Goldplay

Mar 28, 2009

Goldplay
By Chan Akya

"News reports confirm that a two-seater Cessna aircraft crashed into the local cemetery near Washington this morning. Police on the scene have uncovered 100 bodies so far and expect to find many more."

Yes, that certainly is an awful joke; but it well typifies the unintended consequences of actions undertaken by the world's central banks from the past few days. In no particular order, we had the following major developments this week:
1. Egged on by the act of the Federal Reserve buying up US Treasury bonds, the Treasury unveiled its very popular but completely brain-dead proposal for a public-private initiative aimed at removing loans and securities sitting on the moribund balance sheets of US banks.
2. The president of the European Central Bank (ECB), Jean Claude Trichet, rejected demands for an increase in stimulus spending in Europe, a point of contention with the Barack Obama administration.
3. Bank of England governor Mervyn King warned that inflation could worsen in the United Kingdom and require a sharp increase in interest rates thereafter.
4. The governor of the People's Bank of China (PBoC), Zhou Xiaochuan, called for a replacement of the US dollar as the global reserve currency.

At first glance, each of those statements is wonderfully consistent with the requirements of the immediate economy that they are responsible for as shown below:
a. The US banking system is has shown to be refusing loans to businesses given the sharp economic downturn and the impact of further credit losses on the balance sheet that help erode their capital base and thereby make new loans more problematic. By showing a program that ostensibly removes problem loans from bank balance sheets at prices that are "agreed" to by private sector participants, the US government can help the banks clear the logjam and perhaps initiate new lending. The Fed demonstrated its willingness to in essence print currency to allow for an inflation in asset prices thus entailed by the US Treasury moves.
b. In Europe, countries have been fiscally irresponsible during the boom period and are thus constrained in their ability to expand the purse strings into a downturn. Further, the workings of the bond market dictate a shift of pain from the weakest to the strongest economy; in turn rendering the currency (Euro) less credible by the passing day.
c. Weeks after unveiling a quantitative easing strategy (see Buyer Beware, Asia Times Online, March 14, 2009), a jump in inflation above the "target" rate of 3% in the UK sent the Bank of England to reverse course entirely and advise against further fiscal measures due to the likelihood of further currency depreciation and possible national bankruptcy. This is the exact set of worries that I shared with readers in the above article; however the timing of governor King's statement was more focused, coming as it did very close to the unveiling of a national budget in the UK this week.
d. As the holder of the world's largest reserves, much of it denominated in US dollars, it was perhaps all too well for the head of the PBoC to demand changes in the savings regime, being what would be required to reduce the volatility of returns as well as on current income. The statement comes a few days after a warning from Chinese Premier Wen Jiabao about the need for the United States to maintain its creditworthiness if for nothing else, for the sake of China's own "investment" in the country.

Seen from those perspectives, all the grandees in governments around the world have been remarkably consistent in respect of their own situation. That said, it is fair to say that ALL of them have missed the bigger picture; and in so doing have multiplied the damaging effects of their own action.

Chinese water torture
My colleague in Asia Times Online, Julian Delasantellis, has performed a masterful deconstruction of the Fed/US Treasury plans to inject hundreds of billions of dollars into the banking system as a means to artificially inflate asset prices (see for example US Fed's move is the bigger problem, Asia Times Online, March 21, 2009). I note "artificially" because there is no organic, growth or demand-related cause for asset prices to rise in the United States. Instead, this is a completely open declaration of intent to inflate prices, on the two legs of the Fed buying unlimited US Treasury bonds, which uses the funds to buy assets from banks.

Remarkably soon after Wen's statement on the US dollar, this response from the Federal Reserve and the US Treasury can be seen as nothing other than a snub to China. Readers will remember that US Secretary of State Hillary Clinton took the unprecedented step of accommodating the Chinese point of view on several issues, ranging from human rights to Tibet, with a view to securing explicit support from the Chinese government for a continued expansion of the US government balance sheet.

That trip was, however, before the fateful export figures for the month of February were reviewed by the Chinese government, these showed a horrifying 25% decline over the previous year. In effect, the Chinese government has realized that the game was up - that is, even allowing for a willingness to buy more US government bonds, they no longer had a continuing ability to do so given the sharp decline in inflows going forward.

Another element of inflows for China, namely investments, also turned negative in January this year, with changes in foreign exchange reserves relative to trade and other flows pointing to an "unexplained" outflow of around $40 billion by some measures (using other measures that incorporate commercial banks' deposits with the central bank would actually increase the estimated outflows to $75 billion at the beginning of the year). Much of these outflows are from the very businesses that the Chinese government is trying to help with its policy of depreciating the yuan: exporters who are simply not bringing back proceeds or in many cases simply sending money straight back out of China to benefit from further depreciation of the yuan.

Given this context, it is clear that the Chinese government has decided to embark on a series of steps meant to somehow justify their reduced holdings of US dollar assets, a strategy referred to as "making a virtue out of a necessity".

For the rest of the world, these sudden lectures from the Chinese government about fiscal prudence and reserve currencies should ring as hollow as their points about human rights abuses in Western countries. In other words, ignore the shrill talk and focus instead on the real reasons.

This tango between a US government bent on printing money and a Chinese government that can no longer buy any of its favorite toys leads obviously to some fireworks but in effect there is no real drama here. The old rules of banking apply: owe $1 million to the bank and they got you; owe $1 billion and you got them.

