World's Smallest Currency Union: Caribbean Challenges

Yes, Virginia, these dollars bear Queen Elizabeth II's image

The Eastern Caribbean Currency Union (ECCU) is the world's smallest currency union among the four existing worldwide. The European Monetary Union (EMU) is known by all, whereas the other two are in Africa. What makes the ECCU doubly interesting is that it is pegged to the US dollar. In fact, it predates the EMU by half a century, although it changed the currency it is being pegged to from GBP to USD halfway through:

The OECS members share a common currency, the Eastern Caribbean dollar, which has been pegged to the U.S. dollar since 1976 at EC$2.70=US$1, and was pegged to the British pound at EC$4.80=£1 from 1950 to 1976. Prior to the recent inception of the European Central Bank, the ECCB was one of only three common central banks in the world and the only one where the member countries have pooled all their foreign reserves, the convertibility of the common currency is fully self-supported, and the parity of the exchange rate has not been changed.

Now, there's thought-provoking stuff over at the IMF site concerning the challenges faced by ECCU. Overall, it makes economic sense for micro-sized economies to band together currency-wise:

In terms of the benefits, the small size of these countries means that the currency arrangement allows them to take advantage of scale economies. It also allows them to diversify risk. This means that if one country gets hit by an external shock or natural disaster, the other countries can pool resources and deal with the shock more effectively.

Again, because of their size, these islands can provide, at the regional level, more cost-effective public services. So that is a major benefit. What also matters a great deal is when the union speaks with one voice the countries can be better represented at the global level. 

That said, it is subject to the same sorts of problems the Eurozone faces:

Interestingly enough, the ECCU is actually a microcosm of the European Economic and Monetary Union, since the ECCU has also faced rising fiscal deficits, unsustainable debt levels in a number of states, a lack of fiscal integration, and challenges in parts of the financial sector that can undermine the stability of this union. As illustrated by the European experience, overcoming these challenges is particularly difficult in monetary unions. 

What can I say? God save the queen--and the East Caribbean Dollar

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World's #2: Yuan Overtakes Euro in Trade Finance

Trade finance is a somewhat arcane area despite its obvious importance to keeping world trade afloat. To make a long story short, a loan taken out by a trading firm for an international transaction is known as a "letter of credit." [LC] In effect, the lending bank's creditworthiness substitutes for the debtor's, allowing the counterparty to be assuaged regarding credit risk.

In recent times, the Chinese yuan or renminbi has come on like gangbusters as more and more of these instruments are denominated in RMB. Reflecting China's emergence as the world's largest trading nation in merchandise, a significant minority of the world's letters of credit are now in RMB. In fact, it has now reached a milestone of overtaking the vaunted Euro in this application in the month of October of this year:

China’s yuan overtook the euro to become the second-most used currency in global trade finance after the dollar this year, according to the Society for Worldwide Interbank Financial Telecommunication [SWIFT]. The currency had an 8.66% share of letters of credit and collections in October [2013], compared with 6.64% for the euro, Swift said in a statement Tuesday. China, Hong Kong, Singapore, Germany and Australia were the top users of yuan in trade finance, according to the Belgium-based financial- messaging platform.

So the dollar remains far and away the largest prominent currency in trade finance, but keep in mind where the yuan came from as late as January 2012 when it held less than a 2% share. Moreover, the appeal of the currency is coming on strong outside of China:

“It’s true that overseas exporters are using the renminbi more as the contract currency to increase the attractiveness and competitiveness of goods or services sold to China,” said Cynthia Wong, the Hong Kong-based head of emerging-market trading for Singapore and Hong Kong at Societe Generale SA.

That said, the Chinese currency still has a long way to go in terms of becoming a vehicle currency for all sorts of payments and being widely exchanged one in forex markets:

The Chinese currency ranked No. 12 for transactions in the global payments system in October, unchanged from the previous month, according to Swift figures. Payment value for the currency rose 1.5% that month, less than the 4.6% growth for all currencies, the Swift data showed. That saw the yuan’s market share drop to 0.84% from 0.86% in September.

Daily yuan transactions surged to $120 billion in April from $34 billion in 2010, making it the ninth most-traded currency in the world, according to a September report by the Bank for International Settlements in Basel, Switzerland.

So there's still a long way to go in terms of China allowing further capital account openness and market-trading for the yuan to become a legitimate rival to the dollar and the euro. Yet, the demand is likely there--especially for those who regularly trade with mainland China. That the currency is steadily appreciating is a further bonus to those who wish to hold it. To non-mainland residents, that is not an inconsequential draw:

The yuan has appreciated 2.3% against the greenback this year, the best performance in Asia, according to data compiled by Bloomberg...“I’m not surprised as cross-border trades between China and Hong Kong have been quite dominantly denominated in yuan,” Raymond Yeung, a Hong Kong-based senior economist at Australia & New Zealand Banking Group Ltd., said by phone today. “Yuan trades usually increase when there are strong expectations for yuan appreciation.”

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Pound or Euro? Currency of an Independent Scotland

The next few years are literally going to be make-or-break for the United Kingdom. First of all, the ruling Tories have promised a referendum on its membership in the European Union that, if it is held and voters decide against it, will mean the UK leaving the EU. It's a scary thought we can explore in another post; I myself don't see how the EU will lose much given how it has been very aloof.

Next, we also have another referendum scheduled in Scotland voting on staying in the United Kingdom. While it seems just desserts to me that the UK with its breakaway tendencies from the EU would be subject to similar domestic pressures, the political economy of such a move are...complicated. Scottish independence will mean that it will have to reapply for EU membership if it wants to be part of it. Moreover, there is the question of what currency it will use--the British pound, the Euro, or its own currency unit. Obviously, using the Euro will be contingent on first joining the EU and then the EMU. Both will not happen overnight.

How about continuing to use the pound? It is here where the Conservatives are throwing their weight around by threatening to kick the Scots out of the "sterling zone" if they declare independence, leaving them with the sole option of being a small nation with its own currency circa 2014. As Iceland has so vividly demonstrated, this is not such an attractive option in the new millennium, but I digress. From the FT:

Scotland will be forced to quit the sterling currency union if it votes for independence next year, a cabinet minister has said, in the starkest warning yet for Scottish voters to remain in the UK. Speaking to the Financial Times days before the Scottish government releases its vision for an independent Scotland, Alistair Carmichael, the Scottish secretary, warned Holyrood not to assume it will be let back into the sterling area if the country becomes independent.

Such a declaration would complicate efforts of the Scottish National Party (SNP) to portray a "no" vote as a walk in the park:

The Scotland secretary’s words are part of a concerted campaign across the union to rebut suggestions that a separate Scotland could simply continue to use sterling. Carwyn Jones, the Welsh first minister, said in a speech on Wednesday that his Labour-led government should also be given a veto on the idea, which he described as “very messy”

The message comes as the SNP-led government prepares to unveil its blueprint for the make-up of an independent Scotland, designed to answer questions such as what currency the country would use, whether it would belong to the EU and what taxation system it would have...

SNP leaders insist that sterling is an “asset” part-owned by Scotland, and that in the event of a vote for independence, the remaining UK will want to share the currency, not least to minimise exchange rate fluctuations between the two countries. Alex Salmond, SNP first minister, tried to ward off the threat of exclusion from sterling last week by saying that if that happened, Scotland would not be obliged to take on its share of the UK national debt.

My take is that it's a lot of hot air on both sides since poll numbers suggest the Scottish public understands the consequences of independence and generally believes it's not worth the hassle. 

Not gonna happen, as the Yanks would say.

