The Great Economic War (GEW) (Part 6: Geopolitics, monetary policy challenges and the collapsing tripod)

The Great Economic War (GEW) (Part 6: Geopolitics, monetary policy challenges and the collapsing tripod)

Phuah Eng Chye (8 October 2022)

Events are moving quickly; from an environment of relative calm to one of extreme stress. A global volatility blow-out is exposing the vulnerabilities of financial intermediaries, investors and businesses that relied on leverage to hedge risks and maximise returns. Central banks are being shaken out of their complacency and are unlikely to emerge unscathed. There are several aspects and consequences of the extreme monetary disorder to consider.

Geopolitics and reserve management

Rising geopolitical tensions has a key role in the loss of monetary stability. The Goldilocks global economy – of low inflation and interest rates and a relatively stable currency environment – was built on central bank cooperation that relied on the USD as the unifying currency satisfying all aspects of balance sheet management such as safety, leverage, risk-taking and liquidity. In the mid-1980s with Japan and EU, and followed by Asia in the post-2000s, central banks accumulated massive USD foreign exchange (FX) reserves that supported ever-expanding US trade deficits. BIS explains “FX reserves are an integral part of emerging market economy central banks’ policy toolkit. They insure against shocks and complement monetary policy to achieve price and financial stability. Over the last decades, they have surged from, on average, 5% of GDP in 1990 to almost 30% in 2018”. In particular, China’s accommodation extended a fourth leg of “table-like” support to complement the US-EU-Japan tripod underpinning the global monetary order.

With decoupling and now GEW, the “table-like” stability has evaporated as  China and other Asian central banks begun reducing their FX reserves. William Pesek note Asian central banks are “fast depleting foreign currency stockpiles to defend their flagging currencies against US rate hikes”. According to Divya Devesh, in August 2020 the region averaged about 16 months of FX reserves to imports. “At the start of 2022, it was down to 10 months. Today, it’s in the neighborhood of seven months – not where most investors or government officials thought Asia might be”. “By these metrics, Thailand, the Philippines, India, Indonesia and Malaysia warrant the greatest concern from a stability standpoint should the dollar continue surging”. William Pesek cautions “for investors worried about an Asian Financial Crisis 2.0 trajectory for the region, it’s a sign of potential trouble to come”.

The trends in Asian reserve management are worth noting. First, FX reserves are meant to be an umbrella for rainy days. The selling of Asian currencies from deleveraging (including unwinding carry trades) merits using the reserves to slow the depreciation. Second, gains from USD appreciation can be used to offset the mark-to-market losses from rising US interest rates.

Third, in the past Asian central banks FX reserves were considered excessive (to the point where they were accused of currency manipulation). The issue is how much FX reserves are central banks justified in holding as “insurance” against a speculative currency attack. On this note, seven months of FX reserves are considered excessive and between 3 to 6 months of import cover considered sufficient. Hence, Asian central banks should not only allow FX reserves to fall but have little need to replenish particularly if cross-border capital flows are subdued. In this regard:

  • It is costly to hold excess FX reserves due to the relatively low yields from reserve assets. There is also a debate over the efficacy of large FX reserves in stemming a currency attack; e.g. some argue BOJ’s large FX reserves would not be able to stop the yen from falling as it is futile for to intervene on a negative carry[1]. BOJ cannot simultaneously  target exchange rates and interest rates and need to let one target go. On the other hand, BOE  is constrained in defending sterling as they only have two months of FX reserves and need to rely on interest rates.
  • The level of FX reserves needed as insurance against de-stabilising “hot money” outflows diminishes in line with cross-border deleveraging (of public and private foreign currency liabilities). Outflows caused by trade and fiscal deficits, and domestic individuals and firms shifting (siphoning) wealth overseas are a structural challenge and less of a monetary policy issue.
  • Geopolitical forces are probably the most critical driver of reserve trends. Large holdings of “adversarial” currencies are exposed to expropriation risks. In the event a war breaks out, the need for “insurance” is superfluous as countries may as well allow private firms and individuals to default on their foreign liabilities. Central bank unwinding of USD and OECD-denominated FX reserves would compel their counterparties to unwind their positions and accelerate de-risking and diversification trends.

There is an argument that by selling their USD reserves, Asian central banks like PBOC and BOJ are triggering a vicious self-defeating loop as their FX sales would cause US interest rates to rise. This would further widen the differential between US and Asian interest rates and add to the selling pressure on Asian currencies. While the description is correct, this is a short-term dynamic that works itself to a point of exhaustion when Asian currency sales reaches its limits; or is broken either by Asian central banks raising interest rates; or by Fed intervention to lower US interest rates or depreciate the USD. In any case, the objective of unwinding FX reserves is not so much to defend the currency but to reduce inventory to ensure the downswing is orderly. If central banks miss out on the opportunity to reduce (sell) FX reserves when the USD is strong (at higher prices), then the central bank could find itself disadvantaged (in buying) when the USD turns weak. It doesn’t make sense to hold FX reserves  in perpetuality as this turns them into a deadweight. In addition, selling FX reserves will put pressure on hedge funds and others to either increase the size of their bet to neutralise the effect of central bank sales on currency prices (thereby forcing them to take greater risks) or to unwind their round-tripping currency attack.

In general, the long-term trends are unfavourable for the major reserve currencies – as reflected by the recent collapse of the euro, yen and sterling. Mike Dolan notes as at the first quarter of 2002, “almost 5% of the world’s foreign currency reserves were denominated in sterling – a total of $625 billion dollars worth of sterling and sterling assets…that’s more than two thirds of the Bank of England’s own bloated balance sheet – which was amassed since the 2008 banking crash and doubled up during the COVID-19 pandemic”. In the recent run, “there was some suspicion of major investors there bailing out of British holdings. Seven of the world’s top 10 reserve holding central banks are in Asia or the Middle East. China and Japan account for the lion’s share of total holdings with about $4.5 trillion between them – but India, Taiwan, Saudi Arabia, South Korea and Hong Kong account for a further $2.5 trillion of overall reserves…while the European Central Bank holds none”. “An annual UBS survey of global reserve managers in June ominously showed that a net 13% expected to cut allocations to sterling going forward, more than any other currency. None said they planned to increase”.  