In effect, the weaker party in the relationship between China and the United States is the former not the latter. The noise from Premier Wen and governor Zhou is simply a smokescreen to deflect this reality and create a more palatable situation going forward, at least strategically.

Unfortunately, not even the US Federal Reserve and Treasury are that stupid to buy into the risks of the Chinese offensive. If anything, the two agencies may well be overcompensating for greater weakness from China; in effect laying the groundwork for a significant swell in inflation going forward.

With friends like these
Having looked at the Chinese and US situation, it is the turn of the hapless European bankers, Trichet and King. Long-wedded to the inflation-targeting school of central banking, these two banking chiefs were thrust into a new reality following the collapse of the asset-backed commercial paper (ABCP) market in summer 2007; in what was essentially the prelude to the current crisis. Trichet is a card-carrying member of the Austrian school while King was remarkably consistent with inflation fighting through his tenure until 2007.

Already dealing with profligate governments that routinely bust their centrally set deficit criteria (Maastricht treaty), the ECB has the responsibility to supervise the formation of new debt in its backyard. As long as the region retained its ability to export to growing markets in Asia as well as mature markets in North America, the overall balance between government and private sectors remained appropriate for the debt load being undertaken to fund social welfare schemes and the like across Europe.

With the collapse of the US economy and from there to the rest of the world, the balance in Europe has decidedly shifted away to the government; over the next five years it is highly unlikely that the private sector will contribute anything to overall growth. Given that, it is clear that new debt being undertaken by European governments faces the dual risks of increasing leverage even as revenues suffer a semi-permanent decline. That is the essence of the ECB opposition to further stimulus measures in Europe.

Meanwhile in the UK, the Bank of England has been pilloried for its extremely amateurish supervision of the financial industry that has resulted in the collapse of most UK banks (see Beggar, I thy neighbour, Asia Times Online, February 28, 2009). Stung by these failures, the Old Lady of Threadneedle Street may have decided to act aggressively to counter a gathering downturn. This was done by first cutting interest rates and then by quantitative easing (QE).

For its part, the ECB has no role in supervising banks in member states and therefore was stunned to discover decrepit banks in all of them: Ireland, Germany, France, Netherlands, Belgium and so on. The collapse of the banking systems in these countries effectively jammed the compasses of the central banks.

The trouble with doing that though is that the UK is simply the US without a reserve currency status. Soon enough, the currency (GBP) fell against all others; even as global prices of commodities and services fell the decline in the GBP was to prove higher thereby helping to introduce inflation into a dying economy.

That combination of failed government efforts combined with worsening external positions is truly the hallmark of undeveloped countries (see Ask not for whom the bells toll, Asia Times Online, December 25, 2008).

Fear at the possibhle permanence in this downturn was perhaps the main reason for the ECB and the Bank of England to voice their fears respectively on leverage and inflationary risks. However, their actions also betray a sense of betrayal from the underlying governments.

Rather than helping their central banks do their job effectively, it is highly likely that both institutions will be undercut and compromised by their respective member governments. The political nature of appointments to the central banks also means that thei falling into line with the governments is simply a matter of time.

This fear of further government actions led to a historic failed auction for UK Gilts this week, for the first time in 25 years or so. Readers who remember the failed German government bond auction from January will start seeing an obvious pattern at work in Europe: no one who doesn't have a mandate to continue buying these securities has any obvious economic motivation to do so.

These are but the first reactions in the bond markets. Very soon, I expect sales of US government securities to non-US government entities to start falling as well; in effect pushing up longer-term interest rates. This will be conveniently blamed on the Chinese but of course the culprit is closer to home.

Exit strategy
For the global saver, the kind of person who is more intent on preserving his longer-term purchasing power rather than focusing illogically on currency nationality, it is possible that the past week was an eye-opener, combining as it does the elements of both a seller's and buyer's strike in tandem.

In the colloquial, the Americans are afraid the Chinese will stop buying their bonds, while the Chinese are afraid that the Americans will discover they no longer have the money to buy American bonds. In Europe, the British are worried about their economy being blown to kingdom come by inflation, while the Europeans are worried no one around really cares what they think any more.

Going back to our fictitious "global investor" in the above paragraphs, it is clear that engineering by the Group of Seven leading industrialized countries is being finely tuned to produce gazillions of inflationary prints as the sure-fire way of boosting asset prices and ensuring that everyone walks from their horrendous losses on debt holdings.

There is of course a short circuit for all this; something that jolts all of the world's central bankers back into their senses. This involves not some fictional global currency that takes months to discuss, years to build and decades to find acceptance but rather a return to basic principles.

Against the metric of gold, it is highly possible those economies in a permanent downward spiral - Europe, Japan and large parts of the US - simply do not have the fundamental strength to pull off the debt-fuelled rallies being considered now. America can no more pull off a $3 trillion deficit than the old Soviet Union could pull off the stunt of keeping the rouble on parity with the US dollar. European governments simply do not have the demographics or the organic economic strength to pay for all the bonds being issued now to offset the impact of recession on their finances; this renders the idea of the euro as a reserve currency laughable at best.

In effect, the more investors buy gold, the more desperate the lot of the world's central bankers, until finally the bankers gain the upper hand against their own governments and start focusing on the value of money rather than simply its quantity.

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