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The Mother of Market Manipulation In Forex Trading?

With their often haughty attitudes and tendency to focus on short-term profits in the (unfortunately) correct belief that they are too big too fail, banks are easy targets for regulators and critics of capitalism-slash-globalism alike. However, I believe that there are still grey areas and that banker-bashing is not a morality play. It was perhaps inevitable after going after price-fixing in reference-rate (LIBOR) setting that regulators' attention would turn from money markets to the mother of all markets--foreign exchange. This time, the dragnet is not just led by US or UK regulators. Befitting the forex market's global reach, regulators the world over are closing in:

At least six authorities globally – the European Commission, Switzerland’s markets regulator Finma and the country’s competition authority Weko, the UK’s Financial Services Authority, the Department of Justice in the US and the Hong Kong Monetary Authority – are looking into allegations that bankers colluded to move the currencies market.

Banks including UBS, Deutsche Bank, Citigroup, Barclays, HSBC, Royal Bank of Scotland, JPMorgan and Credit Suisse have launched internal probes or received requests for information from regulators, according to people familiar with the situation. “This is an industry-wide issue,” a top executive at a large European bank says. “It is very complex but what is clear is that there are more than just a few big market players involved.”

Anti-globalization activists and Occupy Wall Street flunkies enjoy using gross figures (to paraphrase Carl Sagan, trilyuns and trilyuns) to cast the foreign exchange market as an enormous manifestation of financial depravity with no clear social purpose. Believe it or not, I myself question the benefits of sending money back and forth without a corresponding need for foreign exchange for "real" purposes such as settling trade in goods and services. My point though is that if you recognize that money is not really changing hands long-term but merely goes back and forth, volume in the foreign exchange market is much less impressive. Especially when you realize it's mostly just large banks buying and selling currencies among one another in 5-10 million dollar trades. Absent unusual circumstances, banks' positions generally square at the end of the trading day.

In any event, the much more informal nature of interaction among FX traders is what is causing regulators to look into "collusion":

The probes hit a business area that with $5.3tn in daily volume [sigh, there they go again] is the largest financial market in the world. “I always thought that if there’s a market that’s least manipulated it’s the FX market,” says one investor. Among bankers, the foreign exchange market is often viewed as the less sophisticated relative of the rates market, whose traders are seen to have a reckless culture on the forex trading floor.

In what is a largely unregulated and off-exchange market, traders have devised their own rules of what constitutes fair play. Traders say it is perfectly normal to chat to traders at other banks, sharing views on pieces of economic data due out, or simply gossiping. One senior trader told the Financial Times that it was normal for traders to share details of their positions with each other – so long as they did not name their clients.

So, for example, traders trying to work out whether the euro would rise or fall at the daily 4pm fix – a WM/Reuters benchmark that is crucial for many large client orders – might tell traders at other banks they needed to buy, or sell, euros. From there it could be a short step for the regulator to deduce collusion. One investor says he was very surprised to hear that traders would even share their positions with each other.

This one should be interesting: If found guilty, the stakes would naturally be much higher given the international character of this market and--pardon--its ostensibly larger volumes. That said, I am not certain whether having an informal trading culture is necessarily a smoking gun for culpability. Having been stung before, banks like RBS and Barclays are not exactly waiting around and are now jettisoning forex traders in the belief doing so may help them avoid penalties. We'll see...

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Will the Eurozone/Euro Benefit From a US Dollar Crisis?

With the US supposedly flirting with being the first Western country since 1933 Nazi Germany to default, attention needs to be paid on those other Westerners and their economic plight as a consequence.

As a holder of euros myself and other non-junky stores of value--not gold, not Treasuries or any of that riffraff--I of course wish that the United States' self-inflicted crisis wallops their godforsaken currency. No ifs, not buts. However, the opinion of ECB policymakers is decidedly more guarded. Sure, it may increase the prestige of euro currency at a time when the Eurozone is just exiting a very long recession if its share of global currency reserves increases further. Then again, the bifurcation of Northern and Southern states' economic performance is worrying. Sure the likes of Austria and Germany can survive with the single currency at, say, $1.40. But the hobbling "Club Med" countries declared no mas a long time ago.

So yes, (nominal) Austrian CB guv'nor Ewald Nowotny expresses concern with what happens Stateside:

The dollar's role as the world's leading reserve currency is at risk because of the political impasse in the United States, which has raised fears of a debt default, European Central Bank policymaker Ewald Nowotny said.

Then again, Nowotny wears two hats since he is also a member of the ECB's governing council and must therefore consider the plight of the Euro-laggards:

"This discrepancy is very dangerous and in my view will have a negative impact on the long-term role of the dollar.

Interviewed in Washington during meetings of the International Monetary Fund and World Bank, Nowotny said jitters over the U.S. budget standoff were already pushing the euro higher. This was not such a big problem for Austrian exporters but posed more of a threat to southern euro zone members, said Nowotny, who is also governor of the Austrian central bank.

What's that saying about the weakest link(s)? It's what holding the Eurozone from wishing the US and its currency a well-deserved oblivion. Sure the Eurozone has taken its lumps, but even the likes of Greece and Portugal didn't default outright.


 

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LDC Currency Free-Fall: Party Like It's 1997?

I was dreaming when I wrote this; forgive me if it goes astray. But when I woke up this morning and watched the Bloomberg channel, I could have sworn it was judgment day. Having lived through the 1997 Asian financial crisis while working as a banker (of all things), I have a heightened sensitivity to currencies going berserk. Friends, I feel for the Indian artist above wanting to save the falling rupee. Aside from highly touted BRICs coming under pressure alike Brazil and India, anticipated normalization of interest rates in the United States is unleashing complications around the world. Indeed, there is a fear that we may be on the cusp of another rehash of 1997 given the prevailing uncertainty over the direction of American policy.

Or, are things really that bad?

Plunging emerging market currencies on the prospect of US stimulus tapering have stirred memories of the 1997 Asian financial crisis, but analysts doubt a similar catastrophe is in the making. "There are negative linkages (now) but I don't think that we are in a repetition of the 1990s crisis," said Jean Medecin, a member of the investment committee at the Carmignac Gestion asset manager.

While the Indian rupee has so far taken the worst beating, falling nearly 15 percent against the US dollar over the past three months, Indonesia's rupiah and the Brazilian real are down 10 percent, and the Turkish lira over 5 percent in a trend that is frightfully reminiscent of the crisis that began in Thailand in mid-1997.

Things have changed in some ways. Most especially, LDCs have far accumulated healthier foreign exchange reserves in anticipation of days like these:

Back then, investors reacted by panicking, withdrawing funds en masse, resulting in the Thai bath eventually collapsing. The phenomenon then spread like a wildfire throughout Asia, and even to Russia, with foreign capital vanishing almost with the blink of an eye.

Short of capital, emerging countries suffered acute shortages of credit, plunging them even deeper into the crisis. Fifteen years on, India's Prime Minister Manmohan Singh last week said emerging countries are now much better equipped. In 1991, India had only 15 days worth of foreign exchange reserves, he said. "Now we have reserves of six to seven months. So there is no comparison. And no question of going back to the 1991 crisis," he said.

Moreover, does intervention really work? The historical record is patchy, but that doesn't seem to stop LDCs from trying anyway:

Simon Derrick, chief currency strategist at BNY Mellon said that "letting the currency take the strain might be the smartest move for some emerging market nations". He noted that in 2008, when emerging markets last tried to stop the outflow of funds, they failed despite spending up to 20 percent of their foreign currency reserves [...]

