I was surprised by how conservative China was in the immediate aftermath of the crisis.

TO BE NOTED: From Follow The Money:

"Creditors generally do like to lend in their own currency …

Posted on Tuesday, March 31st, 2009

By bsetser

China may not be an exception after all.

A creditor than lends in its own currency doesn’t have to worry all that much about the risk that it its lending is denominated in a currency that will depreciate. The borrower assumes the risk its currency will depreciate against the currency of its creditor as a condition for getting financing.

That is good for the creditor, and not so good for the borrower.

Back its days as a large creditor, the US (both the US government and private US creditors) generally lent in dollars. That meant that if a Latin currency depreciated against the dollar, the borrower had to find the dollars it needed to repay the US – or default and accept the consequences. Latin countries couldn’t allow their currencies to fall against the dollar and, in the process, reduce the real value of their foreign debts.

China is now a major creditor. But its foreign assets though are denominated in dollars, euros and yen – not RMB. That means that if the dollar depreciates against the RMB, it is China’s problem, not the United States’ problem. The amount of dollars the US has to pay China doesn’t change. But the amount of RMB that China gets for each dollar will fall

China’s willingness to take on this risk in some sense part was a core part of the Bretton Woods 2 system where reserve growth in emerging countries like China financed the United States external deficit. Had the United States external debt not been denominated in dollars, Dr. Roubini and I would have been even more worried by the size of the United States external debt than we were back in 2004. If United States debt structure hadn’t been as favorable, the dollar’s slide from 2002 on would have generated much, much larger problems.

China seems to have woken up, belatedly, to the fact that lending to the United States – or any other country – in its borrowers currency is risky. It probably should have started to worry some time ago, before it had $1.6 trillion or so of dollar-denominated claims. As the FT noted in a recent leader, “The People’s Republic has, however, over-exposed itself to the US, piling up dollar-denominated securities.” China is currently struggling with a problem that is very much of its own making.

China could, in theory, address this problem by ending its accumulation of dollar and euro and yen denominated reserves and instead making RMB denominated loans to the rest of the world.

Internationalizing the RMB poses two problems though.

First, most debtors, including the US, currently do not issue any RMB denominated debt – and I would strongly argue that they shouldn’t start. The countries able to borrow in their own currency at low rates should do so. And countries that have to pay more to borrow to borrow in their own currency also should generally do so, to avoid dangerous currency mismatches. Brazil has benefited immensely in the recent crisis from the fact that most of its debt is now denominated in real.

Second, expanding the “international use” of the RMB is rather hard when China doesn’t want foreign investors to hold RMB denominated assets. If say Argentina had RMB denominated debts, it also might want to hold some RMB denominated reserves as well.

And that would mean allowing foreigners to buy some of the RMB debt that China’s government issues and to hold it as part of there reserves.

That is the rub. Remember, buying RMB debt is also a way of speculating on the RMB.

If China made the RMB fully convertible, anyone could buy long-term RMB denominated debt and benefit if the RMB rose over time. That isn’t something China that has wanted. Remember all the complaints about speculative capital inflows a year ago?

Still, China’s willingness to provide RMB credit to Argentina suggests that China is beginning to recalibrate its definition of its interests.

It is further evidence that China is defining its interest as a creditor – not just as an exporter willing to accept losses on the “vendor financing” it supplies on subsidized terms to those it hopes to encourage to buy its goods.

I was surprised by how conservative China was in the immediate aftermath of the crisis.

It seemed to be concerned almost exclusively with the need to minimize the credit risk in its reserve portfolio. That meant turning down requests from countries like Pakistan for bilateral financing – as well as selling Agencies and buying Treasuries. Now it seems that China has concluded that it has reduced the credit risk in its reserve portfolio to an acceptable level and is turning its eye toward reducing its currency risk.

That though may be a tougher nut to crack.

Perhaps the state council was spooked by a memo the PBoC sent up the food chain laying out all of the risks that remained in China’s portfolio. If the rumors that China’s leaders were surprised to discover the extent of their exposure to Fanny and Freddie are true, the PBoC has every incentive now to make sure that China’s top leaders aren’t surprised by any future currency losses on China’s reserves.

But the state council has also historically been response to the concerns of China’s exporters – and the core tension between China’s interest as an exporter and its interest as a creditor remains.

