particularly in emerging markets that compete with China in export markets. If the yuan rises significantly, it could give a competitive advantage to other Asian economies whose currencies remain weaker by comparison, potentially reshaping trade dynamics in the region”.
Martin Lynge Rasmussen estimates “Fed normalisation could allow a large pickup in dollar sales by Chinese goods traders, perhaps to the tune of $15-22bn per month in the coming quarters”. However, “there are multiple reasons why, even if the Dollar declines substantially, the impact on goods traders’ FX sales this time around could be more muted than has historically been the case, however. Chinese authorities might, for example, push back against aggressive renminbi purchases by goods traders. One reason is that the contribution of net exports is likely viewed as more essential than five years ago, when domestic consumption was growing more quickly”. Thus, the authorities could slow down the yuan’s appreciation by persuading “exporters convert their Dollars into other FX assets and gold rather than into renminbi”. “In terms of international competitiveness we should keep in mind that, though the renminbi remains strong in nominal effective exchange rate (NEER) terms, it fell sharply during 2022 in real effective exchange rate (REER) terms as Chinese inflation has not surged like elsewhere. Another factor is that exporters’ downbeat sentiment on the renminbi could possibly be sticky as the slowdown in Chinese growth is likely (viewed as) more structural than during prior growth declines…Relatedly, US yields could well remain above that in China in the coming quarters. The US-China 2y spread stands at around 230bps, and imply that Dollar deposits will likely continue to yields more than renminbi deposits. In contrast, the 2y spread was consistently negative during 2008-2021”.
In the past, PBOC was concerned by a surge in speculative inflows intended to force a sharp appreciation of the yuan. Concerned with the loss of trade competitiveness, they managed this pressure by sterilising inflows i.e. purchasing USD debt as FX reserves. But circumstances have changed. First, China seems less interested in having a competitive currency. China prefers a stronger currency not because it wants to assist trade rebalancing with the US but rather for the purpose of strengthening domestic stability and promoting de-dollarisation or yuan internationalisation. I think the regulators would prefer their industry to adjust to a stronger yuan and to pass on the higher costs to Western buyers. However, they would intervene if the appreciation was steep and disorderly. My view is that the yuan would need to appreciate to the 6.40 (April 2022 levels) to 6.80 (August 2022 levels) range before it triggered a strong PBOC response.
Second, in theory returning inflows into the yuan are likely to be limited by decoupling and de-dollarisation. However, it would be interesting to consider circumstances under which there could be appreciation pressure on the yuan and what the PBOC can do in response. One possibly is that the Fed copies the BOJ and lowers interest rates sharply (zero-bound) and engages in massive QE. This will create a major source of global liquidity which would find its way to China. However, since China is unlikely to want to sterilise these inflows (because it would not wish to purchase more USD government debt), PBOC’s options are limited to accepting some appreciation, lowering interest rates (in which case they could end up with near-zero rates) or increasing the supply of yuan to meet market demand. Overall, I think market makers and large investors need time to reposition their books and it would take couple of months before we see a sharp move on the yuan.
2030 scenario: Currency areas
A yuan currency area, as a breakaway from the USD-dominated international financial system, could start to take shape by 2030. At the outset, it should be clarified that modern currency areas are not built to optimise regional economic efficiency (e.g. Euro) but arises from geopolitical conflict. Thus, a modern currency area is not an economic union but a geopolitical construct built around an information network of floating currencies benchmarking a lead currency.
The current global currency ecosystem can be considered as a USD currency area – with USD as the lead benchmark around supported by a secondary tier of currencies such as euro, yen, sterling, Swiss franc and Aussie dollar. The yuan currency area is still at a formative stage. It has gained impetus because for countries affected by severe US sanctions like Russia, North Korea and Iran, the USD has become irrelevant and yuan is the most practical alternative. In the fledging yuan currency area, Global South currencies (such as rouble, Indian rupee and dirham) jointly with non-currency assets (such as gold and crypto) are the main secondary tier candidates.
China needs to adopt a more comprehensive approach to accelerate the growth of a yuan currency area; particularly in re-directing flows away from Western intermediaries and markets towards the Global South and to establish a base of yuan and non-Western-denominated “safe assets”. In this context, China has leveraged on its position as the largest player to establish rival price discovery venues for commodities. Pricing differentials between Chinese and Western venues are noticeable. VBL notes gold prices are diverging from the real/nominal yields in the US but are increasingly co-related to the real/nominal yields of its biggest buyer, China. They argue that in a decentralized multipolar world, this reflects not so much a breakdown in correlations but the diminishing dominance of the US. China also needs to spearhead Global South collaboration to promote the growth of non-Western-denominated products, asset managers, financial and information intermediaries (index firms and rating agencies) as well as ensure prudential and efficient payments and robust clearing, settlement and legal arrangements for intra-Global South flows.
I have often argued the West’s ostracization strategies are flawed and self-damaging. Their comprehensive sanctions end up shrinking their network and reducing the space for Western financial intermediaries. On the other hand, the sanctions are boosting the growth of competing networks, creating opportunities for non-Western intermediaries and generating demand for alternative safe assets. The traditional non-geopolitical safe asset is gold while cryptocurrencies, particularly bitcoin, are the modern alternatives.
As de-dollarisation progresses, will the US tolerate the emergence of a rival currency network – particularly as new intermediaries, venues and platforms emerge to assist businesses to bypass sanctions, controls and to evade oversight. There are signs of building political pressure for stern action but it is unclear what would be effective counter-measures. The biggest concern is the loss of interoperability between the two currency areas will be affected by connectivity, liquidity and information inefficiencies.
Given these are the two largest economies, USD-yuan should be the most important exchange rate in the world. But it is not currently. The yuan is often sidelined in favour of other Western currencies because the yuan is subject to capital controls. Hence, the yuan is mainly used for commercial trade and leverage and liquidity is limited. The yuan market has a two-tier structure – the onshore PBOC’s USD/CNY[18] daily fix and the offshore USD/CNH[19] rate. At times, the differences between the onshore and offshore exchange rates can be significant. At some stage, the status of the yuan-USD exchange rate should be elevated; particularly if China succeeds in internationalising the yuan. But there is likely to be resistance from the West which is likely to be opposed to the success of yuan currency area. Given capital flows between the West and China may dwindle, it is worthwhile asking the process for determining USD-yuan exchange rates in the future.