Still, several countries have moved to defend their currencies. Brazil, which had led emerging market complaints that Western stimulus measures had resulted in the appreciation of their currencies and eroded its competitiveness, turned around, saying it would make $55 billion available to prop up the real. Turkey pledged to inject a minimum of $100 million per day, while India announced it would put $1.26 billion into the banking system by buying back long-term government bonds, although it said the move was aimed at making more credit available to boost economic growth rather than defending the rupee.

The bottom line is that LDCs are better prepared this around to weather currency shocks. Still, there may be some validity to assertions that blaming economic woes on American economic machinations hide a number of structural faults at home alike gaping current account deficits. (Not that the US is free of those, mind you.)

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U R in Trouble: Brazilian Forex Intervention

 Here's another victim of the so-called "taper" of Federal Reserve purchases of US Treasuries worth $85 billion a month or so. To make a long story short, rising interest rates Stateside in expectation of less American bond market intervention from the Fed are causing those who've invested abroad in search of higher yields to reassess their strategies. For several years there was a Brazil "carry trade": borrow in dollars, convert to Brazilian real, then lend in real while pocketing the interest rate spread (after charges and fees, of course). 

The end of Fed Treasury purchases has whiplashed many developing countries like Brazil. Not only are their economies slowing down as China does and demand for raw materials dwindles accordingly, but the carry trade becoming less profitable also has negative repercussions for their currencies. Brazil, already encountering an economic slowdown--remember those protests and riots a few weeks back--is simultaneously trying to combat higher inflation. The latter cause will not fare especially well as the real continues its slide.

So, faced with few alternatives, it's back to the time-tested solution: currency intervention...

Brazil's central bank announced a currency-intervention program on Thursday that will provide $60 billion worth of cash and insurance to the foreign-exchange market by year-end, a move aimed at bolstering the country's currency, the real, as it slips to near five-year lows against the dollar.

The bank said in a statement it will sell, on Mondays through Thursdays, $500 million worth of currency swaps, derivative contracts designed to provide investors with insurance against a weaker real. On Fridays, it will offer $1 billion on the spot market through repurchase agreements. Both are designed to prevent companies and individuals with dollar obligations from scrambling to the market at the same time, afraid that waiting will force them to pay more to buy dollars. When that happens, the real tends to weaken further and faster.

What Brazil is essentially trying to do is ensure that not everyone heads for the (Brazilian real) exit at the same time. Still, you have to wonder if this kind of "demand management" is enough to stop the real's slide. At any rate, the irony is not lost here: As the United States winds down its market intervention (Fed Treasury buying),  other countries like Brazil must step up their market intervention (through FX intervention and the like).

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South Korea Declares Int'l Currency War on Japan

Ho hum, another week, another declaration by a non-Western country that it will attempt to staunch the inflow of capital from elsewhere that is driving up the local currency and making imports less competitive. Japan of course started the latest salvo when the LDP regained power and promptly declared that they would use open-ended fiscal and monetary support to get the Japanese economy jump-started after over two decades now of stagnation. (Western nations have long been on this path, having implemented them after the global financial crisis.)

In response, other Asian exporters have been manoeuvring to deal with the ongoing deluge from Nippon. Spooked investors in South Korea have begun pulling out in fear of the authorities taking a more proactive stance in determining the value of the Korean won. I suppose the Korean authorities are pleased with the results of their verbal jawboning thus far of making foreign investors think twice and weakening the currency:

South Korea's threat to impose a broad tax on financial transactions is the first sign of deepening concern in Asia that speculation of competitive currency devaluations is prompting investors to head for the exit. Until then, and because investors had not shown any big signs of concern, Asia's reaction to the tensions centring on the yen had been passive, comprising an asymmetric mix of jawboning and light currency intervention.

The selloff in Seoul markets this week turned into a warning sign. Foreign investors posted their biggest daily stock selloff in 16 months in South Korea and pushing the won, a currency that best serves as a proxy for Asia, to a three-month low. The risk is that the threat of policy action will prompt more market selling, pushing currencies down yet further and raising investor fears of the competitive devaluations that policymakers are trying to avoid.

"Korea is going to be the first domino, and it's that domino effect that the yen's depreciation clearly risks," said Rob Ryan, currency and rates strategist at RBS, referring to the increasing likelihood that Korea announces some form of currency control measure soon. "The real trigger has been the equity market reaction and the outflows from Korea. I think the concerns over intervention are a little overdone just yet, but clearly it is a big risk if the yen continues to weaken..."

The old state-guided development is returning with a vengeance as the government is seeking the cooperation of conglomerates and state-owned firms alike in stemming Korean won strength:

South Korea has understandably been the most vocal of Asian policymakers on the subject of the yen. Heavyweight Korean exporters such as Samsung Electronics Co and Hyundai Motor Co, which compete directly with Japanese electronics and auto companies, have seen their competitiveness eroded as the won increased in value from as low as 15 per yen to near 11.8 over the past six months. Foreigners have sold a net 1.8 trillion won ($1.65 billion) Korean stocks this month. The stock market is down 3 percent so far this year. Foreigners have been buying Taiwanese stocks, but those volumes are far lower than they were in 2012...

The Korean government will tell state-controlled firms to refrain from borrowing abroad and will further tighten rules on banks' currency derivatives trading to ease volatility in foreign exchange markets, Choi said. Seoul was opposed to imposing an outright levy on financial transactions, such as the Tobin tax being debated in Europe. But it would consider similar measures should speculation in the won intensify over time, he said.

There are follow-on effects that may be even direr. China, for one, is South Korea's single largest export market and may not take so kindly if the won is regulated further:

Still, many believe policy risks are rising. Nearly half of Japan's trade is with the Asia-Pacific region and China may not stand pat if Korea imposes currency controls given it is Korea's largest export market. In addition, capital controls have gained some acceptability as a policy response in emerging markets to deal with easy money in the developed world. Even the International Monetary Fund, traditionally a champion of liberalised markets, has conceded that capital controls are sometimes necessary.

I guess the trick is to spook hot money but not real investors who are in it for the longer haul. Where does that divide lie? Hard to tell, but Korea risks negating market sentiment if it goes overboard with these efforts to throw sand into the wheels of international finance and trade. It's not surprising that international currency war has finally hit East Asia--but remember who started it in the first place despite repeated denials.

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Markets, Not China, Will Determine RMB Adoption

I think this is a point we often forget when discussing "China's rise": while its government can tinker with several important factors that will affect RMB adoption alike its convertibility, its interest rate and even its pace of appreciation, markets will ultimately determine the pace at which the rest of the world climbs aboard the yuan bandwagon alike, say, Indonesia and Nigeria. There is an interesting article in the FT by Mike Rees of StanChart that presents a much-needed viewpoint from one of the world's largest commercial banks on this matter. Compared to that of, say, economists or political scientists, they are not interested so much in using econometric models to extrapolate the currency's potential for widespread adoption but rather in its adoption by more and more market participants at the present time.

First, you need to consider the volume of trade denominated in it among freely transacting buyers and sellers in commodities trade:

The exponential growth of the renminbi as a trading currency – and of the offshore renminbi market – continues to stun observers. Three years in, despite global headwinds, and the scarcity of arbitrage opportunities as onshore and offshore rates have converged, renminbi redenomination shows no sign of faltering. Trade in renminbi in 2012 is on track for $425bn, up almost 30 per cent on 2011.

Second, also consider the relaxation of foreign investment quotas and what they mean for the currency:

Deregulation, too, is picking up pace. This year, China quadrupled to Rmb270bn the quota under which eligible institutions invest in China’s stock market. And last month, the first foreign bank was granted approval for a renminbi denominated cross-border loan quota on behalf of a multinational client. The quota arrangement is a major step forward, as corporates can use it to move previously trapped onshore renminbi cash to offshore treasury centres where it can be managed alongside other currencies.