The lack of coordination to assist BOE, BOJ or ECB is also apparent. For the moment, the Fed is perhaps mindful of its recent commitment to continue raising interest rates. The non-USD OECD currencies are also affected by the shrinking of the OECD currency area due to the GEW expropriation risks and declining OECD share of the global economy. Whereas OECD could once count on the export-led emerging economies to absorb its public debt, this is unlikely to be sustained in the future. Currency portfolio diversification will no longer be viewed as choosing among different OECD currencies but choosing between OECD and non-OECD currencies.

The transition favouring emerging currencies will dilute the dollar’s hegemony. In relation to this, Elliot Hentov, Ramu Thiagarajan and Aaron Hurd argue countries are liquidating the dollar’s erosion as a reserve currency is due to “a growing push by reserve currency mangers towards active reserve management” and greater use of bilateral currencies in trade. Hence, there is “growing liquidity in many currencies outside the big four (dollar, pound sterling, yen, and euro)…falling transaction costs – following the advent of electronic trading platforms, automated market making, and automated liquidity management – have deepened these markets, thereby enabling currency reserve managers to comfortably deal in currencies outside the big four…it has become much easier to use other currencies with the rise of technology and harmonized global regulation”.

The main challenger to USD and OECD currencies is the yuan. The yuan’s share of global reserves (below 3%) is not reflective its position in the global economy. The yuan is expected to overtake yen and sterling to become the third largest global reserve currency by the end of this decade[2]. In this context, the pending emergence of a China-Russia currency area represents a large fragment breaking off from the dollarized world. Russia and China have large physical output and trade surpluses and are able to anchor the formation of an alternative currency area operating on different infrastructure, rules, venues and intermediaries. The transition to non-OECD currencies would take several years due to the need to sort out issues in relation to information (language, disclosures), usability (liquidity), reliability, security, legal framework and intermediaries (sanction-proof).

Jamestown Foundation points out while Russia is reduced to using friendly currencies, there are concerns about “the risks of overreliance on the Chinese national currency, which is stipulated by distinctive features of Chinese financial legislation”. “Well-known Russian economist Stanislav Mitrakhovych indicated three main risks…First, the Russian Federation does not have the necessary skills and infrastructure to work with the Chinese currency. Although manageable over the long term, for now, the Russian financial system is ill-equipped and largely unprepared for the challenges of relying more on the yuan. Second, a high level of nonmarket regulations will make the process incredibly difficult. Unlike Russia’s previous experience of dealing with foreign currencies – both the US dollar and euro are currencies of free-market economies – the yuan’s price is regulated by the Chinese state. Thus, when in need, Beijing can easily manipulate the price of the yuan (say, to create favorable conditions for foreign trade). This could leave Russia as a hostage to Chinese interests. Third, despite China’s growing trade power and economic might, the yuan has not yet become a fully independent currency, remaining tight to other leading global currencies…For now, however, making a bet solely on yuan could be a risky enterprise”. Russia admitted their requests for “China to strengthen their partnership in the realm of financial cooperation has not been strongly supported by Beijing. In effect, Chinese authorities are unwilling to change domestic regulations to allow its investors to operate with Russia-issued bonds. Instead, China is more comfortable with foreigners investing in its so-called panda bonds, which are sold only in the internal Chinese market…with 17 percent of foreign exchange reserves in yuan, the Kremlin will not be able to pull money promptly when needed, thereby becoming trapped by China”.

The yuan did not escape the recent selling pressure. But China has maintained capital controls and continues to conduct an independent monetary policy resulting in a divergence between US and Chinese monetary policies[3]. The broad implication is that there is greater pressure for monetary policies to align within a sphere and for policies to be divergent between spheres. This implies a reduction in asset substitutability and paves the way for pricing differentials to emerge in the different currency areas (for example between Western-Russian oil and other commodities and offshore-onshore currency markets). Pricing differentials indicate growing market segmentation and economic inefficiencies. Cross-border intermediation will be re-organised to exploit price differentials. Physical delivery will become an important aspect of arbitraging price differentials while futures and derivative trades will become more costly. This will set the base for the emergence of “new” cross-border mechanisms and intermediaries.

The bigger challenge to China will occur when the USD goes on its downcycle. Would China be tempted to once again accumulate USD reserves to temper the yuan appreciation due to the impact on its production costs? I think the geopolitics of de-dollarisation will prevent a return to sterilising inflows by adding USD to FX reserves. Instead, the challenge is whether China’s and other global south intermediaries can leverage yuan usage to drive economic growth in their sphere in the looming competition between the OECD and global south

Apart from yuan, there is a shortage of viable non-OECD alternatives. The popular alternatives are gold and digital currencies (CBDCs and cryptocurrencies). I do not anticipate a return to a gold standard. My view is that physical anchors are an inadequate substitute for the financial credibility of governments. In my view, digital currencies and non-USD financial products will likely pose the main threats to USD dominance. In this context, I view cryptocurrencies as derivatives[4] rather than substitutes for sovereign currencies. The significance of digital currencies is that they are highly efficient and can reduce settlement times and frictions significantly. This reduces the need for central banks and businesses to maintain FX reserves. The main impact of digital currencies is to disrupt existing OECD-based global intermediation and oversight. Their usage will depend on willingness of governments to share information and to provide payment assurances for cross-border transactions. To some extent, this explains why the global banks are generally retreating. Their profitable cross-border franchise is being threatened by digitalisation while risks are being elevated by government intrusions and monetary disorder.

