Currency Risk

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Obviously, there was a confluence of events triggered by the world-wide re-pricing of inflation expectations & economic output.

The Chinese dealt with illegal bond trading in May, PBoC tightening this year, unwinding carry trades, recapitalizing banks, on & off-balance sheet restructuring, an undervalued currency peg, artificially low real rates, a real-estate bubble, etc.

Minyanville: "when the carry trade is “on” it has the side effect of seeing FX reserves decline at the Federal Reserve, as investors borrow in dollars and sell those dollars to invest in foreign currencies"

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All 3 roc's in money flows (money times velocity), are set to decline until Oct. So we have to confront an upcoming economic deceleration in prices & production (the big picture).

And any currency conversion (hot money flows), is transitory. Cross-border capital movements, or deposit flight, is not a threat to controlling the money stock (e.g., intervention by adding supplementary reserve requirements for euro-dollar borrowings, or federal funds borrowings from non-member institutions, etc. restricts money growth). But it does threaten exchange rate regimes (to where speculators will quickly drive prices down to approximately their purchasing power parity levels).

The mal-investment in external debt (not purposeful in the trade-related hedging of exports & imports & foreign direct investment), stemming from carry trades; currency, trade, & interest rate wars; or competitive depreciation; have previously been arrested using, e.g., subsidies, tariffs, & taxes on foreign purchases of debt or equity.

Exacerbated inflows & outflows of deposits, & the accompanying asset volatility (risk premia), related to the current excessive speculation, or flight-to-safety, transactions (not directly financing current trade & direct investment), are better left to some type of "revert to mean" punishment, or even "jawboning". They should be "self-correcting".

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The net accounting effect of the PBoC’s (People’s Bank of China) buying U.S. dollars is 1) the importer pays in his own country’s currency, 2) the exporter receives payment in his country’s currency, 3) for very debit there is a credit, 4) there is no net transfer of funds, and 5) money is not flowing in or out of the respective countries. This is proved by using “T” accounts. The balance of payments always balances even though the statistics on payment balances never do. To correct this deficiency, the commerce Department inserts an item called “Errors and Omissions”. Thus, the triumph of theory over “facts”.

In foreign trade, imports decrease the money supply of the importing country (U.S/Federal Reserve) while exports increase the money supply, & the potential money supply, of the exporting country (China/PBoC). Purchasing the deficit countries currency & then investing in U.S. treasury bills, will reduce the dollar's supply, but it is important to know that sooner or later the PBoC will have to reverse their positions & the foreign exchange dealers know this (at this juncture gold rises).

Domestic imbalances (current account surplus – trade & capital account flows) represent a large proporation of China’s GDP (increasing FOREX reserves).

The trade-off of reducing the pressure on the global dollar by temporarily decreasing the volume of the dollar-denominated assets requiring conversion into RMB, is the cost of foisting an inflationary policy on mainland China (that is now countering an inflationary bubble). Obviously, & for good reason, the Chinese have reason to resist this kind of assistance. (China’s Premier Wen Jiabao described the Chinese economy as “unstable, unbalanced, uncoordinated, & unsustainable).

The Chinese loss of income & probable exchange rate losses, when the reverse of these recycling operations is consummated at a later date, are, of course, compensated by the Federal Reserve. The adverse effects on the Chinese economy receive no such compensation.

China’s continued intervention in the foreign exchange markets requires that they "sterilize" their FOREX reserves (to manage their currencies de facto-fixed-target brackets: [new +/- 0.5% daily]). That is, the Chinese Central Bank "mops up" the increase in the RMB money supply by selling government bonds or by forcing specific commercial banks to underwrite PBoC bills at a discount to prevailing market rates.

These open market operations convert China’s surplus RMB into government debt, & delay the inflationary impact of an otherwise increase in the volume of RMB. But at some future point, as exchange rate reserves grow, the Chinese capital markets will lose the capacity to absorb new debt.

Eventually, China's protectionism (currency peg) will crack, & the volume of RMB will fuel inflation, as sterilized intervention reaches saturation. (The history of all currency pegs is that sooner or later they fail). Meanwhile the PBoC has been (too little & too late), (1) selling lots of government bonds & PBoC bills to their domestic credit markets, & (2) raising commercial bank reserve ratios, via a creeping & protracted currency peg, to monetize government debt.

Both 1 & 2 represent the PBoC’s sterilized intervention of their FOREX reserves, (selling operations roughly equivalent to its balance-of-payments surplus). The expanded scale of intervention & sterilization postpones the inevitable. If there is a flight from the dollar, it will be because the Chinese waited too long to realign the RMB. E.g., as a sign post, the U.S. National Association of Manufacturers estimates the RMB was undervalued by as much as 40 percent.

While the U.S. will have a temporary gain, as will foreign enterprises engaged in foreign trade who are momentarily freed from excessive fluctuations in the exchange rate, the overall financial effects are a loss to the Chinese & to the Chinese economy. And when the RMB rises, exporters lacking currency hedges, would be undermined by prior contract arrangements.

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Bernanke thwarted a dollar attack:

There’s a correlation between “hot” money flows & the interest rate differentials between countries. Unwinding carry trades can simultaneously influence the dollar’s exchange rate. But selling securities doesn’t always reflect currency conversion. Selling might reflect the redistribution of FX reserves (from foreign short-term claims against the dollar, to longer dated, higher risk, less liquid, investments).

All transactions that require the conversion of foreign currencies into dollars constitute a demand for dollars. These include exports, payments received for services rendered to foreigners, capital flows (interest & dividends collected from foreigners), etc.

Obviously movements in the dollar’s exchange rate which correspond to the bond market exodus implies domestic market flight. But both swaps, & foreign currency deposits & bonds, fell coterminous with the ebb & flow of the U.S. dollar’s value.
My interpretation is that the FED intervened & offset a destabilizing movement (“speculative attack”) by unwinding liquidity pressure (note that the exchange rate of a swap equals the market exchange rate used when the foreign currency was acquired from the foreign central bank).

What’s not so obvious is that the Fed’s lagged reserve accounting is responsible for the disruption in the bond market (bank squaring day & high-payment flows exacerbated by a 13% swing in the system's required reserves).

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From H.4.1 (factors effecting reserve balances of DFIs) 4/24/2013 statement to 6/27/201:

[Total factors supplying reserve funds/assets]:

Central bank liquidity swaps fell -$25,579m to $1,480m (from $28,211m) on April 24th.
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[Total factors, other than reserve balances,
absorbing reserve funds/liabilities]:

Reverse repurchase agreements (Foreign official and international accounts)
Fell from $90,455m to $88,693m
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1A. Memorandum Items:

Securities held in custody for foreign official & international accounts (Marketable U.S. Treasury Securities) fell from 2,951,413 to 2,934,015 (FT’s figure)
[footnote: Includes securities & U.S. Treasury STRIPS at face value, & inflation compensation on TIPS]

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"Recently, the People’s Bank of China and the Bank of England signed a three-year currency swap agreement in the amount of $33 billion (about 300 billion Yuan)...Now, British banks already hold about 35 billion in Yuan deposits. The new currency-swap agreement will for allow the central banks of China and England to swap the fiat money of each and allow for trade to be settled in the sovereign units"

www.fxstreet.com/news/forex-news/article.aspx?storyid=0afaa75a-5d79-4718-b442-51a1cc379d5b

Using the dollar as a transaction currency is diminishing.