In case you're wondering, the "foreign bank" in question is StanChart (again from China Daily). Aside from improving loan flexibility, this facility also increases the offshore utilization of RMB accumulated onshore:

The scheme has transformed the lending of renminbi between companies from one based on a traditional entrustment loan (with banks as intermediary agents) to one where two parties sign lending agreements directly, agree interest rates and manage the loan drawdown themselves.

Anthony Lin, managing director and head of Transaction Banking at Standard Chartered Bank (China) said renminbi cross-border lending brings huge flexibility of corporate treasury management, allowing them to negotiate lending frequency and rate according to their actual needs. He said it also enables corporations to transfer onshore renminbi surplus to their global cash pools for central deployment and use, hence to improve their global treasury efficiency.

Think of MNCs creating currency stashes to be deployed whenever there is a need to do so. In the past this could not be so easily done, but emerging facilities alike this one are cropping up for pooling in treasury centres that are obviously abroad. Ultimately, the RMB will be more widely adopted if market participants demand yuan for more variegated purposes and not actions solely on the part of the Chinese government.

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Trash for Treasure: CenBanks Swapping $ for RMB

The old saying goes "one man's trash may be another man's treasure." To be sure, there are any number of countries around the world that would welcome even dollar foreign exchange reserve assets. Think of Egypt. The happy-sad fact though is that, in part because of international currency war being waged by the United States, several developing nations now have more than adequate reserve holdings going by traditional metrics such as number of months' cover for imports or short-term liabilities (sovereign debt and suchlike maturing within a year). If the latter is the case, you may have a problem of holding excessive dastardly dollar-denominated detritus whose ultimate direction is known to all--downhill from here, baby. This situation calls for a move away from the dollar.

What sort of portfolio diversification in terms of currency holdings is desirable, though? The Euro is remarkably resilient despite the woes of its certain member countries largely due to the ECB's inherent fear of inflation inherited from the Bundesbank. It has, in other words, an appreciating bias especially compared to the dollar. Japanese yen meanwhile yield next to nothing even in this day and age of near-universal zero-interest rate policy among industrialized economies. The pound is nowhere near the value it used to be prior to the financial crisis, and the Swiss franc is not quite as readily traded as some of the currencies mentioned above.

Increasingly, then, the Chinese renminbi is finding favour since its rates of return for yuan-denominated instruments are rather different .There is also the practical matter of the yuan being more convenient not only as a store of value but as a medium of exchange as more and more global trade is being conducted in this currency:

[T]here is little argument about the direction of travel..."The way central banks look at calculating reserves is based on trade balances, so as trade with China grows, they will want to hold more and more renminbi."

Gary Smith of BNP Paribas estimates that the emergence of the yuan as a legitimate reserve asset will nt be long in coming as bandwagoning effect takes hold: "My estimate of central bank holdings (of yuan now) is 0.5 percent or perhaps even less. My estimate of where we're going to is over 10 percent over the next 3 or 4 years," he said, adding that the uncertainty was timing, not percentage...

BNP Paribas' Smith bases his forecasts on discussions with central banks he wished to keep confidential, steps taken by China to facilitate foreign central banks' yuan investments and on the fact that private sector payments in renminbi are growing fast. "A lot of central banks hold some renminbi now, all of them in very very small amounts. Every single one will hold more at the end of the year than they do today," he said. This, he said, will in turn push central banks to hold more of the currency. 

Lastly, LDCs are themselves clamouring for more RMB. I am sure it's flattering to China that others want more of what it has tried to keep to itself before. Actually, the lifting of limits on foreign investment schemes already underway may help facilitate (non-official) accumulation of RMB assets:

Countries including Indonesia have publicly announced that they are buying bonds on China's interbank market. Nigeria has also said it wants to make the yuan a reserve currency. Sovereign wealth funds and central banks have also noted Beijing's decision just before year-end to remove a $1 billion limit for them to buy Chinese assets through its Qualified Institutional Investor Programme.

So far, the only officially sanctioned accumulation of yuan for reserve purposes was that by Japan right before Sino-Japanese relations went awry over a bunch of rocks in the sea. Yet "We want yuan!"is increasingly the new battle cry for central bankers from Jakarta to Lagos.

I sure don't see anyone clamouring for more dollars. There is a moral to the story somewhere in here. 

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The Yen Also Falls: To Negative Nominal Rates?

Everything is less than zero - Elvis Costello

I am constantly befuddled by foreign exchange markets since they tend to display even more "irrational" behaviour than stock markets. Witness Japan and its currency. Beginning 1999 or so, Japan has conducted aggressive monetary easing via its zero-interest rate policy (ZIRP) that entails [duh] near-zero nominal interest rates. However, this and quantitative easing (QE) have done little to pull Japan out of its funk since the bubble burst in 1990. I of course think there are lessons to be learned here for Westerners who do the same Stupid Monetary Tricks, but others would say that their situations are different.

No matter; after being the almighty yen for the past several years, we get news that the yen is (slightly) weakening due to the (actually quite conservative and traditionally dominant) Liberal Democratic Party beating the (once upstart but now quite entrenched and equally staid) Democratic Party of Japan in parliamentary elections. News of an LDP victory has sent the yen tumbling--or at least what passes for it in this day and age of mild rather than wild forex swings in Japan:

The yen slumped to its lowest in over a year-and-a-half against the U.S. dollar on Monday as part of a broad skid after Japan's conservative Liberal Democratic Party, which is committed to aggressive monetary easing, won a landslide victory. The LDP surged back to power in Sunday's election, giving ex-Prime Minister Shinzo Abe another chance to take the helm. The LDP and its ally the New Komeito party secured the two thirds majority needed to overrule parliament's upper house, meaning the new government has a greater chance of pushing though its policies.

The LDP being a traditional practitioner of patronage politics, their priorities lie in American-style "shovel ready" projects. It's somewhat ironic; they taught the Yanks all this ZIRP and QE tomfoolery which they are continuing with anyway, and in turn they are imbibing construction-as-stimulus:

The Bank of Japan meets later this week and most analysts expect the central bank will ease policy further. It will most likely increase its asset-buying and lending programme, currently at 91 trillion yen, by another 5-10 trillion yen, sources have said. Abe, who quit as premier in 2007 citing ill health, has called for "unlimited" monetary easing and big spending on public works to rescue the economy from its fourth recession since 2000.

I have always been a connoisseur of sorts of Japanese economic policy. Accustomed to being meek and mild worker ants in the postwar period, they still display their banzai and kamikaze streaks in a few areas alike macroeconomics. How did they manage to run up a public debt that is 200% of GDP which is set to rise even more sharply with the LDP that's responsible for a lot of it? Honestly, I think that the fiscal levers are well and truly overdone. What's there left? Consider once more the "zero-bound" problem:

In spring 1999, ZIRP was introduced but it was constrained by the so-called zero bound problem. Therefore, worsening deflation meant the real interest rate would rise, aggravating recession and hence deflation.   

What the heck else can Japan do? Having "pioneered" the modern implementation of ZIRP, maybe they can try NIRP--negative interest rate policy. That's right; they should target rates at which they punish you for keeping money in a bank. Certainly even such a palliative won't work--those thin tatami mats they roll away during the day won't hold as many squillion yen as king-sized beds those portly Yanks have--but it may be worth a try as implied by yen weakening as of late. At the very least there will be amusing stories of folks hoarding cash.