Monetary policy challenges

Monetary policy challenges should be framed within the context of a transition to a post-Goldilocks[5], post-QE and a geopolitically-charged environment. The initial transition featured a reduction in FX reserves, attempts by major central banks to normalise their balance sheets and to lift interest rates from near-zero levels. There is no confirmation yet that normalisation has been successful in defeating inflation. Instead, several economies are on the verge of entering into a recession, cross-border deleveraging is ongoing, asset prices and exchange rates have fallen sharply, OECD liquidity and balance sheets are contracting and the risks of financial crises and contagion are rising. The economic pain could be more excruciating in the next phase when governments and central banks are forced to face up to the need to tighten fiscal spending or/and monetary stimulus respectively. The warning signs are there; markets are rebelling against financing large government deficits. This problem will be compounded by revenue shortfalls due to an anaemic economy.

Financial stability risks are now perceived to have overtaken inflation as the priority policy challenge. As US interest rates rise, the differentials with interest rates in major OECD economies have widened and this occurs in tandem with a surging USD. The rise in US interest rates have resulted in significant mark-to-market losses for large holders such as the Fed, foreign central banks, investors and intermediaries. In the meantime, the strong USD is eroding the purchasing power of other OECD currencies, adding to inflationary pressures, raising debt servicing costs and increasing financial stress.

The mark-to-market losses can be severe enough to cause central banks to end up with negative equity[6]. This is not a major concern per se as central banks can be easily re-capitalised by governments. In my view, negative equity matters because it signifies central banks, as market-makers of last resort, are facing insolvency pressures due to their large inventories and mark-to-market losses.

The Fed has the lead role in setting global interest rates as other countries either need to follow their lead or accept currency depreciation. If Fed insists on following through its “Volcker” stance and pushing interest rates higher until it can contain inflationary pressures, the effects may be too severe. In this regard, hiking interest rates to the teens occurred in the 1980s when banks were the main channels for credit. Today, interest rate effects operate through asset management and market channels rather than through banks. Central banks need to guard against raising interest rates too high as this may damage asset prices, markets, funds and the shadow banking industry.

With recent events, market excitement is building on a possible pivot on interest rate policies. Ronni Stoeferle anticipated “given the record high inflation, real interest rates are still clearly negative, giving the impression that the current global cycle of interest rate hikes is far from reaching its end. But this consensus assessment will prove to be wrong. The current cycle of interest rate hikes could go down in history as the shortest and weakest in recent decades”. First, the economic outlook is becoming gloomier faster than expected. Second, “interest rate increases are hardly digestible for the highly indebted countries”. US government debt in the 1970s was around 35% of GDP; today it is about 125% with corporate debt at almost 80%, household debt at 75% – US total debt stands at more than 275% of GDP. The Congressional Budget Office projects “by 2024, interest service will still ease slightly from the current 1.4% of GDP to 1.1%, despite huge budget deficits in 2020 and 2021 of more than 10% each. Starting in 2024, though, interest expense as a share of GDP begins to rise, reaching 8.6% in 2051 in the CBO’s baseline scenario. This would require just under one-third of tax revenues to be spent on interest service alone. This calculation is based on the assumption that the yield on 10-year US Treasuries increases to 3.3% in 2030 and to 4.9% in 2050. This would be a rather moderate increase by historical standards. In 2001, the 10-year US Treasury bond yielded 5.0%, and in 1991 it was as high as 7.9%. Assuming a higher average interest rate on government debt of 2.7% in 2030 and 6.6% in 2050, instead of 2.2% and 4.6% respectively in the baseline scenario, we would end up with an interest service of 15.8% of GDP. The national debt would thereby increase to 260% by 2051”. “The cycle of interest rate hikes will therefore come to an end before it has really begun. Because of the high level of debt, interest rates that actually fight inflation would lead directly to a veritable debt crisis as well as trigger a deep recession. No government in the world would survive such an economic horror scenario”. “For the US, markets currently expect the first interest rate cuts, averaging 60 basis points, as early as the second quarter of 2023”.

As rising US interest rates takes its toll on global markets, economies and intermediaries, it is likely the Fed would pause QT and review its long-term interest rate targets. Is the Fed likely to hold interest rates at between 3%-4% or to allow it to fall back to near zero levels. There are several reasons why the former is more likely. First, even at current levels, real interest rates are negative and it would take at least months before inflation would fall below interest rates. In this regard, interest rate targeting has negligible impact on the supply-driven inflationary shocks. Second, low interest rates will only result in credit rationing and worsen captive market conditions. Interest rates needs to be pegged at levels to entice non-captive participants and to restore market discipline. Third, low interest rates require central banks to restart QE – to buy as much government securities as needed to achieve its target interest rate. However, QE would be “pushing on a string” as there is already excess supply of liquidity; reflecting liquidity trap conditions. Nonetheless, interest rate policy cannot be formulated separately from balance sheet considerations.

Balance sheet policies

In my view, the determining factor setting monetary policy is not the level of interest rates but the size of balance sheets. Once central banks decide on how they intend to manage their balance sheet, the policies for managing interest rates and exchange rates would fall naturally into place.

In this context, central banks are the ultimate market makers or price-setters of interest rates because they have become the largest single holder of government debt with the Fed, ECB and BOJ owning roughly 20%, 30% and 50% of their own government debt respectively. Their large ownership means they are effectively exercising yield curve control (YCC). But their large ownership is problematic and gives rise to captive markets. Captive markets, with concentrated ownership and few outside participants, tend to be illiquid and where large trades have significant price impact or result in large price swings.

