China Should Reduce Reserves By 2/3 to 3/4 of Current Levels

from Xinhua News:


BEIJING, April 23 (Xinhua) -- China should reduce its excessive foreign exchange reserves and further diversify its holdings, Tang Shuangning, chairman of China Everbright Group, said on Saturday.
The amount of foreign exchange reserves should be restricted to between 800 billion to 1.3 trillion U.S. dollars, Tang told a forum in Beijing, saying that the current reserve amount is too high.
China's foreign exchange reserves increased by 197.4 billion U.S. dollars in the first three months of this year to 3.04 trillion U.S. dollars by the end of March.
Tang's remarks echoed the stance of Zhou Xiaochuan, governor of China's central bank, who said on Monday that China's foreign exchange reserves "exceed our reasonable requirement" and that the government should upgrade and diversify its foreign exchange management using the excessive reserves.
Meanwhile, Xia Bin, a member of the monetary policy committee of the central bank, said on Tuesday that 1 trillion U.S. dollars would be sufficient. He added that China should invest its foreign exchange reserves more strategically, using them to acquire resources and technology needed for the real economy.
Tang also said that China should further diversify its foreign exchange holdings. He suggested five channels for using the reserves, including replenishing state-owned capital in key sectors and enterprises, purchasing strategic resources, expanding overseas investment, issuing foreign bonds and improving national welfare in areas like education and health.
However, these strategies can only treat the symptoms but not the root cause, he said, noting that the key is to reform the mechanism of how the reserves are generated and managed.

Reserves May Ignite Much Higher Inflation As Banks Ramp Up Lending

by Scott Grannis at Calafia Beach Pundit blog:

 

Even as the evidence of rising inflation expectations mounts, it's important to not lose sight of the bigger monetary policy picture. The Fed has taken some extraordinary measures to ensure that the U.S. and world economies do not have to struggle with any shortage of liquidity. That involved the purchase of almost $1.5 trillion worth of MBS and Treasury notes. But the popular perception that they have expanded their balance sheet by printing massive amounts of new money (aka monetizing the deficit) is incorrect. Yes, they have created massive amounts of bank reserves, but almost all of those reserves are still sitting on the Fed's books—they have not been turned into newly printed money. The world probably has too many dollars, as suggested by the declining price of the dollar and the rising prices of gold and commodities, but the excess of dollars is not measured in trillions.

As I explained in a prior post, the Fed has not printed $1.5 trillion of new money—they have simply swapped $1.5 trillion of bank reserves for $1.5 trillion of notes and bonds. The bank reserves they have created are functionally equivalent to 3-mo. T-bills, and thus are viewed as among the very safest of asset classes on the planet. The Fed has apparently satisfied the world's demand for safe cash equivalents. By swapping reserves for notes and bonds, the Fed also has effectively shortened the maturity of outstanding Treasury debt. They haven't monetized the debt, they've shortened its maturity. That may well prove to be a very imprudent move from the government's perspective, especially if interest rates rise significantly, but it will shift a meaningful portion of the mark-to-market losses on notes and bonds in a rising interest rate environment away from the private sector and onto the Fed's books. Our government, and ultimately, taxpayers, are now more exposed to rising interest rates, whereas institutional investors are less exposed.

The charts that follow demonstrate that the only extraordinary result of the Fed's extraordinary actions has been an extraordinary increase in bank reserves. All other measures of the money supply are behaving within the range of historical experience. 

Bank reserves have increased by $1.4 trillion since September, 2008, when the Fed first began to implement its Quantitative Easing program. About $400 billion of that increase has occurred since QE2 began last November.