Moreover, I am not exactly sure it would be a good thing for China to replace a lot of dollar lending to the world with a lot of RMB lending to the world. China would take on less currency risk to be sure, but all the problems created by China’s large surplus would remain. Actually, they would get worse — as more risk would be in the hands of the world’s big borrowers.

The FT leader again: “[China] must not just replace its mountain of dollar assets with heaps of other currencies.” Exactly right."

Chinese policy makers increasingly seem to view China’s large reserves as a burden, not as an opportunity.

TO BE NOTED: From Follow The Money:

"The PBoC’s call for a new global currency, the SDR, the US and the IMF

Posted on Sunday, March 29th, 2009

By bsetser

A $200 billion shared pool of reserves ($250 billion counting the IMF’s supplementary credit line) is tiny relative to the world’s $7000 billion in national reserves, or — more importantly — relative to the emerging world’s short-term external debt. The IMF currently lacks enough funds to be a lender of last resort for Eastern Europe, let alone the world. George Soros:

“capital is fleeing the periphery and it is difficult to rollover maturing loans. …. To stem the tide, the international financial institutions (IFIs) must be reinforced … the fact is that the IMF simply doesn’t have enough money to offer meaningful relief. It has about $200 billion in uncommitted funds at its disposal, and potential needs are much greater.”

A bigger IMF implies a somewhat larger role for the IMF’s unit of account: the Special Drawing Right (SDR), itself a basket of dollars, euros, pound and yen. When the IMF lends, its loans are denominated in SDR – not dollars, euros or yuan. China may argue that SDR-denominated lending is the first step toward creating a new “supranational” reserve currency. But that is a stretch. No one made such an argument back when the IMF was making a lot of SDR-denominated loans to Asia in the 1990s.

The IMF pools contributions from many countries, so denominating its accounts in a composite of the world’s main currencies make sense. Using the SDR inside the IMF isn’t a threat to the US dollar either. Last I checked, the dollar has somehow managed to maintain its position as the world’s leading reserve currency even though United States’ contribution to the IMF (its quota) is measured in SDR.

Indeed, the SDR – as the IMF explicitly recognizes on its website – isn’t actually a currency.

“The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.”

Countries intervene in the foreign exchange market with dollars and euros not SDR. An IMF loan is just denominated in SDR – so the amount a country has to repay doesn’t change all that dramatically when the dollar moves v the euro. In practice countries actually want to borrow “freely usable currencies” not SDR. In other words, they generally want dollars and euros.

As Dan Drezner observed, many traders presumably hadn’t read Governor Zhou’s white paper or spent much time brushing up on the mechanics of the SDR . They consequently read a bit too much into the headline that was slapped onto Geithner’s comments at the Council. Macroman is right:

“Geithner said that …. he was certainly open to expanding the pool of IMF SDRs. This was an innocuous enough comment, as the IMF is likely set to see its funding levels increase dramatically.”

Deal Journal is wrong; Geithner never said he was only open to “abandoning the U.S. dollar as the primary global reserve currency.” He was open to increased “use of the IMF’s special drawing rights” but he also said this was “rather evolutionary, building on the current architectures, than — rather than — rather than moving us to global monetary union.”

Indeed, Zhou’s call for a one time SDR allocation (an SDR allocation is complicated ** but it effectively is a way for the advanced economies to help meet emerging economies need for hard currency reserves) is less radical than Martin Wolf’s call for an annual SDR allocation. Soros also wants an annual allocation as long as the crisis lasts. Wolf hopes an annual SDR allocation would allow emerging economies to build up reserves without running large current account surpluses.

A one time SDR allocation to increase the emerging world’s access to dollars and euros (the main current reserve currencies) is quite different than redenominating all of the world’s reserves into SDR. The world’s reserves couldn’t actually be redenominated in SDR unless the US and a host of eurozone countries started issuing a ton of SDR debt to replace all the dollar-denominated Treasuries and euro-denominated bunds, OATs and BTPs*** — now held as part of the world’s reserve portfolio. That isn’t about to happen.

I am still struggling to understand precisely what motivated Governor Zhou’s white paper.

One possibility is that he wanted to highlight the fact that the IMF doesn’t operate in dollars to help “sell”a bigger Chinese contribution to the IMF at home. Zhou can argue that China isn’t handing dollars over to a US dominated institution, as some might think. Or helping to bail out a bunch of countries in Eastern Europe peripheral to China’s national interest. By providing the IMF with SDR, China can argue that it is contributing in a small way to the creation of a new reserve currency.