2030 scenario: Fragility
Alasdair Macleod points out “conditions are very different from the long decline in interest rates from the 1980s, and the subsequent period when they sat at or below the zero bound. The world of fiat currencies has become destabilized, not by the detachment from gold and the market’s adjustment to it as was the case in the 1970s, but by extreme interest rate suppression, inflationary excesses, unproductive debt creation, and massive government debt overhangs”.
Frankly, all the major economies are tottering near a cliff’s edge. It is anybody’s guess as to which economy will be the first to fall. The US has already experienced several bank failures involving crypto-related banks such as Silicon Valley Bank (SVB) and regional banks such as First Republic Bank as well as the demise of cryptocurrency exchange FTX. There is growing concern over the potential fall-out from commercial real estate (CRE) loan and bond defaults and unrealised losses from commercial and government bond holdings.
China’s property crisis was sparked by the 2021 Evergrande Group default and the deflationary malaise has spread across to other sectors. China’s other main fragility is the overhang of local government borrowing. In April 2024, there were worrying signs that deflationary forces are starting to get entrenched. Jeff Pao notes “new renminbi deposits plummeted 51% to 7.32 trillion yuan in the first four months of 2024 from 14.93 trillion yuan in the same period of last year…new renminbi loans fell by 10% to 10.19 trillion yuan from 11.32 trillion yuan for the same period”. This was attributed to the PBOC cap of 1.45% on one-year deposits which prompted depositors to withdraw their savings from banks to either higher yielding wealth management products or to repay mortgage loans. “The PBoC said that China’s aggregate financing to the real economy (AFRE) or total social financing, one of the key indicators of China’s credit demand, was 12.73 trillion yuan (US$1.76 trillion) in the first four months of this year, down 3.04 trillion yuan from the same period of last year. The AFRE was 12.93 trillion yuan in the first quarter. It means that the figure declined by 200 billion yuan in April, the first drop since 2005”.
Simon Black thinks China could be entering a “crunch phase, where China needs to respond forcefully, or face the prospect of a protracted debt-deflation. The signal is coming from falling government yields. They have been steadily falling all year, at a faster pace than any other major EM or DM country. Indeed yields have been rising in almost every other country. That’s a problem for the yuan. The drop in China’s yields is adding pressure on the currency…The question is: will this prompt a devaluation in the yuan? The short answer is less likely than not, but it can’t be discounted, and the risks are rising as long as capital outflows continue to climb”. “So far, China appears to be managing the decline in the yuan versus the dollar…through the state-banking sector”. “China has plenty of foreign-currency reserves to stave off continued yuan weakness, but there is always the possibility policymakers decide to ameliorate the destructive impact on domestic liquidity from capital outflow by allowing a larger, one-time devaluation. There is speculation this is where China is headed, and that it is behind its recent stockpiling of gold, copper and other commodities”.
In Japan, Tyler Durden notes reports speculating that Norinchukin Bank, Japan’s 5th largest bank, “will sell more than 10 trillion yen ($63 billion) of its holdings of U.S. and European government bonds…as it aims to stem its losses from bets on low-yield foreign bonds, a main cause of its deteriorating balance sheet, and lower the risks associated with holding foreign government bonds.” “As of the end of March, Norinchukin had approximately 23 trillion yen of foreign bonds (about $150 billion), amounting to 42% of its total 56 trillion yen of assets under management”. Norinchukin, a major institutional investor in Japan, holds as much as 20% of the 117 trillion yen of outstanding foreign bonds held by depositary financial institutions. “If and when the selling begins by a bank that holds 20% of all foreign bonds in Japan, the liquidation cascade will quickly spread to Mrs Watanabe. According to the U.S. Treasury Department, Japanese investors held $1.18 trillion of U.S. government bonds as of March, the largest slice among foreign holders”.
In Europe, Credit Suisse was hit by scandals including exposure to the collapses of US hedge fund Archegos Capital and UK finance firm Greensill Capital. A deposit run forced the Swiss authorities to arrange for its rescue by UBS. In UK, a steep rise in sovereign yields and the collapse of sterling in September 2022 exposed the fragility of British pension funds. By relying leveraged liability-driven investment (LDI) strategies, the pension funds were exposed to large mark-to-market losses with lenders or derivative counterparties and their positions were subject to large margin calls. Their selling of gilts catalysed further selling and it was only after the Bank of England intervened by setting up a temporary gilt purchase program that stability was restored.
Governments and central banks themselves are not in good shape either. Alasdair Macleod notes the “debt-to-GDP ratios of the G7 group of countries in 2022 averaged 128%. This list was headed by Japan at 260.1%, followed by Italy at 144%, the US at 121.3%, France at 111.8%, Canada at 107.4%, the UK at 101.9%, and Germany at 61.8%. The conditions of currency instability of the 1970s with their higher interest rates have returned, giving rise to an overriding question: how are these budget deficits going to continue to be financed”.
Central banks in US and Europe are already saddled by negative equity. Stephen Cecchetti and Jens Hilscher notes “during and after the Global Financial Crisis of 2008-09, central banks engaged in large-scale asset purchase programmes, significantly increasing the size of their balance sheets. Purchases continued during the COVID-19 pandemic in the early 2020s…the consolidated assets of the Federal Reserve System and the Eurosystem…peaked at nearly ten times their level in 2008. Importantly, central banks purchased bonds when long-term rates were low. So, when interest rates rose in 2022 and 2023, their holdings started to generate losses. This sparked a debate both over whether it was prudent to amass these portfolios and if the mounting losses would undermine the ability of central banks to meet their price stability objectives”.