Desperate times call for desperate measures. Bring on the NIRP! It's the ultimate weapon--unthinkable, even--in international currency war (and more specifically Japan's two-decade-long battle with deflation).

Screw M2, if you know what I mean.

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Michael Pettis Should Read More, Blog Less

Skip the maths, will ya?

I have in the past tied Michael Pettis to the whipping post for uncritically accepting Bernanke's self-serving notion of a "global savings glut" amidst falling levels of savings worldwide and a fantasyland assertion that the US household savings rate would hit double digits. It didn't, and I still don't quite understand why someone who keeps making factually inaccurate statements and predictions remains popular. If you read blogs to keep ahead of the curve of mainstream media or to understand the antecedents of various economic events, well, I would not be so sure about that if you are a regular China Financial Markets reader.

I do not like to keep doing this, but he has done it again (and again and again). In a recent blog, he takes Arvind Subramanian and Martin Kessler to task for their argument that there is a "yuan bloc" emerging in East Asia. The PIIE authors base this argument on movements of several regional currencies covarying more with the Chinese yuan and less with the US dollar. However, Pettis argues that this argument is artifactual:

Well actually you can argue with the math, or at least you can argue with the interpretation of the math. There are alternative – and much simpler, I think – explanations for the increased “co-movement”, and these do a much better job, I think, of explaining what is happening than reserve currency displacement.

Assume for a moment a global scenario in which the largest exporter of manufactured goods in the world has a significantly undervalued currency. Assume further that many of its competitors also have undervalued currencies, and would like to revalue in order better to manage their domestic monetary policies. Assume finally that the world is in crisis, and exporting nations are having trouble maintaining the necessary growth rate of their exports, so they cannot allow their currencies to rise faster than that of their main export competitors.

In this scenario which currency would the currencies of the smaller exporting countries track, the US dollar, or the undervalued currency of the largest and most competitive exporter of manufactured goods in the world? Almost certainly the latter, right? The smaller exporters would want their currencies to rise, but the rise in their currencies would be limited by the rise in the currency of their largest competitor. This would happen not because they are tracking a new reserve currency but only because they are in export competition with that currency.

That is all well and good if Subramanian and Kessler didn't bother to consider this scenario as Pettis clearly suggests, but they did. On page 11, the PIIE boys write:

i. Is the RMB bloc related to trade integration with or competition against China?
A currency could co-move with the RMB because it is integrated with China in terms of common supply chains. A related but distinctly different reason for co-movement could be if policy targets the RMB because countries do not want to lose competitive advantage vis-à-vis Chinese exporters and domestic manufacturers. In other words, the reason for the co-movement could be competition against rather than integration with China.

How can we distinguish the two? One way of measuring competition is to see if a country exports products similar to China’s. Mattoo, Mishra and Subramanian (2012) develop such an index of competition relative to China. Unfortunately, they compute this index for fewer emerging market countries than contained in our sample.

When we introduce this index of competition (which is country-specific), it has consistently the right sign (the more a country competes with China, the more likely its currency to track the RMB). But is not consistently significant in a statistical sense (in Table 6, the index is statistically significant in column 2 but not in column 1). And when we run a horse race between this competition variable and a pure integration variable, the latter consistently trumps the former. So, the evidence, albeit limited, favors an explanation for co-movement that is more related to trade integration than competition, although a role for the latter cannot be ruled out. One reason for that last caveat relates to the findings reported in Table A6. It seems that outside East Asia, more countries track the RMB when it depreciates than when it appreciates. Moreover, the average magnitude of the CMCs outside East Asia more than doubles in such instances. So, we cannot rule out entirely a competitive pressure motivation for currencies to track the RMB.

PIIE boys did their homework, period. Some points:

1. I don't know why Big Name Authors think they can get away with such sloppy writing;
2. My policy of not having a comments section is vindicated by the echo chamber over at Pettis' blog. 59 comments...and not one who points this out either. I guess the Pettis Fan Club takes his word for gospel truth for better or worse--rather worse here;
3. I'm afraid that this is another example of inept blogging. Pettis writes--and he sure does write with posts extending to thousands and thousands of words--but he clearly doesn't do so from a position of knowledge of the material he himself links to;
4. This demonstrates why some quantitative analysis skills are worth learning for those interested in the subject matter. How do you measure covariance? How can alternative variables be included in models to account for alternative hypotheses? Pettis is a poet with limited numbers chops, so this probably explains his lack of awareness about such things. Do the math.

Note to Mike: If you link to something, at least try to understand what you're criticizing. I am not convinced that the yuan is going to take over as the world's dominant currency soon either, but I think it's at least worth trying to understand the arguments of Subramanian and Kessler before criticizing them for faults they didn't commit.

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New PRC Leaders' Fully Convertible Yuan by 2015?

With the new Chinese leadership coming in early next year with Premier-Elect Xi Jingping, leaders' promises to make the yuan (renminbi) fully convertible gain urgency given China's slowing economy. Last year Chinese officials told their EU counterparts that convertibility would come "by 2015." Lest you think that this was an offhand statement, market commentators have this year raised expectations of this coming true. Even the outgoing central bank governor indicates that his successor will make this move:

China’s central bank governor said convertibility will be the next step in the overhaul of the exchange-rate system as calls grow for the nation’s new leadership to deepen changes in the economy to sustain growth.“For the central bank, I think the next movement related to the yuan is going to be reform of convertibility,” Zhou Xiaochuan said at a conference in Beijing on Nov. 17. “We are going to realize it, we are moving in this direction, we need to go further, we will have some deregulation.” 

Interestingly enough, even party-favoured elites who've benefited from previous policies see the writing on the wall and accept that state banks lending large sums to state-owned corporations must be curbed. Capital account liberalization is but a part of a whole range of reforms to make China more market-oriented:

“Expectations are high” for change as government intervention, ranging from excessive regulation to rigid price controls, has become “unbearable” over the last couple of years, said Li Jiange, head of the country’s biggest investment bank and a vice chairman at the government-run company that holds stakes in state-owned lenders. Li, who spoke at a separate conference in Beijing on Nov. 17, is chairman of China International Capital Corp., and a vice chairman of Central Huijin Investment Co., a unit of the nation’s sovereign wealth fund.

Unless you listen exclusively to American politicians b*tch and whine about China, the RMB has already appreciated considerably in nominal terms--by about a third. Moreover, a recent HSBC poll of China-based firms also expects 33% of their transactions to be yuan-denominated come 2015. Hence, full convertibility is envisioned to be a natural progression in a sequence of steps towards China opening up to the world economically:

The yuan has appreciated about 33 percent against the dollar since the revaluation. The currency had its biggest weekly gain in a month in the five days through Nov. 16...“Interest rates should be liberalized, rates should be decided by market demand and supply,” [Justin Yifu] Lin, a former World Bank chief economist, said at a forum in Beijing yesterday. 

China’s financial system is dominated by large state-owned banks and the stock market and favors big “capital-intensive” players, said Lin, who is a professor at Peking University’s China Center for Economic Research. China must develop small, local banks to serve rural areas and small businesses, he said.

Lin was at the World Bank when it published a 448-page report in February titled China 2030, which outlined policies to help the nation sustain growth while avoiding the so-called middle-income trap, where expansion slows because of a failure to implement reforms needed to create a wealthy middle class. 

Actually, I do not expect full convertibility to be achieved by that date. Rather, significantly relaxed controls on the capital account may be adjudged as more practical and realistic by the PRC leadership come 2015. Moreover, there will likely be more market-determined rates of lending insofar as credit is extended more to SMEs and non-SOEs. In any event, I am in agreement that the RMB will not appreciate much more. Not only is China's growth slowing relatively speaking, but  more importantly it's certainly no longer as undervalued as it once was.