The Journal’s Batson hints as such a motivation when he reports:

“China has resisted the U.S. push to make an immediate loan to the IMF because that wouldn’t give China a bigger vote. Ms. Hu said Monday that China, which encourages the IMF to explore other fund-raising options, would consider buying into a bond issue. The IMF has been working on a proposal to issue bonds, probably only to central banks”

Of course, Zhou’s call for a new global reserve currency was also intended to signal China’s concern about the direction of US policies. And just perhaps, to signal that China’s government is taking domestic criticism that it has squandered China’s savings to heart.

It some ways Zhou’s call is a sign of weakness as much as a sign of strength, as China’s leaders are now is clearly worried about the value of its reserve portfolio. Or perhaps they are just worried about being blamed for losses on China’s reserve portfolio.

Chinese policy makers are sophisticated enough to know that the US is not going to embrace a true supranational currency. Agreeing to a world where the IMF calculate its accounts in a basket of dollars, euros, pound and yen is one thing. Agreeing to a new currency that supersides the dollar is quite another.

Moreover, China’s call for a change in the global order is rather undermined by China’s ongoing desire to peg to the plain old dollar.

A discussion of reserve currencies ultimately is also a discussion about the exchange rate regimes that led a host of emerging economies to accumulate reserves. Zhou’s call puts some issues that China hadn’t wanted to discuss at the last leaders meeting on the table for international discussion.

Perhaps China’s leaders wanted to insulate their dollar peg from criticism, both at home and abroad, by arguing that they cannot change their peg without a broader change in the international monetary regime. China can argue that if the US doesn’t want to abandon the dollar, China shouldn’t be pushed to abandon its dollar peg.

The only problem is that there is no real link between the two issues. China could easily join those emerging economies that already allow their currencies to float against the dollar and the euro even in the absence of any agreement on a new global currency.

In a lot of ways, though, the most surprising proposal in Zhou’s paper wasn’t his call for a new global currency; it was his call for “international” management of national reserves. Zhou wrote:

Compared with separate management of reserves by individual countries, the centralized management of part of the global reserve by a trustworthy international institution with a reasonable return to encourage participation will be more effective in deterring speculation and stabilizing financial markets …. With its universal membership, its unique mandate of maintaining monetary and financial stability, and as an international “supervisor” on the macroeconomic policies of its member countries, the IMF, equipped with its expertise, is endowed with a natural advantage to act as the manager of its member countries’ reserves

That would really be a change. China currently isn’t willing to tell the IMF the currency composition of its reserves. And now it seems to be hinting that it might allow the IMF to manage a portion of its reserves!****

Chinese policy makers increasingly seem to view China’s large reserves as a burden, not as an opportunity.

Unfortunately, China is already stuck with this burden. In some sense, the current debate in China over the cost of maintaining a large reserve portfolio is a debate China should have had four or five years ago. Back then it was clear that China had put itself on a path that would lead it to accumulate huge reserves at a substantial cost to itself. It didn’t change though. As a result, it ended up providing a lot of dollar-denominated credit to the US over the last four years.

Now it is struggling to accept the consequences of the policy choices that left it with over 50% of its GDP in reserves or quasi-reserves.

That presumably is why previously unthinkable options – like global management of China’s reserves – seem to be getting serious consideration.

*”Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions.”
** As I understand it, the IMF grants all countries SDRs. And then emerging economies can use their SDRs as collateral to borrow dollars and euros and the like from the central banks of the world’s advanced economies. It is a way countries that don’t have currencies of their own that the Fed is willing to accept as collateral in swaps can get hard currency reserves. If there is a better explanation, I am all ears.
*** German, French and Italian government bonds
**** Dr. Summers, in his academic days, made a similar proposal."

It also sent a signal that China, unlike Japan, will not be satisfied with the status of a second-rate power

TO BE NOTED: From Dragonbeat:

"China’s global currency proposal: more politics than economics

March 29, 2009 1:14pm

by Arthur Kroeber

Last week we wrote that China was unlikely to make a substantial contribution to discussions about reorganising global economic governance.

Hours after our post went up, it was neatly contradicted by Zhou Xiaochuan, governor of the People’s Bank of China (PBoC), who published an essay on the bank’s website suggesting the creation of a new supra-national reserve currency to replace the US dollar. This was followed later in the week by another essay on how to secure global financial stability, and an article by a PBoC research institute on how to improve global economic regulation.