Stephen Cecchetti and Jens Hilscher explain “the nature of the losses, and their resulting economic impact, depends on what it is that the central bank chooses to purchase: domestic bonds or securities issued by a foreign entity. Purchases of domestic sovereign bonds change the maturity structure of privately held government debt, implying no direct ex-ante transfer of wealth, though there may be transfers ex post…Similarly, purchasing private sector bonds can create ex-post transfers. But since owners of the bonds’ issuing companies are domestic, this is a within-country transfer. In contrast, purchases of foreign securities result in transfers to foreigners. Importantly, however, central bank losses are distinct from central bank solvency. As a technical matter, central banks have very little capital. For example, the Eurosystem as a whole had capital equal to €120 billion supporting total assets of €8.8 trillion in October 2022 – a leverage ratio of roughly 75. Similarly, the Federal Reserve System has $43 billion of capital with peak assets of $9.0 trillion, implying leverage of over 200. As a result, even very modest losses can lead to insolvency. Our view…this is a technical issue with only tangential relevance for the ability of central banks to carry out policy. However, solvency may be essential for credibility. Importantly, with the appropriate fiscal support (which is generally not in question), solvency will never be an issue. Notably, though, the form and timing of the fiscal support is important. Two aspects are relevant: when the central bank realises losses and when the fiscal authority transfers funds to make the central bank whole again”. “To get some sense of the magnitude of the losses, and the fiscal implications, we consider two examples: the Bank of England and the Federal Reserve. Both hold primarily domestic sovereign bonds. But the specific holdings, size and treatment of losses are different. Importantly, the UK has indemnification rules which mean that any realised losses translate almost immediately into a fiscal expenditure. In the case of the Fed, the losses simply postpone the date when transfers to the US Treasury will restart (they are currently on hold). Finally, the undiscounted sum of the Bank of England’s losses appears to be larger than that of the Fed – 7.8% versus 0.8% of nominal GDP – and could stretch out for decades as opposed to lasting for only a few years”.
Stephen Cecchetti and Jens Hilscher add “when the central bank purchases foreign securities, the transfers are between domestic residents and foreigners. Assuming that countries place different welfare weights on domestic and foreign residents, transfers are qualitatively different. To get a sense of the potential magnitude, consider the case of the Swiss National Bank. In stark contrast to the Fed and the Bank of England, the central bank’s losses, which are mainly transfers to foreigners, are quite large: annual net income varies from +8% to –17% of GDP”. In the case of the Eurosystem, it is complicated because “the (currently 20) national central banks each have their own balance sheets, they share some portion of both income and risk…the overall consolidated losses look to be even smaller than in the US”. Even a small rise on yields can result in massive equity losses for the BOJ as it accumulated financial assets at negative yields while its balance sheet capital amounts to only 100 million yen. Nonetheless, most economists believe the ability of the central banks, as the sole issuer of the domestic currency, to conduct monetary policy will not be impaired.
Apart from negative equity, Paul De Grauwe and Yuemei Ji notes raising interest rates has led to record high interest payments by the central banks to banks. “Interest payments are particularly high in the case of the Bank of England, reaching 1.5% of GDP (in May 2024)”. In comparison, interest payments was estimated at 0.88% of GDP for the Eurosystem and 0.67% for the Fed. “The existence of these large transfers has become a political issue…as many are questioning why the public sector transfers £40 billion a year to the banks while the UK government faces a budget deficit of £120 billion, which will necessitate large spending cuts. The counterpart of these large transfers to banks are large losses for the central banks. For the UK, the yearly loss has been estimated at £23 billion”. “While these transfers are likely to decline in the future, they will remain at significant levels for years to come”. Assuming BOE maintains a level of bank reserves of the order of £345-£490 billion and “a long-term neutral rate of interest of 3%, this means that in steady state the Bank of England is expecting to pay out £10-15 billion a year to banks indefinitely. It also means that the central bank intends to transfer to banks most of their seigniorage gains that should accrue to the Treasury, and this for the indefinite future. This is quite a change from the old days when central banks transferred seigniorage to the Treasury”. They recommend that changes be made to “reduce the unwarranted large subsidies to banks and at the same time would make monetary policies more effective in combatting inflation”.
Other signs of market fragility include a build-up in product risk and risk concentrations. Alasdair Macleod notes that according to the Bank for International Settlements, open interest in regulated futures totaled $37 trillion in June 2023, and in December last year, the notional value of OTC derivatives stood at an additional $630 trillion, giving us a total of $667 trillion. Banks, insurance companies, and pension funds are the counterparties in these transactions, and the failure of a significant counterparty could threaten the Western financial system.
Tyler Durden notes IMF’s Global Financial Stability Report highlights that “as of December (2023), about half the two-year Treasury short positions in the futures market were in the hands of eight traders or less…It was at a similar level at the end of 2019, just before a surge in funding costs in the early days of the pandemic spurred traders to unwind the positions, which helped boost volatility in bonds at a time of upheaval across financial markets…A Fed study last month estimated that hedge funds have amassed at least $317 billion in Treasury holdings related to basis trades since the first quarter of 2022, although the size is significantly less than it previously estimated”. Stricter oversight by the Securities and Exchange Commission have led to “a decline in leveraged funds’ short positions in bond futures. The concentration in these bets has also diminished. In two-year futures, net short positions controlled by eight traders or less have dropped to about 38% of total open interest, from 50% in early January…Despite that unwinding…the short positions of leveraged funds remain large, which means they may still loom as a risk”. “Basis trade investors rely on low repo haircuts and low repo rates to leverage their positions and increase basis trade profitability…A spike in repo rates – triggered, for example, by surprises in quantitative tightening – can render the trade unprofitable and could trigger the forced selling of Treasury securities and a brisk unwinding of futures positions as funds seek to quickly delever.” “Some of these funds may have become systemically important to the Treasury and repo markets, and stresses they face could affect the broader financial system;” in which case they may necessitate a bail-out. Tyler Durden estimates, based on “regulatory leverage, the actual amount allocated to basis is orders of magnitude greater than $550BN, more likely in the $2+ trillion ballpark across the entire global hedge fund industry”.
