Tuesday, December 14, 2004

Fine-tuning Currency Intervention

Andy Xie (Hong Kong), Morgan Stanley

I still believe that Asian central banks should shorten the duration of their dollar reserves as much as possible. At a minimum, Asian central banks should park the increases in their dollar reserves in the money market in order to decrease the distortion in the US$ yield curve.

Shortening the duration of Asia’s dollar reserves would remove a perverse incentive for the US to push down the dollar. When a policymaker in Washington talks down the dollar, it incites hot money flows into Asia. If the Asian central banks mop up the hot money and buy US treasuries with it, it depresses the US bond yield and boosts the US economy. The US is in a win-win situation by talking down the dollar.

If Asian central banks cease buying US treasuries with the dollars from their currency market interventions, the US bond yield will rise when the US policymakers attempt to push down the dollar, canceling the benefits of a weaker dollar for the US economy.

The US policymakers have been quiet for a few days and the dollar has rebounded a little. I suspect that this is not the end. Thus, Asian central banks must prepare for another round of intervention and, preferably, to reinvest the purchased dollars in the money market, not treasuries.

Banks Need to Prepare for More Currency Intervention …

The case for intervention is based on the premise that hot money has exaggerated the demand for Asian currencies, which may recede over time (after doing unnecessary damage to the Asian economies) or push Asia’s economies into a Japan-style trap of strong currencies, low growth and persistent current account surpluses.

The capital inflow, as measured by the difference between the increase in foreign exchange reserves and the foreign trade surplus, has resurged since August. The inflow was US$69 billion in 2002, US$332 in billion 2003, and US$215 billion in the first quarter of 2004 alone. The massive inflow in the first quarter became a small outflow of US$11 billion in the second quarter, as China’s rhetoric over macro tightening became more aggressive, which discouraged speculation. The outflow was US$6.1 billion in July but reversed to an inflow of US$11.5 billion in August and US$11.8 billion in September. The inflow has since mushroomed again, mainly targeting China, as China has gone soft on macro tightening and the US has gone hard on pushing down the dollar. I think the inflow in the fourth quarter could exceed US$100 billion, implying a total inflow for 2004 of US$322 billion – similar to that in 2003.

Asia experienced annual capital outflows of US$33 billion between 1990 and 2001 and US$21 billion between 1980 and 1989. The cumulative outflow was US$611 billion between 1980 and 2001. The inflow between 2002 and 2003 reached US$712 billion, exceeding the outflow over the previous 22 years. Some of the inflow is Asia’s past outflow returning. However, I estimate that the returning money accounts for one-third of the inflow at most – with the rest just hot money. In fact, even the returning money is mostly hot money, in my view.

I believe the presence of hot money on a massive scale justifies government intervention in the currency market. The argument that the market should determine currency values just does not cut it when hot money flows are so substantial.

… Avoid Interventions Distorting Monetary Conditions …

Intervention by Asian governments should attempt only to neutralize the hot money, in my view. The hot money is borrowed in the money market. I believe Asian intervention in the currency market should put that money back into the money market to avoid distortions.

When policymakers in Washington say that the dollar’s value should decline, speculators may decide to borrow dollars in the money market to buy Asian currencies. That speculative demand for dollars then pushes up the short-term dollar interest rate. In light of its short-term interest rate target, the Fed then releases more money to meet this demand and maintain the stability of short-term rates.

When an Asian central bank buys these speculative dollars, it issues a local currency bond to sterilize the impact on domestic liquidity, and may put that money into the dollar money market again. The additional liquidity then pushes down the short-term dollar interest rate. The Fed, in order to keep the short-term interest rate stable, has to soak up this excess liquidity to keep the short-term rate stable.

The above currency intervention is completely neutral to the monetary conditions in the US or Asia. Assuming that the speculative demand is transitory, the currency intervention simply prevents an irrational force from damaging the global economy. If Asian central banks follow such non-distortionary interventions, US policymakers should find that their verbal interventions in the currency market are not effective.

However, if an Asian central bank buys US treasuries with the dollars from the currency intervention, it artificially depresses the US bond yield. The lower bond yield boosts the US property prices, which causes US homeowners to refinance their mortgages to cash out part of the property appreciation for current consumption. The US trade deficit widens. The massive purchases of the US treasuries by Asian central banks have thus inadvertently contributed to widening the US trade deficit, in my view.

At a minimum, I think Asian central banks should park the increases in their dollar reserves in the money market only. It is understandable that Asian central banks want to benefit from higher US bond yields compared with the short-term rate. However, Asian central banks have to be responsible and cannot afford to focus on profits. I believe that Asian central banks need to focus carefully on how to invest their dollar reserves.

… and Hold Steady in the Storm

Financial markets are not efficient and exaggerate currency fluctuations. In the 1980s, the ‘Japan as Number One’ mentality dramatically distorted asset markets around the world. Ten years ago, ‘The East Asian Miracle’ hype caused European and Japanese banks to lend massive amounts of money to corrupt businesses in Southeast Asia. In 1997-98, the ‘Asian Crony Capitalism’ scare triggered massive capital flight out of Asia and brought ruin to millions of Asian people. In 1999-2000, the ‘New Economy’ hype persuaded people around the world to put their savings into US tech companies. Now, the hype appears to be ‘America falling to zero and China rising to infinity’. What’s next?

Major moves in financial markets have become like fashionable fads – and for a good reason. As institutional investment has proliferated, it has become extremely difficult to earn extra returns on fundamental research. When life is hard, people become credulous. That is what’s going on in the financial sector, in my view. Financial investors want to believe the ‘free lunch’ stories. A concept like ‘the New Economy’ or ‘China rising’ can suck in many people and make the markets self-fulfilling in the short term.

I suspect it would take only one significant event for most people who are singing China’s praises to turn bearish. The fascination with China’s growth could easily turn into fear of China’s bad debts. In the financial market, the distance between euphoria and despair can be quite short.

Financial ‘fashions’ can trigger big moves in major currencies. Since 1990 the yen/dollar rate has moved from 160 in 1990, to 80 in 1995, to 146 in 1998, to 103 this year. Can fundamentals justify such wide swings in the exchange rate between the world’s two largest economies? I think not.

Unlike fashion shows, big currency moves can damage the livelihoods of millions of people, especially in emerging economies like China. The big currency moves do not change the Japanese or US economies dramatically, as they are mature and have sophisticated financial systems and fiscal cushions. However, a shock from a major currency move can push an emerging economy onto an entirely different path. Southeast Asia, for example, would likely have followed a different path since 1997 had speculative attacks not destroyed its financial stability in 1998.

I believe that Asian central banks must hold firm on sterilizing hot money and not succumb to the ‘free market’ mantra from some quarters.


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