While central banks have committed to downsizing their balance sheets to reduce their ownership of government debt, it is proving difficult to exit from the QE trap. Japan[7] tried on many occasions but failed. Recently, the Fed, ECB and Bank of England (BOE) have barely started QT and raising interest rates to find their currencies, markets and financial intermediaries swooning under pressure.

Viral V Acharya, Rahul S Chauhan, Raghuram Rajan and Sascha Steffen point out “the starting point for QT today is different. The Fed does over 2 trillion dollars in reverse repo transactions with the non-banks (typically money market funds)…To the extent that the initial shrinkage of reserves reduces these reverse repo transactions, it should have little consequence for bank-level liquidity mismatches. However, this will reduce the aggregate availability of reserves relative to claims on liquidity. More problematic will be when the aggregate reserve shrinkage starts reducing the reserve holdings of individual banks. If banks do not reduce the claims they have written on liquidity commensurately as observed in the past QT period, the system could become more prone to liquidity stress. Another difference today is that the Fed introduced the Standing Repo Facility (SRF) in 2021 (partly in response to previous episodes of liquidity stress). This allows primary dealers, among others, to borrow more reserves from the Fed against high-quality collateral. While the SRF will help alleviate individual liquidity stress at primary dealers, it is not universally available…the real problem could emanate if some banks/dealers with access to liquidity hoard liquidity in times of stress. The Fed will then have no option but to intervene once again and lend widely as it did in September 2019 and March 2020. Such repeated intervention may not just go against the Fed’s monetary policy stance, but may also engender less liquidity-prudent behavior in the private sector”.

Viral V Acharya, Rahul S Chauhan, Raghuram Rajan and Sascha Steffen argue “evidence suggests banks in aggregate do not seem to be taking advantage of the compression in term spreads. Instead, they have been shortening the maturity of their liabilities, even within deposits, over the period of QE, making it harder for them to finance long-term loans”. “We have documented an important phenomenon of liquidity dependence that has implications for monetary policy and financial stability. As the Federal Reserve increased its balance sheet through successive waves of quantitative easing, commercial banks issued claims on liquidity such as demand deposits and lines of credit. This certainly meant that liquidity was never as plentiful as suggested by the simple increase in reserves. Indeed, claims on liquidity may not only render the banking sector vulnerable to liquidity stress…but bank actions may also have limited the working of monetary policy”.

The QE trap is a paradox where excess QE-created liquidity co-exists with market illiquidity. The liquidity-illiquidity paradox arises because central bank liquidity is mostly parked in short-term assets (marketable funds) and is unsuited to long-term lending due to maturity and credit mismatch risks. If the central banks mop up the excess QE liquidity at a positive interest rate, the central bank effectively provides risk-free income to financial institutions and investors. To reduce policy tightening costs, central banks should normalise their balance sheets before raising interest rates. However, the removal of excess QE liquidity is complicated by potential market dysfunction risks (such as taper tantrums) and by the reduction of FX assets by foreign central banks and investors.

The policy dilemma thus is that central banks cannot undertake QT and lower interest rates at the same time. In this regard, there doesn’t appear to be any room for central banks to retreat to QE. The BOJ is trying to be the exception but it is having to aggressively buy even more government debt. The ability of central banks to absorb government debt is limited by the effects of the growing disproportion between central bank and private sector balance sheets. Apart from worsening the captive market problem, it would increase inflationary risks with future monetisation of government debts.

Monetary policy discussions also tend to neglect the need for central banks to address the critical challenges posed by private sector balance sheet retrenchment (deleveraging) and financial product overhang. In my view, central banks need to stay committed to normalising their balance sheets (in an orderly manner) to drain excess liquidity from their financial system so as to restore the markets’ role in determining interest rates. In tandem with normalisation, central banks need to steer market clearing, find temporary storage for excess inventory, and fast-track debt resolution. This would facilitate orderly asset repricing to enhance risk-adjusted returns and create opportunities to repair damaged public and private sector balance sheets. This would then pave the way for a sustained recovery via private sector re-leveraging.

The collapsing monetary tripod

The three major OECD central banks form the legs of the USD-based global monetary tripod but the tripod has been weakened by over-extended balance sheets – first in response to the 2008 global financial crisis and recently to deal with the pandemic. It has become increasingly difficult to maintain financial stability with their economies besieged by an anaemic economy, high fiscal expenditures and inflationary pressures. Internationally, geopolitical fragmentation is shrinking the OECD currency area, diminishing the role of OECD intermediaries in cross-border financial intermediation, diminishing market liquidity and increasing price volatility. The three banks could attempt to coordinate policies to address the growing risks. But none of the central banks seem to be in a position to accommodate each other’s fiscal deficits or QE. If one or two legs collapse, will it be possible to maintain global monetary stability? The dilemma of the three central banks can be examined individually.

  • US – US monetary policy is hobbled by an unprecedented rise in national debt. Wolf Richter notes “the US gross national debt has now reached $30.4 trillion, having spiked by a $7.0 trillion since March 2020”. According to Treasury International Capital (TIC) data, foreign central banks and governments and foreign private entities held $4.1 trillion and $3.5 trillion of US treasuries as at March 2022. US government holdings (pension funds and social security) held $6.5 trillion; a 21.5% share of US national debt, down from 45% in 2008. The Fed held $5.8 trillion; but its share of US national debt dipped to 19.8%. US banks held only $1.7 trillion or 5.6%. The balance of $8.8 trillion was held by US investors and others. Since March 2020, the biggest increases in holdings have been by the Fed (up $2.4 trillion) and US investors and others (up $2.4 trillion) while banks and foreigners are no longer significant buyers.