The Monetary Base (which consists of bank reserves and currency in circulation) has increased by about $1.6 trillion since quantitative easing started. $1.4 trillion of that increase represents bank reserves, and most of the remaining $200 billion consists of an increase in currency in circulation. As the second chart above shows, the growth of currency has not been exceptional at all when viewed in an historical perspective. In fact, currency growth was much faster during the 1980s and 90s, when inflation was generally falling. The most important fact to remember when it comes to currency is that the Fed only supplies currency to the world on demand. The Fed does not print up piles of currency and then dump them into the world. People only hold currency if they choose to hold it; excess currency can be easily converted into a bank account at any bank, and the Fed must absorb any unwanted currency at the end of the day, since banks are free to exchange unwanted (and non-interest-bearing) currency for interest-bearing reserves, and would be foolish not to.

The M2 measure of the money supply includes currency, checking accounts, retail money market funds, small time deposits, and savings deposits. As the chart above shows, M2 has been growing about 6% per year on average, after experiencing a "bulge" in late 2008 and early 2009 that was caused by an exceptional increase in the public's demand for liquidity. If banks had been turning their extra reserves into newly-printed money (which our fractional-reserve banking system allows), then M2 would be growing like topsy: $1 trillion of new bank reserves could theoretically support about $10 trillion of new M2 money, and nothing like that has happened.

So, at the end of the day, about all that has happened is that the Fed has exchanged about $1.4 trillion of bank reserves for an equal amount of notes and bonds. No new money has been created in the process, beyond that which would have been created in a normally growing economy with relatively low inflation.

That's not to say that banks will forever allow their reserves to sit at the Fed. In fact, banks appear to be stepping up their lending activities to small and medium-sized businesses, but these actions are still in the nature of baby steps. If the Fed fails to take action to withdraw unwanted reserves in a timely fashion, or to somehow convince banks to leave their reserves on deposit at the Fed, then we could have a real inflation problem on our hands. But that remains to be seen. The weak dollar and rising commodity and gold prices suggest we are in the early stages of a rise in the general price level that, in turn, would equate to a rise in inflation to, say, 5-6% per year. If banks begin to turn their reserves into new money in a big way, then we could potentially see inflation rise well into the double or even triple digits.

Allen Meltzer yesterday proposed one solution to this potential problem in yesterday's WSJ: "The Fed Should Consider a Bad Bank." He suggests that the Fed simply transfer all the extra reserves to a separate bank where they would be held until maturity, and thus unavailable to the banking system. I think it's also possible that the Fed could sell a significant portion of its reserves, by effectively reversing the swaps that created them in the first place. Would banks, and the financial system they serve, be willing to swap their risk-free reserves for notes and bonds? They might, especially if interest rates rise by enough, and if the world sees that the Fed has embarked on a viable exit strategy that will avoid totally undermining the value of the dollar.

The monetary policy picture is far from clear, and it is still potentially very disturbing. But it is not impossible or even catastrophic, not yet.

El Erian: Egypt Is Ominous Sign for Dollar

The lack of a flight to the US dollar and Treasurys during the crisis in Egypt is a warning sign that investors are moving away from traditional American safety plays, Pimco's Mohamed El-Erian told CNBC.

Photo: Norbert Schiller for WEF

Since the revolt against President Hosni Mubarak hit a tipping point in late January, the dollar has changed little—slumping initially and on a slight uptick in the past few trading sessions. Treasurys, meanwhile, have sold off sharply, sending yields to their highest levels since April 2010.

At another time, such geopolitical turmoil might have sent investors flocking to the traditional safe-haven plays, but that has not been the case so far.

"Had you asked me 19 days ago what happens to the dollar if we have the sort of developments we had, I would have told you the dollar would be stronger," said El-Erian, co-CEO at the company that runs the largest bond fund in the world. "With the exception of three days, the dollar has weakened during that period. You are seeing a reassessment of the standing of the US dollar and the US Treasury market has the flight to safety, the flight to quality."