Things change, my dear.

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Fed, Asia & Bailing Heavily Indebted Rich Countries

A recent speech by this rather deplorable character Ben "Choplifter" Bernanke defends US monetary policy from its international critics by shifting the blame on them as frustrating global rebalancing. Quoth he:

In some emerging markets, policymakers have chosen to systematically resist currency appreciation as a means of promoting exports and domestic growth. However, the perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation...

Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone's benefit in the long run by putting the global economy on a more stable and sustainable path. 

Needless to say, I find his reasoning to be self-serving and unconvincing. But first, some history. You will of course remember the late-nineties to mid-noughties effort to (successfully) cancel the debts of Highly Indebted Poor Countries (HIPCs). The cause was championed far and wide, including by the Roman Catholic Church that made it a central feature of its Jubilee 2000 millennial advocacy. So far, thirty-four countries have availed of full debt relief from the likes of the IMF, World Bank, the Paris Club of sovereign lenders, and regional development lenders alike the African Development Bank (AfDB).

Nowadays of course, the world is (very reluctantly) extending financial help to yet more fiscally challenged nations, the Highly Indebted Rich Countries (HIRCs). Undeserving yet troubled European nations aside, the United States tops all comers of course with a historically unprecedented and rapidly growing public debt which amounts to almost $16.2 trillion last time I checked.

However, the international repercussions of American penury are more systemically serious for developing nations. Insofar as we still have not escaped the era of dollar dominance, the United States is still able to partly make other countries shoulder the costs of its Looney Tunes-style financial shenanigans combining unlimited megadeficit spending with ultra-loose cash. For most other open economies, for instance, holding ever more depreciating dollars is a cost that must be borne to maintain export competitiveness. It's not that they want to; it's that they still have to as part of playing the globalization game as capital flows head toward their shores in search of better returns than those offered by US dollars. Hence Brazilian Prime Minister Guido Mantega's notion of "international currency war" (though some dispute this idea like Ben).

It would of course be less of an injustice if only major LDC economies alike Brazil and China bore the brunt of American beggar-thy-neighbour strategies. However, it is also small nations that must put up with US actions. Take the Philippines. It is usually regarded as one of Asia's development laggards even if it has been described in more flattering terms as of late. That said, the Philippines is typical of other Asian nations which now have questionably large foreign exchange reserves. While bountiful reserves would have been welcome during the Asian financial crisis, nowadays it's just a waste of resources, most of which are in dollars. From p. 42 of the Philippine central bank's 2011 annual report:

In terms of currency composition, 75.2 percent of the total reserves (excluding gold) were denominated in US dollars; 15.3 percent were in yen; 3.8 percent were in euro; and the balance of 5.7 percent were in SDR and other currencies.

More recently, we received word that Philippines foreign exchange reserves have risen further to $81.88 billion for reasons no doubt familiar to LDCs:

The country’s foreign exchange reserves increased further to a new all-time high of $81.88 billion at the end of September as the central bank kept buying additional dollars from the market to prevent what could have been a sharper rise of the peso. In a report released Friday, the Bangko Sentral ng Pilipinas said the latest gross international reserves (GIR) were enough to cover for 11.8 months’ worth of the country’s imports and 6.5 times the combined debts to foreign creditors of private and government entities in the Philippines.

The BSP admitted that its foreign exchange operations, under which it trades currencies in a bid to prevent sharp and sudden fluctuations in the exchange rate, caused the GIR to shoot up...The Philippines and other emerging markets are attracting foreign “hot money” because of the crisis in the Europe and the anemic performance of the US economy. Problems confronting the advanced economies are driving portfolio funds to better-performing economies in Asia.

Precisely to cope with American-style ZIRP, I of course approve of LDCs like the Philippines having a managed currency float to smooth out volatilities introduced by certain others. Yes, it does involve open market operations in the form of buying dollars and selling Philippine pesos in this case if appreciation is too sharp. From Bernanke's rationalization, the Fed is merely helicopter-dropping dollars to fulfil its dual mandate--especially that of promoting full employment. Moreover, the Philippines would be one of those dastardly countries using monetary policy to frustrate international rebalancing by, among other things, preventing peso appreciation. However, Bernanke's reasoning is itself flawed. Consider:

1. In the same speech, Bernanke says earlier that "As I have said many times, however, monetary policy is not a panacea";
2. He continues by saying " the most effective approach would combine a range of economic policies and tackle longer-term fiscal and structural issues";
3. Yet, in fact, ultra-loose American monetary policies have been complemented by massive deficit spending;
4. Nor is it clear that these very costly "unconventional" measures have improved economic conditions Stateside as still-below-trend economic growth--1.3% in Q2--has supported only subpar job creation;
5. Given the uniquely central position of the dollar in the world economy, the US still can still shower its trade partners with friendly fire (love that Choplifter analogy) by forcing them to pick up the slack from printing unlimited IOUs. 

Quite frankly, only the most gullible central bankers would render their countries vulnerable to this sort of American foul play. Remember too that these Yanks are precisely the same folks who advocated Washington Consensus-style policies to poor countries when they were in trouble, only to flout them when the US itself got into trouble. Prudent financial management? Getouttahere! In other words, it's always fine to make poor countries pay the costs of adjustment, but Americans will always refuse to do so.

The standard for reserve adequacy used to be for three months' worth of imports. With the Philippines' reserves approaching a year's worth of imports, think of almost nine months' worth of reserves as a subsidy to US profligacy--the world's most highly indebted rich country. While Bernanke refrains from commenting much on fiscal policy, you cannot ignore the complmentary role of both fiscal and monetary policy in describing the ill effects of US policy on the rest of the world. And again, they've burned through literally trillions and trillions of dollars from various creditors with nary an improvement in their fiscal or structural situation as Bernanke professes. Couldn't poor countries like the Philippines have used so much money wasted by those profligate Americans for far better and more developmental purposes?

Meanwhile, the Philippines has had one of the world's top six central bankers for two years in a row [1, 2] while Bernanke is not at all well-regarded in financial circles. I guess the "managed float" is not an odious practice as Bernanke implies, but rather his own monetary shenanigans in the eyes of central banking practitioners. The world economy has changed in some ways with the emergence of HIRCs, but not necessarily for the better. Unlike with HIPCs, there is no morally uplifting aspect to bailing out HIRCs.

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What Euro at $1.31 Says About Western Economies

Not to my particular surprise--I too believe that the world should worry about the dollar and not the euro--the common currency went back up to $1.31 after the Federal Reserve announced QE3. Oh, the irony. Here we were supposing that old Europe had been left for dead, yet even this currency used by various troubled peripheral nations alike Greece, Ireland, Italy, Portugal and Spain has managed to bounce back despite everything.

To cut a long story short concerning the battle of the moribund Western economies, consider:

1. If subprime growth [U-S-A!] combined with unlimited deficit spending is preferable to fiscal retrenchment resulting in (a hopefully short-lived and transitional) recession [E-U!], then why is the currency of the latter preferred to the former?
2. As per point (1), does the market prefer policies that involve tackling fiscal problems head-on despite the immediate costs over delaying any meaningful effort to address deficits?
3. Considering that the bond yields of the aforementioned PIIGS range from 5.01% to 20.90%, then what would the market-determined yield of US treasuries be without such heavy Fed buying distorting the market?

Both Europe and the US happen to be in sorry shape, but the latter is the biggest loser hands down--together with those poor sods dumb enough to hold its currency.