Tyler Durden points out a record $2.3 trillion is parked at the Fed’s overnight facility. It was costless when rates were zero, “but at 1.55% which is the current reverse repo rate, that $2.33 trillion is a golden goose for the 108 counterparties that are parking cash at the facility, a mixture of money market funds, banks, GSEs and various other financial intermediaries…the payment in interest that the Fed makes day on this record $2.33 trillion in funds: as of today it amounts to just over $100 million every single day”. At the same time, “the Fed’s Interest on (Excess) Reserves rate, or IOER, is 1.65%. This translates into $141 million in daily interest payments every single day to the various banks (mostly foreign)…Combining the two we get nearly a quarter billion…and rising, in interest payments…with the Fed Funds rate at 1.75%…the Fed hopes to keep hiking at least another 175bps (or more) in the next 6 months, which will push the rate to 3.50% and will mean that the Fed will be paying half a billion in interest every single day to a handful of mostly unknown counterparties every day, money which for said counterparties is also known as (riskless) profit and which is only the result of the Fed’s previous money printing”.

Tyler Durden notes the “Fed allowed $30bn of Treasury and $17.5bn of mortgage-backed holdings to mature in June. In September, the Fed will double that amount, increasing the caps or run-off amounts to $60bn per month for Treasuries and $35bn per month for mortgage-backed securities”. As a matter of comparison, “in 2017-2019, the Fed’s balance sheet run-off shrank bank reserves held at the Fed from a peak of $2.36tn to $1.39tn in September 2019 when repo markets turned disorderly and broke out of the Fed’s desired rate corridor. Today, the Fed has over $5.5tn in reserves including $3.3tn of bank reserves held at the Fed and $2.2tn in the Fed’s overnight reverse repo programme…Consensus foresees slightly more than $2tn in balance sheet reduction: the Fed is expected to sustain its $60bn per month reduction of Treasury holdings until the end of 2023. After that, the pace of reduction may slow and cease by spring 2024. The Fed may independently sustain reductions of its MBS portfolio throughout 2024. Eventually, the Fed will need to buy Treasuries again to offset the reduction: the $64 trillion question is when”.

Wolf Richter notes “under the new regime of QT, total assets[8] have dropped by $139 billion from the peak…on September 1. But it’s the liabilities that limit how far the Fed’s assets can theoretically drop under QT”. The four largest liabilities are bank reserves ($3.25 trillion), Currency in circulation ($2.28 trillion), reverse repurchase agreements (RRPs) ($2.53 trillion) and US Government’s account at the Fed ($670 billion). The two main items determining the QT  floor are (1) “Reserve balances peaked in December 2021, after the Fed had begun reducing its asset purchases. Since then, reserve balances have plunged by $1.03 trillion…due in part to a shift to RRPs via Treasury money market funds”. The floor for bank reserves could be less than $1.6 trillion; a drop of $1.6 trillion from current levels; and (2) “Overnight RRPs, currently $2.25 trillion, are cash from Treasury money-market funds” and “in theory, they can drop to near-zero as liquidity is wrung from the system” ; a drop of $2.2 trillion from current levels. “Four years from now, based on these estimates, the floor for total assets on the Fed’s balance sheet would be about $5.2 trillion, below which the Fed could not go. At the peak, the Fed had $8.97 trillion in assets. So my calculus says that the Fed could do a maximum QT of about $3.8 trillion. This would be a huge reduction in liquidity, and it would sack asset prices…And something big might blow up before the Fed even gets to the theoretical floor”.

Overall, the US economy is in a relatively strong position as it has been a major beneficiary of high energy and commodity prices, reshoring and strong global defence spending. However, monetary policy has been inconsistent. Recently, the Fed committed to QT and raising interest rates but there is growing pressure (from even the UN and WTO) for the Fed to halt raising interest rate due to the global spillover effects. Another predicament is that unless the US government limits or reduce fiscal spending, the likelihood is that the Fed would be forced to stop QT and to restart QE. This could have dire consequences for its currency and economy.

  • Japan – The travails of BOJ to exit from the QE trap are well-studied[9]. With Abenomics[10] in 2013, the BOJ instead doubled down on QE. Michael Lebowitz explains “Japan’s debt to GDP ratio[11] at 2.25x is nearly twice that of the United States…ratio at 1.23x is problematic…BOJ’s assets have risen by six trillion since 1998. While nominally somewhat on par with the Fed, Japan’s economy is less than a quarter of the size of the U.S… As a result of QE, the BOJ[12] now owns more than half of the nation’s Treasury debt and is the largest holder of its stocks…The size of the yen carry trade has declined in recent years…Even at 100 trillion yen, carry trade investors control approximately $80 billion worth of assets worldwide”. “The excessive liquidity spewed by the BOJ grossly distorted asset and interest rate markets in Japan and provided liquidity to the world. Japanese citizens and large pension funds are crowded out of local bond markets by the BOJ. Between the BOJ’s massive holdings and the large number of bonds held to maturity by pension funds, liquidity in its bond market evaporated. The lack of supply resulted in negative rates and no incentive to invest in bonds. With limited choices, domestic retail and institutional investors went to foreign markets and sent their money abroad in search of extra yield and liquidity…as of January 2022, Japan holds over $1.3 trillion of U.S. Treasury debt, $286 billion of U.S. agency bonds, $310 billion of U.S. corporate bonds, and $861 in U.S. stocks”. He points out “Japan can ill afford higher interest rates with its massive debt levels. However, as the BOJ tries to stop rates from rising, they weaken the yen. Japan is in a trap. They can protect interest rates or the yen but not both. Further, its actions are circular. As the yen depreciates, inflation increases and the Japanese central bank must do even more QE to keep interest rates capped. Either way, this inflationary impulse is far different from minor impulses in the past. Further, given the surging price of global commodities and Japan’s lack of natural resources, it will be near impossible to avoid inflation[13]”. “This hawkish scenario, which hasn’t been seen in Japan in thirty years, is deeply troubling. A strong yen and higher rates will entice liquidity to flow back to Japan. Yen carry trades will be reversed as their borrowing costs rise alongside an appreciating yen. Such is a recipe for a global drain of liquidity and possibly a financial crisis. Japanese citizens and pension funds will start to bring their money home to take advantage of higher yields without the currency risk. Such a reversal of liquidity is not a Japan-centric problem as the tentacles of the yen carry trade spread through global financial markets. The loss of liquidity will be felt worldwide”.

