The following is a paper published earlier this week by former Sempra Metals economist John Kemp looking in detail at the Fed’s emergency money market operations and its ultimate reliance on Chinese support. It’s a long read - 5,000 words - so we’ve split it into five parts. If you would like an accompanying selection of charts that are simply too large to publish here email alphaville@ft.com.
This brings us to the last part of the puzzle: the behaviour of the exchange rate and international capital flows. The current crisis is remarkable because the currency of the country at the centre of the crisis (the US dollar) has strengthened substantially against the currencies of almost all its major trading partners. The dollar’s strengthening is counter-intuitive. It is as if the inhabitants of the building were running towards the seat of the fire rather than away from it after the fire alarm sounded.
The obvious answer is that the currency is benefiting from safe-haven flows, as investors flock to the safety of the US government bond market, and perhaps calculate that the US government’s aggressive stabilisation efforts contrast favourably with the slower and more piecemeal moves in Europe and elsewhere. But while it is easy to see how investors in the United States itself might flock to the apparent safety of the US government bond market, it is less clear why investors in overseas markets would rush to increase their exposure to the country at the very heart of the crisis. The point about running towards the seat of the fire after the alarm has gone off applies.
But at least two factors appear to be supporting the US dollar. US banks and corporations are almost certainly liquidating some of the assets they own overseas and bringing funds home to strengthen their balance sheets and reduce the amount they need to borrow in the short-term. US corporations hold substantial assets overseas, some of them long-term, others short-term funding held in offshore vehicles to minimise tax liabilities.
On Fri Oct 3, the Internal Revenue Service (IRS) relaxed the rules governing how much of these funds corporations can bring back on a temporary basis without having to pay 35% corporate income tax on them. Normally IRS allows corporations to bring funds back from overseas subsidiaries for up to 30 days twice each year. Following Friday’s extension, corporations can bring funds back for up to 60 days, three times per year. The IRS move was explicitly designed to provide some help to corporations experiencing severe funding pressures.
But it is likely corporations were already bringing some funds back, and were liquidating longer-term assets to strengthen the parent company’s financial position, even before the IRS move. Liquidation of overseas portfolios, or borrowing from overseas subsidiaries with surplus cash, is a one-time source of support for the currency, however, and will dry up when the liquidation is completed, or even go into reverse when the borrowing from subsidiaries has to be repaid. So this source of dollar strength could prove to be strictly temporary.
The other source of dollar strength is probably from quiet intervention in the foreign exchange markets by one or more central banks. The final interesting item on the Fed’s Condition Statement is a memorandum item at the bottom of the table which shows the volume of US Treasury securities which the Fed holds as custodian for foreign governments and central banks. The Fed doesn’t own these securities, and it cannot lend them out without authorisation, but it provides a convenient repository for other central banks to hold their US paper, including the People’s Bank of China.
The volume of Treasury securities held in custody by the Federal Reserve Banks for foreign account holders has soared from $732 billion at the end of 2001 to $1.061 trillion at the end of 2003, $1.519 trillion at the end of 2005 and $2.056 trillion at the end of 2007. When foreign central banks buy dollars to prevent their own currencies from appreciating, the proceeds are usually converted into US Treasury bonds, and many of them are held in the Fed’s custody. The Fed’s custody account therefore provides a useful indicator of the volume of foreign exchange intervention, and the surge in custody holdings over recent years is a useful yardstick of the extent to which China, as well as some other countries in Asia and the Middle East running large balance of payments surpluses, have intervened to support the dollar and keep their own currencies from rising too much.
Throughout this year, the level of foreign exchange intervention has been modest. The Fed’s custody holdings have grown by perhaps $10-20 billion per week. But in the most recent week, ending Oct 1, the Fed’s custody holdings surged by almost $44 billion, suggesting heavy intervention by one or more overseas central banks has been supporting the dollar.
The Fed’s custody holdings amount to a staggering $2.466 trillion – of which $1.495 trillion is invested in Treasury securities and another $970 billion is in agency bonds. To put this in perspective, of the $5.850 trillion worth of US Treasury debt which is actually held by the public rather than as an accounting entry in the Social Security and other trust funds, foreign governments hold about 25% of the total in their Fed custody accounts.
Two points follow.