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The Fading Dream of Yuan-Yen Direct Exchange

One of the things people unfamiliar with currency markets do not fully appreciate--and these include poo-bahs alike Fred Bergsten of the Peterson Institute of International Economics--is that all currency pairs involve the US dollar and something else. To change Japanese yen into Chinese yuan for instance, you would typically refer to the USD/JPY exchange rate first to obtain dollars, then change the dollars to yuan via the USD/RMB exchange rate.

Recently, the Chinese and Japanese governments established mechanisms to bypass the need to exchange their currencies into dollars first. In other words, you could exchange yen for yuan and vice-versa straight without changing first into dollars. It sounds great in theory: why mess with dollars when you are doing trade within Asia, anyway? The transaction costs of not having to obtain dollars in the process should reduce the costs of foreign exchange.

However, things have not quite worked out that way it seems. Because the market in direct yen-yuan or yuan-yen foreign exchange remains thin or lightly traded, bid-offer spreads tend to be fat. In layman's terms, the prices at which traders are willing to sell yuan and buy yen--or buy yen and sell yuan in the opposite instance--differ markedly. OTOH, in an active market, the prices for both should be nearly identical since there are many buyers and sellers of both currencies competing with each other for business. That is, profit margins would be wafer-thin. As it so happens, the practice of intermediating yen-dollar-yuan or yuan-dollar-yen trades still comes out cheaper since the dollarless trading markets are illiquid. From the WSJ:

When direct dealing started, it met with great fanfare. Japanese finance ministry officials played up their high hopes for the shift and what a step forward it would be for Sino-Japanese economic relations. Following suit, the media extensively covered the move and brokerages started related new services...

According to Mizuho Corporate Bank, direct yuan-yen daily turnover is currently around ¥5 billion ($63 million), half the initial June level. That compares with total dollar-yen daily volume in Tokyo of $145.4 billion, based on the latest Bank of Japan figures released in July. 

OK...so the situation is not so promising--yet. What needs to emerge is an economy of scale that reduces transaction costs that quite frankly isn't there yet:

One misconception has been the idea that direct yuan-yen trading would automatically be cheaper than the two steps of yuan-dollar and dollar-yen trading combined. Traders say this can be true in theory, and may eventually happen, but for now the low trading volumes mean the single bid/ask spread is larger than in undertaking the two trades.

"The transaction cost is represented by the difference between offer and bid levels, not the number of trades to execute an order," said Junya Tanase, chief currency strategist at J.P. Morgan Chase Bank in Tokyo. The wider spread for yuan-yen trading reflects the low volume, creating a classic "chicken-and-egg" dilemma for those in the market. "Yuan-yen trading size must match at least euro-yen trading volumes for us to be able to use regularly," a major non-Japanese bank dealer in Tokyo said. That would mean that volumes would need to soar to more than $20 billion daily. 

Current yuan-yen turnover is $63 million, while commentators suggest that it would only be cheaper to do direct deals when turnover reaches $20 billion--a 317-fold increase. To make an understatement, the yuan has a long way to go before becoming a "medium of exchange" even in its own backyard.

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Maybe the Renminbi Won't Rule the World After All

Here's a neat riposte from Eswar Prasad and Lei Ye to the idea that the RMB will surpass the dollar as the world's most important currency over the next decade or two. That point of view has been famously espoused by Arvind Subramanian of the Peterson Institute of International Economics and, for you trivia buffs out there, occasional co-author of Dr. Prasad. Anyway, I found the Prasad/Ye commentary in the current issue of IMF Finance & Development which we receive copies of here at the office. It's often an interesting, easy to read publication that keeps you up to date  on things that are on the minds of IMF staffers.

First, let's begin with their recounting of the standard criteria (store of value, medium of exchange, unit of account) by which the functions of money are evaluated to see whether the RMB is indeed catching up with the US dollar:

The answer to that question depends on three related but distinct concepts about the currency: •Internationalization: its use in denominating and settling cross-border trade and financial transactions—that is, as an international medium of exchange;

•Capital account convertibility: how much a country restricts inflows and outflows of financial capital—a fully open capital account has no restrictions; and

•Reserve currency: whether it is held by foreign central banks as protection against balance of payments crises.

The rest of their short contribution is well worth reading, but here's the concluding portion where they give the store away:

Is the renminbi on a trajectory to usurp the U.S. dollar’s role as the dominant global reserve currency? Perhaps, but the day is a long way off. It is more likely that, over the next decade, the renminbi will evolve into a reserve currency that erodes but doesn’t end the dollar’s dominance. About two-thirds of global foreign exchange reserves are now held in U.S. dollar–denominated financial instruments. Other indicators, such as the dollar’s shares of foreign exchange market turnover and cross-border foreign currency liabilities of non-U.S. banks, confirm the currency’s dominance in global finance...

Moreover, a gulf remains between China and the United States when it comes to the availability of safe and liquid assets such as government bonds. The depth, breadth, and liquidity of U.S. financial markets are unmatched. Rather than catching up to the United States by building up debt, the challenge for China is to develop its other financial markets and increase the availability of high-quality renminbi-denominated assets. The renminbi is attaining more prominence in international trade and finance. While this importance is sure to grow, the renminbi is unlikely to become a prominent reserve currency—let alone challenge the dollar’s dominance—unless it can be freely converted and China adopts an open capital account.

The challenge for the Chinese government is to back up its modest international policy actions with substantial domestic reforms. The renminbi’s prospects as a global currency will be shaped by a broader range of policies, especially those related to financial market development, exchange rate flexibility, and capital account liberalization. The path of China’s growth and the renminbi’s role in the global economy will depend on those policy choices.­

Actually, I do not trivialize what China needs to do to attain such a status. Nevertheless, I remain convinced that the RMB will inevitably become an important reserve currency in its own right--particularly in the Asia-Pacific as trade becomes more Sinocentric. However, surpassing the dollar outright will take more time, and even then I'm not entirely sure whether that's a pressing objective of Chinese leaders anyway. As I said, we're moving to a more multipolar world, and in such a world, there is no corresponding need to have an "alpha currency." There is no dollar-gold standard out there anymore, and there's little point in speculating that there will emerge an SDR-RMB standard or any suchlike.

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'The World Economy Reeks Again, So Buy Yen'

I have an avowed love-hate relationship with newswire coverage of various financial markets. With regard to currencies, one of the things I am most cautious about is the need to constantly provide explanations of why currency movements occur. I suppose having to provide a laundry list of reasons is a necessary task in the news business. Yet, the ephemeral nature of the task makes it subject to no small amount of improvisation and, dare I say it, conjecture.

Something that's fascinated me as of late are movements in the Japanese yen. Despite the continuing deflationary situation, the aftermath of the terrible tsunami and their budget deficit over 200% of GDP, the yen managed to strengthen to all-time (nominal) highs. Many reasons have been given for the mighty yen--some convincing, others less so.

However, the yen appears to have run out of nitro or whatever is fuelling its ascent in recent weeks as the currency has shown signs of coming back to Earth and the gravity of Japan's unpromising economic situation reasserts itself. Or think again. What we've have in the past few days is the yen strengthening against most other major currencies as "risk off" conditions indicative of the global economy slowing down once more favour it once more as a safe haven bet (of sorts). From Reuters:

The safe-haven yen held on to overnight gains in Asia on Friday, having risen across the board as investors gave risk currencies like the Australian dollar a wide berth on worries about the health of the global economy. Surveys on Thursday showed manufacturing shrank for a fifth month in China, while factory activity in Germany and France -- Europe's two biggest economies -- suffered big falls.