Alejandra Medina and Carl Magnus Magnusson point out “total outstanding corporate bond debt stood at $33.6 trillion globally at the end of 2023, up from $21 trillion in 2008. Most of the increase comes from non-financial companies…A notable change is the structural decrease in credit quality. In 2021, the global average credit rating for non-financial company bonds had fallen from an average corresponding to A- in the 1980s to just above BBB-, the lowest investment grade rating”. “In parallel, the ownership landscape has changed. The most notable development is the increased prevalence of investment funds. In the US, the world’s largest bond market, investment funds increased their ownership share of the non-financial market from 8% in 2008 to 34% in 2021 (before dropping to 23% in 2022)”. They note “a concentration of increasingly indebted BBB-rated issuers in the investment grade segment and an increased prevalence of investment funds as owners combine in a way that may have implications for market stability in a context of tighter monetary policy. The withdrawal of a major market player through quantitative tightening and continued elevated sovereign borrowing needs mean significant amounts of government debt need to be absorbed by investors other than central banks. With sovereign securities now offering more attractive yields than in previous years, this raises the question of what the consequences will be for the corporate bond market. This is especially pertinent given the extent to which this market has become dominated by more price-sensitive investors. In addition to the refinancing risks of the broader market, there are also specific considerations for bonds around the investment grade threshold which merit attention given the increase in such debt in recent years…In early 2024, investment grade funds’ net exposure to BBB rated securities represented over a fifth of their total portfolio, equivalent to more than $650 billion. This portfolio structure, together with the investment grade fund label, make these funds particularly exposed to fire sale risks, beyond the regular exposure stemming from the liquidity mismatch between fund shares and underlying assets. In a scenario where a significant share of triple B bonds are downgraded, investment grade funds may need to sell substantial amounts into illiquid secondary markets. Even if this happens over an extended period, it could have a large impact, with possible broader ramifications for market functioning and stability. It is ambiguous whether this risk differs between ‘traditional’ open-ended funds and ETFs. While some research suggests that the structure of bond ETFs allows them to absorb liquidity pressures and counteract fire sale dynamics, there are also indications that ETFs tend to worsen liquidity conditions in periods of stress”.
Despite their fragilities, the major economies have, so far, proven to be resilient and demonstrated their ability to withstand stress. But this is due to fiscal spending and central bank balance sheets so large that it dominates all other economic trends. It is troubling that the size of central banks, funds and financial products have outgrown banking intermediaries. This hints that there is a shortage of private-based regulatory capital to cover potential highly-leveraged losses in the event of a sharp fall in asset prices. Today’s major financial stress points are a run on financial products and investment firms and private sector dependence on central banks to act as the liquidity provider of last resort. Chances that a financial crisis occur before we reach 2030 are high. It won’t really matter which economy falls off the cliff first, other countries will be affected, one way or another.
The geopolitics of Global South debt crises
Vasuki Shastry and Jeremy Mark notes “the International Monetary Fund (IMF) estimates that 60 percent of low-income countries are in, or at high risk of, debt distress – double the 2015 level…By some estimates, China’s collection of official and quasi-official lenders accounts for around 13 percent of Africa’s stock of private- and public-sector external debt, much of it made at commercial rates. The private sector, by contrast, accounts for about 40 percent. Multilateral lenders such as the IMF and World Bank, which lend at zero or extremely low interest rates, account for an additional 32 percent”. “Debt resolution in the post-pandemic era has turned into a four-legged stool comprised of national governments, the Paris Club coalition of long-time government lenders and multilateral agencies, China, and private creditors – and if two legs break, the whole stool collapses. That appears to be the case in a world with shifting power dynamics as the Paris Club, led by the Organisation for Economic Co-operation and Development, has found itself out-flanked by more powerful creditors such as China and the private sector”.
Conor Gallagher points out “the US and US-led institutions are already trying to sideline China in countries struggling to make debt payments… Washington estimates that Chinese lending ranges from $350 billion to a trillion dollars. In recent years, western officials and media have ratcheted up criticism of China’s lending practices, claiming Beijing is putting its boot on the neck of countries, holding back their development, and is seizing assets offered as collateral”. However, he cites research
showing “that Chinese banks are willing to restructure the terms of existing loans and have never actually seized an asset from any country…Beijing’s preference has always been to try and tackle debt repayment issues at a bilateral level, typically by extending maturities rather than accepting write-downs on loans”.
Conor Gallagher notes “in 2020, the G-20 countries created the Common Framework for Debt Treatments to provide relief to indebted countries, which included fair burden sharing among all creditors. Beijing’s reluctance to agree to such burden sharing is illustrated by the case of Zambia…More than a third of the country’s $17 billion in debt is owed to Chinese lenders. Zambia worked out a deal with the IMF for a $1.3 billion bailout package but can’t access the relief until its underlying debt is restructured – including Chinese debts. But the IMF prescription for Zambia is a blow to Beijing…Zambia will shift its spending priorities from investment in public infrastructure – typically financed by Chinese stakeholders – to recurrent expenditures. Specifically, Zambia has announced it will totally cancel 12 planned projects, half of which were due to be financed by China EXIM Bank, alongside one by ICBC for a university and another by Jiangxi Corporation for a dual highway from the capital. The government has also canceled 20 undistributed loan balances…While such cancellations are not unusual on Zambia’s part, Chinese partners account for the main bulk of these loans…While some of these cancellations may have been initiated by Chinese lenders themselves, especially those in arrears, Zambia may not have needed to cancel so many projects. Since 2000, China has canceled more of Zambia’s bilateral debt than any sovereign creditor, standing at $259 million to date. Nevertheless, the IMF team justified the shift because they – and presumably Zambia’s government – believe that spending on public infrastructure in Zambia has not returned sufficient economic growth or fiscal revenues. However, no evidence is presented for this in the IMF’s report. Zambia will also cut fuel and agriculture subsidies. So instead of infrastructure investment and social spending, the country gets austerity. The IMF deal also relegates China to the backseat, as it allows for 62 concessional loan projects to continue, only two of which will involve China. The vast majority of the projects will be administered by multilateral institutions and involve recurrent expenditure rather than infrastructure-focused projects…The US effort to sideline China in Zambia comes at the same time that Washington is trying to tighten control over resources in the region. Note that back in December the US signed deals with the Democratic Republic of Congo and Zambia (the world’s sixth-largest copper producer and second-largest cobalt producer in Africa) that will see the US support the two countries in developing an electric vehicle value chain…Meanwhile, Zambia has halted work on several Chinese-funded infrastructure projects, including the Lusaka-Ndola road, and canceled undisbursed loans in line with the IMF prescription for its debt problem. Chinese companies are now attempting to work around these roadblocks by shifting more toward public-private partnerships. For example, a Chinese consortium is now planning to build a $650 million toll road from the Zambian capital to the mineral-rich Copperbelt province and the border with the Democratic Republic of the Congo. The situation in Zambia does not bode well for other nations needing debt relief, as the delays while the West and China clash mean more pressure on government finances, companies and populations. And if the West’s primary goal in offering debt relief is to sideline Beijing, as it appeared in Zambia, then that will mean a drastic scaling back of infrastructure projects replaced by austerity”. “While it remains illusional to insulate sovereign restructurings from geopolitical considerations, there is a risk that they would turn into a game of chicken between China on the one hand and the IMF and Paris Club on the other hand. The problem being that if none of the players yields, it will just mean more economic and social hardship for the debtor country stuck in the middle”.