This was a salutary reminder that the Chinese government (or at least some members of it) can be a bit more agile than foreigners typically believe. It also sent a signal that China, unlike Japan, will not be satisfied with the status of a second-rate power. Japan in the 1980s expended enormous energy in fighting bilateral battles with the US but did little to make itself relevant to global economic decision-making. China has a long-term vision of its rightful place in the world and will work on a variety of fronts to secure that place.

That said, the PBoC papers are interesting more for their political than for their economic content. Their immediate aim was to establish a stance ahead of this week’s G20 meeting in London. The essence of that position is:

• the root cause of this and previous financial crises was the special position of the dollar as the world’s reserve currency (and not, therefore, the “Asian savings glut”)
• the self-regulation model for financial supervision touted by the US has been proved bankrupt
• global financial regulation (eg the Basel II accords on bank capital) needs to be made less pro-cyclical.

The second and third points fall well within the realm of conventional wisdom these days. But discussing them enabled Chinese officials to exact a little payback for all the sanctimonious hectoring they have had to endure from arrogant US officials over the years about the superiority of the American financial system.

Invoking a supposed principle of “oriental philosophy” that self-criticism is essential to self-improvement, the PBoC research department paper called on the US to exhibit remorse for its errors, stop blaming other countries for its problems, and reject the “prevalent complacency” that allowed its financial excesses to overwhelm the world. Such sermonising, though excusable, adds little to the sum of world knowledge.

Mr Zhou’s global reserve currency idea is more interesting. This is not because the proposal is likely to lead anywhere. There is almost no chance of that – as we suspect Mr Zhou knows.

But as a political statement it is ingenious. By arguing that the IMF should become the issuer of a new global reserve currency, Mr Zhou cleverly positions China as a champion of strengthening a rules-based multilateral system of global economic governance, rather than as a bare-knuckled aspirant hankering to knock off the current kingpin bully. Many have feared that China’s rise must be de-stabilising and that China will have no stake in “playing by the rules.” By identifying – accurately – the moral hazard and instability risk inherent when a single national currency serves the global reserve function, Mr Zhou articulates China’s national interest in promoting and participating in a rules-based, multilateral system.

This argument is directed at a domestic as well as an international audience. Some in the Chinese government fantasise that China’s big surpluses give it power, and that the renminbi can swiftly replace the dollar. Mr Zhou knows better, and is trying to steer the domestic debate in a more useful direction.

The second political purpose of Mr Zhou’s paper was presumably to suggest some conditions for China’s participation in the expansion of the IMF’s capital, which is a keenly-desired outcome of the G20 process. The rich countries want China to stump up US$100bn-US$200bn, largely to enable the IMF to bail out the bankrupt economies of eastern Europe. China rightly questions what benefit it would derive from paying such tribute. An expansion of its voting rights in the IMF is a paltry prize, both because it would take at least a decade under current rules to give China a voting share commensurate with its economy’s size, and because the IMF is marginal to global economic decision-making. By proposing a vastly stronger role for the IMF, Mr Zhou indicates that China deserves and seeks real influence, not meaningless trappings.

The global currency idea itself, however, is impracticable. Mr Zhou proposes that the IMF’s special drawing rights (SDRs) be converted into a global reserve currency, supported by large-scale issuance of SDR-denominated bonds. One obvious question is who would decide on the volume of SDR issuance – ie the size of the global money supply? The IMF is not set up as a central bank. The Bank for International Settlements is another possibility; but any multilateral institution would suffer from a diversity of masters with different political agendas and thus would find it difficult to shift monetary conditions decisively in times of crisis, which is an indispensable attribute of a central bank.

This points to deeper objections: reserve currencies are a reflection of political as well as economic power, and they are determined not by negotiation but by market activity. They are subject to “network effects” similar to those that apply for computer operating systems – the more people gravitate to a standard, the more incentive other people have to follow. Once a standard is established it is exceedingly difficult to dislodge.

Despite the current crisis, America’s political hegemony is secure and its ability to guarantee the long-term value of its debt securities is still superior to that of any imaginable political collective overseeing a global currency. The dollar’s position as the main reserve currency is still secure. But China has served notice that the US will need to work a bit harder to justify its “exorbitant privilege.”