Tyler Durden notes to prevent yield curve control (YCC) from collapsing, the BOJ purchased JGBs worth 14.8 trillion yen ($110 billion) in June 2022 with an estimated holding of 514.9 trillion yen, 50.4% of the long-term JGBs. Their concentrated purchases are causing “distortions in the bond market including a deeply inverted yield curve…At this rate…the BOJ will own the entire bond market in another decade or so…lead to a broken market…there are days when not a single trade crosses”. In contrast, “JGBs held by private financial institutions have been rapidly declining: as of the end of March, banks and other deposit-taking institutions held 11.4% of the total, while insurance and pension funds held 23.2%. This means that the BOJ is now taking on even more risk of incurring losses if long-term interest rates rise and JGB prices drop. Japan’s three megabanks hold a total of over 70 trillion yen in JGBs. The average maturity is 2.8 years for Mitsubishi UFJ Financial Group, 2.8 years for Sumitomo Mitsui Financial Group, and 1.2 years for Mizuho Financial Group. In recent years, these banks have been investing mainly in bonds with shorter maturities to prepare for rising interest rates”. “The problem for the BOJ is that it can’t stop buying now…or ever: According to estimates by the Japan Center for Economic Research, the BOJ will need to increase its JGB holdings by 120 trillion yen from the current level of over 500 trillion yen to keep long-term interest rates at 0.25%. The central bank’s JGB holdings are quickly approaching and are expected to exceed 60% of total…Until now, the BOJ has concentrated on specific JGBs, holding 87.6% of newly issued 10-year JGBs, a measure of long-term interest rates. However, at this rate it will soon run out of 10Y paper to buy and will be forced to move left and right on the curve”. “This means that market participants believe the BOJ will soon no longer be able to maintain the current interest rate control measures…A failure to defend YCC could lead to a catastrophic move lower in the JGB market, and spark a hyperinflation collapse of the Japanese yen, and the entire economy”.

The BOJ could sell its massive USD reserves to staunch the fall in the yen. But it didn’t do this perhaps to avoid putting pressure on a US Fed attempting to normalise its balance sheets and risk further de-stabilising global markets. However, it is evident that BOJ is no longer in a position to finance US deficits while its resolve to maintain zero-bound interest rates would get further tested if inflation accelerates in Japan.

However, Tyler Durden points out “Japan is a net capital exporter[14], which means the capital flows of domestic investors, rather than foreign investors, are the dominant long-term driver of the currency. Momentum is driving the yen now, but its fall this year likely has two principal underlying drivers”. First, Japanese investors have been buying more foreign equities because the rise in US short-term yields relative to long-term ones has made FX-hedged USTs unattractive to Japanese investors. “Unlike debt, equity purchases tend to be unhedged or underhedged, meaning the flow is yen-negative”. Second, rising energy prices means Japan’s trade account is in deficit. “With not enough dollars from exports to pay for more expensive energy, in aggregate Japan is selling foreign assets – mainly debt securities – to get dollars. As debt is more likely to be FX hedged, unwinding the hedge is yen-negative as there is no offsetting capital flow back into Japan”. In addition, “Japan listed-companies’ FX-hedging sensitivity is low right now” while “Japan has been all but closed to foreigners since the pandemic, taking the net annual travel surplus of over $50 billion in 2019 to almost zero now”. He argues this is setting the yen up for a sharp rally. Given “Japan is the world’s largest net creditor…with a net international investment position (NIIP) of almost $3.5 trillion, the amount of capital returning is potentially vast”. Several factors “would trigger a reversal in the yen that could very quickly become self-reinforcing”. The BOJ could intervene directly or abandon its cap for 10-year JGB yields. Energy prices could fall and reduce demand for USD. Firms would be more inclined to reset FX hedges if they thought the yen’s trend had reversed. Foreign assets would be sold for yen as capital would be returned home. Foreigners would be more inclined to buy Japanese assets if they thought the currency was on an upward trend. And as the border is gradually opened up, there will be plenty of pent-up demand for cheap Japanese holidays and business travel. “Suddenly, USDJPY at 120 looks more likely than USDJPY at 160”.

  • EU and UK – There are similarities in the circumstances surrounding the collapse of the euro and the yen. Both EU and Japan are large energy importers, run large fiscal deficits, have oversized central bank balance sheets, maintained negative interest rate regimes, and have been accused of zombification[15]. But there are differences. The euro maintained an outsized 20% share in global currency markets whereas Japan’s share has steadily declined to about 3%. ECB holdings of USD government debt is considerably light as compared with BOJ which is the world’s largest holder.

The ECB has finally begun tightening. Wolf Richter notes on 27 July 2022, “the ECB finally exited its Negative Interest Rate Policy (NIRP) by hiking all its policy rates by 50 basis points”; raising the deposit rate from -0.5% to 0.0%; the main refinancing rate to 0.5%; and the marginal lending rate to 0.75%. The rate hikes were the first since 2011 and the biggest since June 2000 and November 1999. The ECB also hinted more and bigger rate hikes are pending in September. It also unveiled the Transmission Protection Instrument (TPI) to pre-empt a Eurozone sovereign debt crisis. The TPI facilitates the ECB to sell higher quality debt (e.g. German) and to purchase other debt (e.g. Italy) to prevent spreads[16] from widening too much”.