2030 scenario: Global breakdown or cooperation
Economies operate on the same global boat. However, beggar-thy-adversary policies are intensifying and this is increasing the likelihood that a major economy will totter off the cliff. A recession or financial crisis in a major economy would certainly have spill-over effects on other countries. There are fears that liquidity trap conditions or a prolonged stagnation, once isolated within Japan, could envelope China, Europe and US[20].
In past decades, countries cooperated to nullify the forces of contraction and illiquidity and there were joint efforts to address the long-term threats posed by the withdrawal of fiscal stimulus and debt forbearance, balance sheet impairment, market illiquidity and debt and market crises.
In today’s geopolitical climate, anaemic economies can expect to be left to fend on their own. Even with the restart of QE, liquidity is no longer able to flow to where it is needed to stimulate growth. For example, decoupling and an exodus of Western capital has aggravated the deflationary effects of a property crisis in China. China has pretty much needed to deal with its economic and financial downturn. Yet, the West hopes China will undertake a massive stimulus to reflate consumer demand as this would have positive spillover effects on their economies. Is it a surprise then that China has instead adopted a more conservative approach of accepting lower economic growth while selectively channelling funds for domestic needs and staying on course to achieving its long-term “modernisation” goals. If the West enter into a recession or face a rerun of the 2008 crisis, it is unlikely China would come to their aid this time; at least not without Western concessions such as the withdrawal of blockades, sanctions and tariffs.
The post-globalisation conundrum is that it doesn’t make sense to rely on adversaries. This raises the question of whether it is possible for countries to rely only on themselves or their allies to sustain growth momentum. Domestically, rising interest rates are a sign that fiscal gravity is finally kicking in to constrain fiscal stimulus. I am doubtful if central bank “puts” or emergency liquidity infusions will be sufficient to revive economic growth as they have lost efficacy over time (due to over-use). When it comes to cooperation among allies, I think most have already exhausted their policy resources and space and are no longer in a position to expand trade, generate revenue and sustain leverage levels. Outside of the US which enjoys leadership advantages, the prospects for allies are cloudy. The real vulnerability is that the private sector has taken a beating from government policies and risk aversion particularly among the small to medium-size businesses is rising. If the unquantifiable animal spirits never recovers, this would hasten a return to depression economics.
Things could get worse in a nightmare break-up scenario. At the extreme, there could be an all-out beggar-thy adversary competition with the US imposing comprehensive financial sanctions, similar to those applied to Russia, on China. The measures could include sanctioning China’s banks; restricting their access to SWIFT and freezing or even expropriating China’s international assets and even restricting cargo and passenger travel. It is no longer possible to dismiss nightmare scenarios as it could be triggered by a direct military confrontation. Accompanying this would be the severing of official USD-yuan convertibility and an overnight collapse in global trade between the West and China. Global South countries will no longer be given the space to be “non-aligned” and will be forced to pick a side. But it is not clear how the West would make Global South countries fall in line as they risk alienating countries by extending secondary sanctions. What would be the future for global multilateral institutions such as IMF and World Bank, SWIFT, BIS and global financial intermediaries? What would be the future for global MNCs and global public goods such as mutual recognition of patents? Is it feasible for the US to go ahead make such decisions on their own or would they need to solicit support from allies before such drastic undertakings? The economic loss for the world would be extensive.
Global cooperation is the last line of defence against economic and financial crises. If we revisit the 1980s, the Fed under Paul Volcker raised its Fed funds rate to a peak 20% in 1981 to finally tame inflation but at the expense of a deep recession. In 1985, US sought the “assistance” of Japan and Germany, under the Plaza Accord, to engineer a USD devaluation to lay the groundwork for its economic recovery. In tandem with the sharp depreciation of the USD, the Fed was able to lower its Fed fund rate to below 5% from 1991 onwards. It is uncertain the extent to which the Plaza Accord contributed to the US recovery but it was at least symbolically helpful to the cause. What is certain today is that the geopolitical landscape is different and not conducive to global coordination. Unlike Japan and Germany, US has an adversarial relationship with China.
Nonetheless, both sides recognise their mutual interests particularly on maintaining global financial stability to keep the global economic engine running and, at the very least, to ward off crisis threats. Despite the deteriorating bilateral relationship, nonetheless, as Evelyn Cheng reports, both countries agreed to cooperate on financial stability under the auspices of the US-China Financial Working Group. But how far such gestures would go given the low levels of trust between the two countries remains to be seen. We are likely to hit several more air pockets on the way to 2030 and we will see how feasible it is for adversaries to cooperate to ward off a global crisis.
References
Alasdair Macleod (4 November 2023) “Macleod: The future of fiat”. Zero Hedge. https://www.zerohedge.com/markets/macleod-future-fiat
Alejandra Medina, Carl Magnus Magnusson (28 June 2024) “Changes in global corporate bond markets and dynamics around the investment grade threshold”. Voxeu. https://cepr.org/voxeu/columns/changes-global-corporate-bond-markets-and-dynamics-around-investment-grade-threshold
Alexandra Prokopenko (27 May 2024) “What are the limits to Russia’s Yuanization?” Carnegie Endowment. https://carnegieendowment.org/russia-eurasia/politika/2024/05/china-russia-yuan?lang=en
Brad W. Setser (5 February 2024) “China’s new currency playbook”. Council for Foreign Relations. https://www.cfr.org/blog/chinas-new-currency-playbook
Brad Setser (May 2024) “Power and financial interdependence”. French Institute of International Relations (Ifri). https://www.ifri.org/sites/default/files/atoms/files/ifri_setser_power_financial_interdependence_2024.pdf
Charlie Zhu, Helen Sun (15 July 2024) “Chinese regulators intensify efforts to tighten control over financial markets”. Bloomberg. https://www.zerohedge.com/markets/chinese-regulators-intensify-efforts-tighten-control-over-financial-markets
Chu Daye (5 July 2024) “Reported move by PBC on treasury bond borrowing aimed at stabilizing market, managing expectation: Analysts”. Global Times. https://www.globaltimes.cn/page/202407/1315491.shtml
Conor Gallagher (19 March 2023) “Interest rate hikes and IMF bailouts: The US tries to roll back Chinese influence in the Global South”. Naked Capitalism.