The first is that if the US Treasury is going to issue another $700-1,000 billion of new debt to cover TARP and other credit extensions, finding domestic buyers for all of it may prove difficult, and it will probably need to persuade foreign governments to absorb at least a proportion of the new total. For several years, US legislators have complained vigorously about the volume of foreign exchange intervention by foreign central banks. They have argued that it has kept emerging markets’ exchange rates unusually low and granted an unfair advantage to their exporters, without realising that it has also helped support US government borrowing and kept yields and the whole spectrum of US interest rates lower than they would been otherwise. The recycling of balance of payments from the Middle East and Asia into the US bond market helped finance much of the 2002-2007 expansion, as well as the subprime crisis that ended it. But in the medium term, continued foreign government support for the US bond market will become more important than ever before as the US Treasury tries to borrow its way out of the crisis by replacing impaired bank and mortgage debts with paper newly issued by Uncle Sam.
The second point is that the $2.4 worth of Treasury and agency securities held in custody, including $1.5 trillion worth of Treasury securities, is now very large indeed, especially relative to the Fed’s own rather meagre pool of unlent securities. The Fed has no authority to lend them out without permission of the owning governments and central banks. But it is possible to envisage circumstances in which the Fed could obtain permission to swap those Treasury securities for mortgage-backed and other private securities, while taking on the credit risk itself and guaranteeing the ultimate owners of the foreign reserves against the risk of default. The Fed, and ultimately the US Treasury, would still be liable for the cost of any defaults. But they would not need to issue so many new Treasury bonds to finance the swap programme, and could circumvent the statutory debt ceiling more easily.
The Fed does not divulge the exact owners of the securities in its custody. But by far the world’s largest accumulator of reserves has been China, and the country is widely assumed to own a very large share of the total. China has already expressed some anxiety about its concentration of reserve holdings in dollar-denominated assets and the resulting exchange rate risk. Senior policymakers have repeatedly indicated that they would like to diversify the country’s reserves into other currencies, but the attempt has been frustrated because as the largest holder of dollar reserves China stands to lose the most from any loss of confidence in the currency and consequent devaluation. So while China probably does not want to add to its holdings of dollar assets and its exposure to the United States, the size of its existing holdings, and its need to protect their value, may leave it no choice.
China has other reasons to support the United States. North America and Europe are by far the most important markets for China’s export-dependent economy. China will not avoid a sharp slowdown, and the risk of social instability, in the event of a deep recession in the United States that spreads to Western Europe and Japan. So China’s government has strong reasons of self interest to support the Fed’s and the Treasury’s efforts to stabilise the financial system. Finally, by supporting the United States, China would be playing the role of international lender of last resort, and confirm its emergence as one of the top-tier participants in the world economy and financial system, taking its place alongside the United States, Japan and the eurozone. The gain in prestige would be enormous and it would prove impossible to deny China the right to participate alongside the G7 countries in shaping the future of the financial system.
China’s support for the stabilisation package will be crucial, though what form it will take is unclear. Explicit support via a loan to the US Treasury or swap arrangements using its huge stock of US Treasury securities would probably represent too much of a humiliation for the US authorities. But support could be offered more tacitly in the form of foreign exchange intervention to support the value of the US dollar, especially as the impact of repatriation flows unwinds, and continued support for the government debt market in the form of further purchases of newly issued US Treasury securities is probably essential. Explicitly or tacitly, China’s support is a necessary condition for stabilisation to be a success.
During the 1920s and 1930s, the United States, acting through the Federal Reserve, repeatedly had to support the Bank of England and the Bank of France when periods of tight credit and the outflow of funds threatened to overwhelm their modest balance sheets. The Fed acted, albeit inconsistently, reluctantly and not always reliably, as a sort of international lender of last resort, because it alone had the free reserves, in this case the free gold, to support the other central banks when their own balance sheets came under pressure. Now that China, and to some extent the major oil exporters of the Middle East, have amassed a huge stockpile of US Treasury paper, they alone have the resources to take up the role of international lender of last resort. In one form or another, whether explicitly or tacitly, they will have to support this stabilisation if it is to succeed. They have powerful reasons of self interest to do so, and China’s stock of Treasury bond holdings is so large it has little choice. But as the phrase goes, he who pays the piper names the tune. Just as the Fed’s lending in the 1920s and 1930s bolstered its position in the international financial system relative to London and the centres of Continental Europe, so support for the bailout from China and the rest of Asia will mark a further shift in the financial system’s centre of gravity towards the east.
/ends