China's Monstrous Currency Reserve Bubble

from Bloomberg:
Feb. 4 (Bloomberg) -- Real estate, stocks, credit. China sure has its share of bubbles. Oddly, little attention is paid to the biggest one of all.
China’s currency reserves grew by more than the gross domestic product of Norway in 2009. Its $2.4 trillion of reserves is a bubble all its own, one growing before our eyes with nary a peep out of those searching for the next big one.
The reserve bubble is actually an Asia-wide phenomenon. And we should stop viewing this monetary arms race as a source of strength. Here are three reasons why it’s fast becoming a bigger liability than policy makers say publicly.
One, it’s a massive and growing pyramid scheme. The issue has reached new levels of absurdity with traders buzzing about crisis-plagued Greece seeking a Chinese bailout. After all, if economies were for sale, China could use the $453 billion of reserves it amassed last year to buy Greece and Vietnam and have enough left over for Mongolia.
Countries such as the U.S. used to woo the Bill Grosses of the world to buy their debt. Now they are wooing governments. Gross, who runs the world’s biggest mutual fund at Pacific Investment Management Co., is still plenty important to officials in Washington. He’s just not as vital as the continued patronage of state asset managers in places like Beijing.
Next Step
You have to wonder what folks at the International Monetary Fund are thinking these days. Their aid packages tend to come with messy requirements, such as “get your economy in order.” China’s are merely about scoring resources or geopolitical points. We have already seen China throw lifelines to Wall Street giants, including Morgan Stanley. Entire countries seem like the natural next step.
China’s huge arsenal of reserves is increasing its global influence. The trouble is, China is trapped in an arrangement of its own making. As China and other Asian nations buy more and more U.S. Treasuries, it becomes harder to unload them without causing huge capital losses. And so they keep adding to them.
“This is a titanically large foreign-exchange trade,” says David Simmonds, London-based analyst at Royal Bank of Scotland Group Plc. “It’s the biggest one history has ever seen and there’s nowhere for these reserves to go.”
China aims to diversify out of U.S. Treasuries into other assets and commodities. The question that governments are grappling with is which markets are deep enough to absorb China’s riches? Gold? Oil? Euro-area debt? The Madoff family’s next Ponzi scheme?
Ending Badly
The challenge for China alone is like trying to park an Airbus A-380 super-jumbo in a Volkswagen. Like all pyramid schemes, there’s no easy end in sight and things could end badly. If the dollar collapses, panicked selling by central banks looking to limit losses would shake global markets more than the U.S. credit crisis has.
Two, reserves are dead money. The wisdom of currency stockpiling came from the chaos of 1997. Speculators sensed authorities in Thailand were sitting on few reserves, and they were right. Their attack on the Thai baht set the stage for an Asian meltdown. Governments spent the 2000s determined not to repeat the mistake.
Asian economies have too much of a good thing on their hands. In July 2007, on the 10th anniversary of Thailand’s devaluation, Asian Development Bank President Haruhiko Kuroda said the accelerating accumulation of reserves was a major concern for the region. Too bad nobody listened to him.
Vast Sums
These huge sums of money could be used to improve infrastructure, education, health care and reducing carbon emissions. Never before have we seen such a misallocation of such vast resources. Asia can do better with its money.
Three, reserves add to overheating risks. When policy makers buy dollars, they need to sell local currency, increasing its availability and boosting the money supply. Next they sell bonds to mop up excess money in economies. It’s an imprecise science that often leads to accelerating inflation. The strategy works out to be an expensive one.
The stakes are rising fast. The risks in Asia are skewed firmly in the direction of inflation. The focus is now on central banks to see if they will pull liquidity out of economies with higher interest rates. More attention should be on how reserve management is working at odds with that goal.

Central banks face a difficult task. They must withdraw excess liquidity without devastating their economies and running afoul of politicians. Only now is Asia finding out how some of its economic-protection tactics are amplifying the challenge.
Asia has been holding down currencies to support exports for more than a decade. It’s silly to ignore the side effects of that strategy for the region’s economies.
Think about how Dubai shook the global economy, or how the mere hint that Chinese growth may dip below 8 percent inspires panic. These disappointments pale in comparison with the turbulence that may come from Asia’s biggest bubble popping.