David Scutt (26 March 2024) “Explainer: the PBOC USD/CNY fix and how it impacts FX markets”. Forex.com. https://www.forex.com/ie/news-and-analysis/explainer-the-pboc-usd-cny-fix-and-how-it-impacts-fx-markets/
Death Taxes and QE (29 August 2024) “Swimming naked: How the coming rate cuts will end in a treasury market puke”. Zero Hedge. https://www.zerohedge.com/news/2024-08-27/how-coming-easing-cycle-will-lead-treasury-market-puke
Evelyn Cheng (19 August 2024) “U.S., China sign agreement to cooperate on financial stability”. CNBC. https://www.cnbc.com/2024/08/19/us-china-sign-agreement-to-cooperate-on-financial-stability.html
Fernando Broner, Sergio L. Schmukler, Goetz von Peter (28 March 2024) “The growth of the South in global finance: New bilateral data and stylised facts”. Voxeu. https://cepr.org/voxeu/columns/growth-south-global-finance-new-bilateral-data-and-stylised-facts
Global Times (10 July 2024) “GT Voice: Yuan going global to support economy, not replace others”. https://www.globaltimes.cn/page/202407/1315805.shtml
Global Times (18 July 2024) “Yuan’s global payment ranking remains in fourth place for eighth consecutive month in June”. https://www.globaltimes.cn/page/202407/1316298.shtml
Gita Gopinath (7 May 2024) “Geopolitics and its impact on global trade and the dollar”. Stanford Institute for Economic Policy Research. https://www.imf.org/en/News/Articles/2024/05/07/sp-geopolitics-impact-global-trade-and-dollar-gita-gopinath
Guido Ascari, Giancarlo Corsetti, Tilda Horvath, Riccardo Trezzi (26 July 2024) “The US fiscal mess: Some unpleasant fiscal simulations”. Voxeu. https://cepr.org/voxeu/columns/us-fiscal-mess-some-unpleasant-fiscal-simulations
International Monetary Fund (IMF) (April 2024) “World economic outlook”. https://www.imf.org/en/Publications/WEO/Issues/2024/04/16/world-economic-outlook-april-2024
International Monetary Fund (IMF) (April 2024) “The last mile: Financial vulnerabilities and risks”. Global Financial Stability Report. https://www.imf.org/en/Publications/GFSR/Issues/2024/04/16/global-financial-stability-report-april-2024
Jan Nieuwenhuijs (12 February 2024) “Gold wars: The US versus Europe during the demise of Bretton Woods”. Gainvesville Coins. https://www.zerohedge.com/geopolitical/gold-wars-us-versus-europe-during-demise-bretton-woods
Jason Choi, Duong Dang, Rishabh Kirpalani, Diego Perez (26 August 2024) “Exorbitant privilege and the sustainability of US public debt”. Voxeu. https://cepr.org/voxeu/columns/exorbitant-privilege-and-sustainability-us-public-debt
Jeff Pao (14 May 2024) “Unleashed bank deposits misused in Chinese economy”. Asia Times. https://asiatimes.com/2024/05/unleashed-bank-deposits-misused-in-chinese-economy/
Jodi Vittori, Lakshmi Kumar (26 June 2024) “Sovereign Wealth Funds: Corruption and other governance risks”. Carnegie Endowment. https://carnegieendowment.org/research/2024/06/sovereign-wealth-funds-corruption-illicit-finance-governance-risks?lang=en
Kandy Wong (29 July 2024) “Global use of China’s yuan up sharply, beating pound and yen on internationalisation index”. South China Morning Post (SCMP). https://www.scmp.com/economy/economic-indicators/article/3272194/global-use-chinas-yuan-sharply-beating-pound-and-yen-internationalisation-index?module=top_story&pgtype=homepage
Kate Mackenzie, Tim Sahay (17 April 2024) “New world order?” Phenomenal World.
Macro Butler (20 July 2024) “Fiscal dominance steers bankers’ wars”. Zero Hedge. https://www.zerohedge.com/news/2024-07-20/fiscal-dominance-steers-bankers-wars
Mandy Zuo, Ralph Jennings (28 February 2024) “In finance war with US, former official says China risks staring down the barrel of a capital conundrum”. South China Morning Post (SCMP). https://www.scmp.com/economy/china-economy/article/3253532/finance-war-us-former-official-says-china-risks-staring-down-barrel-capital-conundrum?module=top_story&pgtype=homepage
Martin Lynge Rasmussen (29 August 2024) “Unwind Of China’s great carry trade could unleash $20 billion in monthly FX sales”. Money: Inside and Out. https://www.zerohedge.com/markets/unwind-chinas-great-carry-trade-could-unleash-20-billion-monthly-fx-sales
Maurice Obstfeld (August 2024) “Misconceptions about US trade deficits muddy the economic policy debate”. Petersen Institute for International Economics (PIIE). https://www.piie.com/sites/default/files/2024-08/pb24-7.pdf
Michael Lebowtiz (14 August 2024) “Stealth QE or rubbish from Dr Doom?” RealInvestmentAdvice.com. https://www.zerohedge.com/markets/stealth-qe-or-rubbish-dr-doom
Michael Pettis (8 August 2024) “Will technology differentiate China today from Japan in the 1990s?” Carnegie Endowment. https://carnegieendowment.org/posts/2024/08/will-technology-differentiate-china-today-from-japan-in-the-1990s?lang=en
Michael Pettis (14 August 2024) “What is driving China’s long-dated bonds?” Carnegie Endowment. https://carnegieendowment.org/posts/2024/08/what-is-driving-chinas-long-dated-bonds?lang=en
Niccolo Conte (16 April 2024) “U.S. debt interest payments reach $1 trillion”. Visual Capitalist. https://www.visualcapitalist.com/u-s-debt-interest-payments-reach-1-trillion/#google_vignette
Nigel Green (28 August 2024) “Tectonic shift coming on global currency markets?” Asia Times. https://asiatimes.com/2024/08/tectonic-shift-coming-on-global-currency-markets/
Paul De Grauwe, Yuemei Ji (24 June 2024) “The new operating procedures of the Bank of England: A bonanza for the banks”. Voxeu. https://cepr.org/voxeu/columns/new-operating-procedures-bank-england-bonanza-banks
Pepe Escobar (16 May 2024) ‘De-dollarization bombshell – The coming of BRICS+ decentralized monetary ecosystem”. Zero Hedge. https://www.zerohedge.com/geopolitical/escobar-de-dollarization-bombshell-coming-brics-decentralized-monetary-ecosystem