Alasdair Macleod thinks “the euro system and its currency are descending into crisis”. “Normally, a central bank is easy to recapitalise. But in the case of the euro system, when the lead institution and all its shareholders need to be recapitalised all at the same time the challenge could be impossible. And then there’s all the imbalances in the TARGET2 system to resolve as well before national legislatures can sign it all off. Additionally, but part of the TARGET2 problem there’s the repo market with €8.7 trillion outstanding, set to implode on rising interest rates, destroying commercial bank balance sheets which are already highly leveraged. This goes some way to explaining the deep reluctance the ECB has about raising interest rates”. He estimates the ECB’s Asset Purchase Programme, amounting to €3,265,172 million as at June 2022, had a mark-to-market loss of around €750bn on a rise in yields of about 1.8% from a year ago; “almost seven times the combined euro system balance sheet equity and reserves of €109.272bn. And as yields rise further, euro system losses of double that are easy to imagine. Doubtless, if challenged the ECB would claim the euro system will hold these bonds to maturity, so they will continue to value them at par”. He points out the fragility of the Eurozone’s global systemically important banks (G-SIBs). “Gearing between total assets and balance sheet equity (which includes undistributed profits and ranking capital other than common shares) average just over twenty times for the Eurozone G-SIBs, ranging from Credit Agricole at 27 times to Unicredit at 14.8 times. Price to book values for all these banks are at a discount, some deep enough to call their immediate survival into question…If they are to protect their shareholders’ equity, these banks have no alternative but to contract their balance sheets where they can. Indeed, when it occurs, a downturn in GDP is due in large measure to the withdrawal of bank credit. This is bound to expose and create bad debts, which threatens to wipe out shareholders’ capital entirely”. “Much of the devil is to be found in those non-performing loans. It has become routine for national regulators to deem them performing so that they can act as collateral for loans from the national central bank…Shuffling non-performing loans into central banks is achieved principally through the repo market. Under a repurchase agreement (repo), a bank swaps collateral for cash, a transaction which is reversed later. In this way the central bank ends up with collateral, which has been cleared as performing by the local bank regulator, and the commercial bank gets cash and a seemingly clean balance sheet…The euro repo market is enormous, estimated by the International Capital Markets Association to have been €8.726 trillion outstanding in June 2021. It is far larger than the US dollar equivalent, which at the moment is just over $2 trillion of reverse repos…While much of this excess in euro repos is the consequence of negative interest rates, even paying banks to borrow against government bond collateral, it is of such a size as to easily hide bad and doubtful debts within the central bank settlement system. The ECB has fostered this market, because it creates demand for government debt to be used as collateral, which with minimal and even negative yields would not otherwise be bought. Rising interest rates will collapse this market, withdrawing liquidity from the commercial banks and putting yet more pressure on them to reduce their balance sheets. It is hard to avoid the conclusion that the ECB must prevent rising interest rates and bond yields at all costs, not only to preserve the euro system itself, but to prevent a collapse of the entire commercial banking network…Therefore, the euro is extremely unlikely to survive its systemic crisis”.

The EU is thus in a precarious situation in relation to normalising its balance sheet. While collectively it is a major economic force, the GEW is accelerating erosion of its share of the global economy and the use of the euro. In addition, several members – Greece, Italy (high levels of government debt), Scandinavia, Switzerland (high household and corporate debts) and France (total debt at almost 350% of GDP) – are vulnerable to rising interest rates.

The UK, the world’s sixth largest economy with the fifth largest reserve currency, came under the spotlight when a reckless budget proposal triggered a plunge in sterling and an interest rate spike. The BOE, having earlier committed to QT was forced to intervene “into the UK government bond market last week to stop a panic that had turned into a self-propagating death spiral, that was threatening to blow up £1 trillion in gilts-based derivatives that pension funds were using to achieve their investment goals”. Wolf Richter reports “the Bank was informed by a number of LDI fund managers that, at the prevailing yields, multiple LDI funds were likely to fall into negative net asset value. As a result, it was likely that these funds would have to begin the process of winding up the following morning…In that eventuality, a large quantity of gilts, held as collateral by banks that had lent to these LDI funds, was likely to be sold on the market, driving a potentially self-reinforcing spiral and threatening severe disruption of core funding markets and consequent widespread financial instability.” The BOE announced it would purchase up to £5 billion of gilts per day and the intervention was successful in halting the death spiral with total purchases of only £3.66 billion in bonds since the program started. The BOE plans to end the intervention program on October 14 and appears to be still on course to start QT by selling gilts on October 31.


OECD central banks face stark policy choices ahead. They not only have to grapple with the dilemma of fighting inflation and normalising their balance sheets but now have to manage financial stability concerns. The question today is whether central banks can return to QE given that governments seem determined to spent their way out of inflation instead of allowing prices to ration supply. The likely answer is that central banks cannot revert to QE due to the adverse consequences. Therefore, central banks still need to continue with normalisation but have to be careful not to allow an orderly QE exit to turn into a rout. In addition, the OECD central banks also need to manage the currency and interest rate volatility arising from global fragmentation and deleveraging. Monetary policy tightening will have substantial spillover effects on global economic activities. If central banks are unable to stabilise the global monetary order, the world economy would move closer to the tipping point into a global depression.


Alasdair Macleod (18 July 2022) “The collapsing euro and its implications”.

Alicia García-Herrero (15 September 2022) “Shinzo Abe’s economic legacy: a glass half full”. Bruegel.

Bank for International Settlements (BIS) (October 2019) “Reserve management and FX intervention”.

David Marsh  (22 June 2022) “Uncomfortable realities behind ECB’s dilemma over fragmentation and inflation”. Official Monetary and Financial Institutions Forum (OMFIF).