This prompted investors to dump growth-linked currencies and take shelter in the yen, which rose against the dollar, euro, Aussie and kiwi. The dollar fell more than 1 percent on Thursday to a 1-1/2 week low of 82.31 yen, before recovering a bit of ground to last stand at 82.60. "Fears of a Chinese hard landing are on the rise; overdone we think," said Vincent Chaigneau, strategist at Societe Generale. "Concerns over Europe are burgeoning again, rightly so given the weak economy and the toxic focus on enlarging the firewall," he added. 

So we have above the World Economy Reeks explanation for safe haven flows into the yen without necessarily comprehending why the Japanese yen would be a safer choice than, say, the Canadian dollar. At the risk of adding to this already long laundry list of explanations of how Things Going Wrong Elsewhere Affect the Yen, consider too the annual Yen Repatriation Story in the run-up to the end of March when Japan's financial year ends. Some IPE bozo explains the phenomenon thusly:

Longtime FX followers will know that yen movements around this time of the year are attributed to repatriation flows as firms wrap up their fiscal year at the end of March. That is, they need to reconvert their foreign exchange holdings back to yen for the purposes of financial reporting as they close the books. 

However, the MoF indicates that it canvassed Japanese MNCs' requirements for purchasing yen for the said event and found that there would be no large requirement this year. Go figure; FX is an especially wacky game to speculate in.

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RMB Internationalization's Coming Along Fine, TY

This is a short follow-up to a post I recently made about how the RMB was becoming more integrated into the global SWIFT interbank transfer system as well as the emergence of RMB libor creating reference rates for yuan-denominated borrowing. All point towards inroads the renminbi is making towards becoming a global reserve currency. Today's post dwells on the recent figures for the Hong Kong-based offshore renminbi market. To be sure, the headline numbers are mixed but positive overall. Yuan offshore holdings that usually show some variability are down (a negative for the store of value function), but there is a marked and steady increase in yuan-denominated trade (a positive for the unit of exchange function). From our friends over at Reuters:

While CNH deposits in Hong Kong banks fell by more than 6 percent to 588 billion yuan at end-December from the previous month, trade settled in renminbi logged a remarkable 239 billion yuan. That is the highest monthly volume [since] June 2009, when Beijing began an experiment to denominate more of its trade in the Chinese currency.

The numbers suggest that the offshore yuan market is now being used not just by smart mainland importers looking to boost their profit margins by arbitraging between the two markets, but as a viable trade channel by exporters and importers. And more "two way" yuan flows between the onshore and offshore markets via trade channels and increased usage of direct investment channels signal a rising level of maturity of the CNH market.

"The renminbi is now increasingly being used in the real economy than just for arbitrage purposes [through the difference in the onshore and offshore yuan exchange rates] between the borders which is a healthy sign for the longer-term growth of the market," said Becky Liu, a strategist at HSBC in Hong Kong.

The increased use of yuan in trade or the current account coincides with long-awaited reforms on the capital account including the launch of a sizeable 20 billion yuan cross-border investment scheme in December and relaxing rules on yuan foreign direct investment. Officials from the Hong Kong Monetary Authority say the export-import mix of cross-border yuan trade has reached a balanced level from the 1:3 ratio seen in the second half of 2010, HSBC analysts wrote in a note [my emphasis].

The changes couldn't have come at a better time. Yuan gain expectations have decreased noticeably and CNH trades in Hong Kong are more volatile, increasing pressure on authorities to allow offshore investors more access to the mainland markets to ensure the yuan internationalisation experiment doesn't falter.

Since yuan FDI rules were first announced in mid October, a total of 21 billion yuan in 10 projects have been approved until end-December and total CNH loans has grown to more than 25 billion yuan by end-November from nowhere a few months earlier. All of which will increase the cross-border flow of money, deepening the CNH market, but will also slow the growth in offshore yuan deposits, which has grown by a factor of ten in only two years.

Credit Agricole expects the pool of CNH deposits in Hong Kong to rise to only 610 billion by end 2012, marginally higher than the 588 billion at the end of 2011. "The negative headline such as decline in deposits is more of a short-term nature, and might not make the regulators overly concerned about the situation," HSBC's Liu said. She expects the speed at which authorities have been moving to support the offshore market and open the capital account to continue.

At first I too was rather sceptical about the idea that the renminbi would supplant the dollar's role in a decade's time. But, with such rapid gains, who knows? It's the same story with growth figures with the PRC posting lurid numbers year in and year out. Surely both the Chinese currency and economy can surpass their American counterparts in the matter of a few decades if they keep up this torrid pace?

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2012: Year of the Dragon, Year of the Renminbi!

A week ago today, the Chinese and their vast diaspora celebrated Chinese New Year. As it so happens, it also ushered in the Year of the Dragon. Famously the most auspicious of characters, this too may be the year that the PRC powers-that-be become serious about internationalizing the RMB with the long-term goal of reforming the international monetary system in mind. Just as red envelopes like those above are used to give gifts in cash, 2012 may be the year the Chinese give the gift of renminbi internationalization to the world in a meaningful way. I've mentioned recent efforts to make RMB use more widespread worldwide, but I forgot to mention these two that point towards the same trend.

First, Chinese authorities are improving RMB payment handling systems' integration with the international standard SWIFT (Society for Worldwide Interbank Financial Telecommunication):

The People's Bank of China, the country's central bank, is in the process of upgrading what is known as China's National Advanced Payment System, or Cnaps [I pronounce it as 'Schnapps' ;-)], to better facilitate cross-border trade denominated in yuan, according to government officials and executives at Chinese banks. The processing of yuan payments isn't at the same level of efficiency as a cross-border payment in other major currencies like U.S. dollars, with a hands-on system that often leads to high transaction costs, some observers said.

"The processing cost of yuan payments must come down, so that when corporations do start to put significant yuan volumes through, banks can handle them smoothly and efficiently," said Patrick de Courcy, head of markets in the Asian-Pacific region for Swift, which operates a world-wide financial-messaging network between banks and other financial institutions.

Mr. de Courcy said China's central bank has agreed to use messaging standards adopted by Swift to support electronic payments into its system. A central-bank official confirmed the bank is upgrading the yuan-payment system. The bank declined to comment further.

Next, aside from payment handling, another obvious avenue for making the yuan more widely used is establishing a benchmark interbank lending rate alike LIBOR (London Interbank Offered Rate) and its various offshoots. This process has begun (where else?) in the Hong Kong offshore lending market:

Hong Kong's banking association this week began widely disseminating yuan-lending rates offered by three of the city's biggest banks to their peers, marking an important step toward the development of benchmark rates that could spur growth in the market for offshore yuan loans.

The Treasury Markets Association's daily interbank reference rates from HSBC Holdings PLC, Standard Chartered PLC and BOC Hong Kong (Holdings) Ltd. involve loans ranging from overnight to one year. The association has said it aims to increase the number of banks contributing rates, in a bid to set benchmark yuan-lending rates.

Setting benchmark levels for yuan loans similar to the London interbank offered rate, or Libor—the most common global benchmark for short-term borrowing costs—is necessary so that banks can better price loan risks and measure borrowing costs, bankers and analysts say.

Elsewhere, currency-watching stalwart Jeffrey Frankel handicaps prospects that the RMB will overtaker the dollar in short order based on historical precedents. Also note how African nations are gearing up in a similar fashion to handle RMB. Regardless, all I can say is that Chinese authorities are committing substantial efforts in making the RMB an international currency. Indeed 2012 may be remembered as the year the currency broke ground on the world stage in a major way.

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