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 (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-4-lessons-from-plaza-accord/
Phuah Eng Chye (28 August 2021) “Global reset – Monetary decoupling (Part 6: The forthcoming currency war)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-6-the-forthcoming-currency-war/
Phuah Eng Chye (11 September 2021) “Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-7-currency-wargame-scenarios/
Phuah Eng Chye (25 September 2021) “Global reset – Monetary decoupling (Part 8: Sovereign digital currencies and networks in the currency war)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-8-sovereign-digital-currencies-and-networks-in-the-currency-war/
Phuah Eng Chye (20 November 2021) “Global reset – Monetary decoupling (Part 12: Role of intermediaries – Disintermediation and fintech regulation)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-12-challenges-for-intermediaries-disintermediation-and-fintech-regulation/
Phuah Eng Chye (4 December 2021) “Global reset – Monetary decoupling (Part 13: Intermediaries in the era of globalisation and decoupling)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-13-intermediaries-in-the-era-of-globalisation-and-decoupling/
Phuah Eng Chye (10 September 2022) “The Great Economic War (GEW) (Part 4: Battles reshaping the global monetary order)”. http://economicsofinformationsociety.com/the-great-economic-war-gew-part-4-battles-reshaping-the-global-monetary-order/
Phuah Eng Chye (24 September 2022) “The Great Economic War (GEW) (Part 5: Global economic breakdown and monetary disorder)”. http://economicsofinformationsociety.com/the-great-economic-war-gew-part-5-global-economic-breakdown-and-monetary-disorder/
Phuah Eng Chye (8 October 2022) “The Great Economic War (GEW) (Part 6: Geopolitics, monetary policy challenges and the collapsing tripod)”. http://economicsofinformationsociety.com/the-great-economic-war-gew-part-6-geopolitics-monetary-policy-challenges-and-the-collapsing-tripod/
Phuah Eng Chye (9 December 2023) “The dismal decade (Part 1: De-dollarisation and currency landscape in 2030)”. http://economicsofinformationsociety.com/the-dismal-decade-part-1-de-dollarisation-and-currency-landscape-in-2030/
Phuah Eng Chye (27 January 2024) “The dismal decade (Part 2: Adversarial monetary policies)”. http://economicsofinformationsociety.com/the-dismal-decade-part-2-adversarial-monetary-policies/
Phuah Eng Chye (24 February 2024) “The dismal decade (Part 3: The economic race: How US is faring)”. http://economicsofinformationsociety.com/the-dismal-decade-part-3-the-economic-race-how-us-is-faring/
Phuah Eng Chye (30 March 2024) “The dismal decade (Part 4: The economic race: Can China catch US by 2030)”. http://economicsofinformationsociety.com/the-dismal-decade-part-4-the-economic-race-can-china-catch-us-by-2030/
Phuah Eng Chye (27 April 2024) “The dismal decade (Part 5: China and Japanification risks)”. http://economicsofinformationsociety.com/the-dismal-decade-part-5-china-and-japanification-risks/
Phuah Eng Chye (29 June 2024) “The dismal decade (Part 6: Seven forces shaping 2030 #1- #3)”. http://economicsofinformationsociety.com/the-dismal-decade-part-6-seven-forces-shaping-2030-1-3/
Phuah Eng Chye (27 July 2024) “The dismal decade (Part 7: Seven forces shaping 2030 #4)”. http://economicsofinformationsociety.com/the-dismal-decade-part-7-seven-forces-shaping-2030-4/
Reuters (22 July 2024) “China cuts several major interest rates to support fragile economy”. https://www.reuters.com/markets/asia/china-central-bank-cuts-short-term-policy-rate-2024-07-22/
RT (28 December 2023) “Moscow’s anti-sanctions tsarina: What the woman leading Russia’s Central Bank says about economic war with the West”. https://swentr.site/business/589811-elvira-nabiullina-interview-rbk
Robert Greene (5 December 2023) “The difficult realities of the BRICS’ dedollarization efforts – and the renminbi’s role”. Carnegie Endowment. https://carnegieendowment.org/2023/12/05/difficult-realities-of-brics-dedollarization-efforts-and-renminbi-s-role-pub-91173
Robin Brooks (9 May 2024) “Is China financially decoupling?” Brookings.
Simon Black (25 April 2024) “Falling bond yields show it’s crunch time in China”. Zero Hedge. https://www.zerohedge.com/markets/falling-bond-yields-show-its-crunch-time-china
Stephen Cecchetti, Jens Hilscher (26 June 2024) “Fiscal consequences of central bank losses”. Voxeu. https://cepr.org/voxeu/columns/fiscal-consequences-central-bank-losses
Tumoas Malinen (20 August 2024) “Into the Great Depression, Part 1: The roaring ’20s & the creation of the Fed”. Zero Hedge. https://www.zerohedge.com/economics/great-depression-part-1-roaring-20s-creation-fed
Tyler Durden (19 April 2024) “Huge bond wagers make some hedge funds too-big-to-fail, IMF warns”. Zero Hedge. https://www.zerohedge.com/markets/huge-bond-wagers-make-some-hedge-funds-too-big-fail-imf-warns
Tyler Durden (19 June 2024) “CBO figures out how to math, raises 2024 US budget deficit by $400bn to $1.9 trillion”. Zero Hedge. https://www.zerohedge.com/markets/cbo-figures-out-how-math-raises-2024-us-budget-deficit-400bn-19-trillion
Tyler Durden (19 June 2024) “The music just stopped: Japan banking giant Norinchukin to liquidate $63 billion in treasuries & European bonds to plug massive unrealized losses”. Zero Hedge. https://www.zerohedge.com/markets/music-just-stopped-banking-giant-norinchukin-liquidate-63-billion-treasuries-and-european
Tyler Durden (30 July 2024) “Treasury estimates $1.3 trillion in borrowing needs for the remainder of 2024”. Zero Hedge. https://www.zerohedge.com/markets/treasury-estimates-13-trillion-borrowing-needs-remainder-2024
Tyler Durden (31 July 2024) “Quarterly refunding: Treasury to hold bond, note sales steady for several quarters, will modestly increase bill offering size”. Zero Hedge.