Elliot Hentov, Ramu Thiagarajan, Aaron Hurd (13 September 2022) “What does the weaponization of global finance mean for U.S. dollar dominance?” War on the Rocks.

Evelyn Cheng (4 September 2020) “China’s yuan could become the world’s third largest reserve currency in 10 years, Morgan Stanley predicts” CNBC.

Jamestown Foundation (28 September 2022) “What does the Yuanization of the Russian economy mean for the dollar?” Oil Price.

Maurice Obstfeld (12 September 2022) “Uncoordinated monetary policies risk a historic global slowdown”. Petersen Institute for International Economics (PIIE).

Michael Lebowitz (27 April 2022) “Liquidity crisis in the making – Japan’s role in financial stability”. Real Investment Advice.

Michael Lebowitz (4 May 2022) “Japanese inflation – Part 2 Liquidity crisis in the making”. Real Investment Advice.

Mike Dolan (28 September 2022) “Sterling needs the kindness of reserve managers”. Reuters.

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.

Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”.

Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”.

Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”.

Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.

Phuah Eng Chye (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

Phuah Eng Chye (14 August 2021) “Global reset – Monetary decoupling (Part 5: The end of USD supremacy – Will it be different this time?)”.

Phuah Eng Chye (28 August 2021) “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)”.

Phuah Eng Chye (25 September 2021) “Global reset – Monetary decoupling (Part 8: Sovereign digital currencies and networks in the currency war)”.

Phuah Eng Chye (9 October 2021) “Global reset – Monetary decoupling (Part 9: Information perspectives on digital currencies)”.

Phuah Eng Chye (23 October 2021) “Global reset – Monetary decoupling (Part 10: CBDC implementation)”.

Phuah Eng Chye (6 November 2021) “Global reset – Monetary decoupling (Part 11: The future of cryptocurrencies)”.

Phuah Eng Chye (20 November 2021) “Global reset – Monetary decoupling (Part 12: Role of 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)”.

Phuah Eng Chye (30 July 2022) “The Great Economic War (GEW) (Part 1: The beginning)”.

Phuah Eng Chye (13 August 2022) “The Great Economic War (GEW) (Part 2: Strategic concepts and implications)”.

Phuah Eng Chye (27 August 2022) “The Great Economic War (GEW) (Part 3: The financial nuclear bomb)”.

Phuah Eng Chye (10 September 2022) “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)”.

Richard C. Koo (2015) The escape from balance sheet recession and the QE trap. Wiley

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Toshiro Nishizawa (10 August 2022) “Waking up from the Japanese debt dream”. Asia Times.

Tyler Durden (21 June 2022) “Bank of Japan spends a record $81 billion to avert collapse, but $10 trillion JGB market is now completely broken”. Zero Hedge.

Tyler Durden (29 June 2022) “The Rubicon has been crossed: The BOJ Now owns more than 50% of all Japanese bonds”. Zero Hedge.

Tyler Durden (1 July 2022) “The Fed is quietly handing out $250 million to a handful of happy recipients every single day”. Zero Hedge.

Tyler Durden (24 August 2022) “Fed balance sheet shrinkage kicks into high gear in September”. Zero Hedge.

Tyler Durden (8 September 2022) “When the tide turns, brace for a face-ripping yen rally”. Zero Hedge.

Ulrich Bindseil, Jürgen Schaaf (10 January 2020) “Zombification is a real, not a monetary phenomenon: Exorcising the bogeyman of low interest rates”.

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William B. English, Donald Kohn (1 June 2022) “What if the Federal Reserve books losses because of its quantitative easing?” Brookings.

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Wolf Richter (21 July 2022) “ECB exits negative interest rates, hikes by 50 bpts, double its promise, bigger hikes on tap, shows off new glue gun to prevent sovereign debt crisis during rate hikes & QT”. Wolf Street.

Wolf Richter (5 September 2022) “By how much can the Fed reduce its assets with QT? Fed’s liabilities set a floor”. Wolf Street.

Wolf Richter (20 September 2022) “Even in Japan, inflation begins to rage after 23 years of true price stability”. Wolf Street.

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[1] An example of negative carry is when the BOJ buying yen debt to interest rates below low and selling USD at higher interest rates.

[2] In 2020, Morgan Stanley analysts predicted the yuan’s share of global FX reserves assets could rise to between 5% and 10% by 2030, surpassing yen and sterling. See Evelyn Cheng.

[3] See Maurice Obstfeld (12 September 2022) on how uncoordinated monetary policies risk a historic global slowdown.

[4] See “Global reset – Monetary decoupling (Parts 8 to 12).

[5] See  Global reset – Monetary decoupling (Parts 1-2).

[6] See William B. English and Donald Kohn on negative equity issues related to QE.

[7] See Richard C. Koo.

[8] Total liabilities are down by the same amount.

[9] See Richard C. Koo.

[10] See Alicia García-Herrero’s analysis of Abenomics.

[11] See Toshiro Nishizawa for analysis of Japanese debt.

[12] Tyler Durden notes “a little over three years ago, the Bank of Japan crossed a historic milestone…become a top-10 shareholder in 50% of all Japanese companies. Since then, the central bank’s equity stake across Japanese corporations has only grown”.

[13] See Wolf Richter’s analysis on Japanese inflation.

[14] See Zhang Rui for detailed analysis on Japan’s overseas assets.

[15] Zombification refers to government support of unproductive and highly indebted businesses. See Ulrich Bindseil, Jürgen Schaaf on zombification arguments on Europe and Yasuo Goto, Scott Wilbur on Japan.

[16] See David Marsh on the political, legal and technical issues that makes it difficult for ECB’s to resolve its difficulties over fragmentation and inflation.