Vasuki Shastry, Jeremy Mark (22 February 2023) “China and private lenders are blocking a solution to the global debt crisis. The G20 must step in”. Atlantic Council. https://www.atlanticcouncil.org/blogs/new-atlanticist/china-and-private-lenders-are-blocking-a-solution-to-the-global-debt-crisis-the-g20-must-step-in/
VBL (16 May 2024) “Gold: China correlations matter”. Zero Hedge. https://www.zerohedge.com/news/2024-05-15/unlocked-gold-correlates-china-rates
William Pesek (14 August 2024) “China has a bond vigilante problem”. Asia Times.
William Pesek (22 August 2024) “Yuan to surge as yen carry trade goes awry”. Asia Times. https://asiatimes.com/2024/08/yuan-to-surge-as-yen-carry-trade-goes-awry/
Winni Zhou, Summer Zhen (13 August 2024) “Explainer – What is the Chinese yuan carry trade and how is it different from the yen’s?” Reuters. https://finance.yahoo.com/news/explainer-chinese-yuan-carry-trade-043313350.html
Wolf Richter (20 August 2024) “QT continues: ECB balance sheet: -€2.39 trillion or -27% from peak, to €6.45 trillion, lowest since August 2020. Wolf Street. https://wolfstreet.com/2024/08/20/qt-continues-ecb-balance-sheet-e2-39-trillion-or-27-from-peak-to-e6-45-trillion-lowest-since-august-2020/
Wolf Richter (19 June 2024) “The foreign holders of the ballooning US debt: They’re buying, but don’t keep up”. https://wolfstreet.com/2024/06/19/the-foreign-holders-of-the-ballooning-us-debt/
Wolf Richter (23 June 2024) “Who Holds the recklessly ballooning US national debt of $34.7 trillion?” Wolf Street. https://wolfstreet.com/2024/06/23/who-holds-the-recklessly-ballooning-us-national-debt-of-34-7-trillion/
Wolf Richter (5 July 2024) “Fed balance sheet QT: -$34 billion in June, -$1.74 trillion from peak, to $7.22 trillion, lowest since November 2020”. Wolf Street. https://wolfstreet.com/2024/07/05/fed-balance-sheet-qt-34-billion-in-june-1-74-trillion-from-peak-to-7-22-trillion-lowest-since-november-2020/
Wolf Richter (2 August 2024) “Japanese stocks plunge, yen rises from the ashes as BOJ hikes, ends free money, and starts QT”. Wolf Street. https://wolfstreet.com/2024/08/02/japanese-stocks-plunge-yen-rises-from-the-ashes-after-free-money-ends-boj-tightens-and-starts-qt/
Wolf Richter (2 August 2024) “Stocks swoon amid rate-cut hopes after they’d soared amid rate-cut hopes? Whatever. Mag 7 -$2.26 trillion from peak, semis crushed, Nasdaq bloodied”. Wolf Street. https://wolfstreet.com/2024/08/02/stocks-swoon-amid-rate-cut-hopes-after-theyd-soared-amid-rate-cut-hopes-whatever-mag-7-2-26-trillion-from-peak-semis-crushed/
Wolf Richter (28 Aug 2024) “Treasury department aggressively pushes down long-term interest rates via shift to T-bill issuance and bond buybacks”. Wolf Street. https://wolfstreet.com/2024/08/28/treasury-department-aggressively-pushes-down-long-term-interest-rates-via-shift-to-t-bill-issuance-and-bond-buybacks/
Yu Yongding (May 2024) “China’s foreign exchange reserves: Past and present security challenges”. Wenhua Zongheng. Originally published in China Reform. https://thetricontinental.org/wenhua-zongheng-2024-1-china-foreign-exchange-reserves/
[1] See RT’s interview with Russian central bank head Elvira Nabiullina for her account of how policies were adapted to counter sanctions risk to ensure macroeconomic and financial stability.
[2] See Tyler Durden.
[3] See Tyler Durden on refunding operations of US government debt.
[4] “According to FDIC data, the total amount of all types of securities held by banks – Treasury securities, MBS, and other securities – was $5.5 trillion at the end of Q1, with cumulative unrealized losses on all their securities rising to $517 billion”. See Wolf Richter.
[5] See Jan Nieuwenhuijs for background on the USD hegemony.
[6] Jason Choi, Duong Dang, Rishabh Kirpalani and Diego Perez explain the convenience yield refers to the benefit from the ability of the US government to “issue debt at very low interest rates. On average, the yield on US Treasuries is 60 basis points lower than on comparable safe corporate bonds”.
[7] “US inflation, which peaked at 14.8 percent in March 1980, fell below 3 percent by 1983. The Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well, which helped lead to the 1980–1982 recession, in which the national unemployment rate rose to over 10%”. https://en.wikipedia.org/wiki/Paul_Volcker
[8] See “The dismal decade (Part 2: Adversarial monetary policies)”.
[9] “A liquidity trap is a situation, described in Keynesian economics, in which, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt (financial instrument) which yields so low a rate of interest. A liquidity trap is caused when people hold cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Among the characteristics of a liquidity trap are interest rates that are close to zero and changes in the money supply that fail to translate into changes in the price level”. https://en.wikipedia.org/wiki/Liquidity_trap
[10] See Brad Setser (May 2024) “Power and financial interdependence” on The link between financial self-reliance and geopolitical power.
[11] Maurice Obstfeld provides an interesting rebuttal of arguments that foreign trade surpluses, underpinned by unfair trade practices or a global savings glut, were necessarily the factors that caused US trade deficits, shrinking US exports and America’s industrial base to hollow out. He thinks “the ills that are blamed on trade (as well as other ills) owe in large part to purely domestic policy failures that no degree of trade restriction can repair”.
[12] https://en.wikipedia.org/wiki/Impossible_trinity
[13] PvP arrangements help ensure that the final settlement of a payment in a currency occurs if and only if final settlement of a payment in another currency takes place; this mitigates settlement risk.
[14] Kandy Wong notes the index uses data on “the yuan’s settlement in trade, financial transactions and use as an official reserve currency in other countries to determine the currency’s internationalisation level”.
[15] https://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp
[16] See Brad W. Setser analysis of China’s new strategy of indirect currency intervention through state banks.
[17] See “The dismal decade (Part 5: China and Japanification risks)”.
[18] See David Scutt.
[19] https://statrys.com/blog/cnh-vs-cny-differences-chinese-renminbi
[20] See Tumoas Malinen for background on the 1930s Great Depression.