The FT on BW2 free-riding and capital losses on holdings of dollar reserves: A “Hot Rotten Potatoes” Musical Chair Game…
The FT has published yesterday an interesting editorial on the incentives of the small countries in the the Bretton Woods 2 periphery to free ride on the center (China/Japan) and on the potential large capital losses on holdings of dollar reserves once these Asian and other currencies were to move.
And similar points have been picked up before in the press.
One comment on the good FT editorial: it is clear to all that if a large country such as China and/or Japan were to diversify (say towards Euros), both their currency value relative to the US dollar would sharply change and also the cross rate between the US $ and the Euro. The question is what happens when a small country at the periphery of BW2 diversifies say into Euros or Yen. Is the US $ exchange rate relative to the Euro or Yen affected and is the exchange rate of this country relative to the US $ affected? The FT correctly argues that a small country that diversifies may not affect its currency value relative to the US $. The FT also suggest that such diversification may instead affect the $ /euro or the $/ yen exchange rate. A few caveats on that point:
1. If the amounts sold by these small central banks are modest, relative to the size of the $/euro and $/yen fx markets, then this free riding could have little effect on those cross currency values. Thatis the entire point of bein small and free riding.
2. Of course if many BW2 periphery small countries free ride, that would affect the $/euro and $/yen rates as their joint behavior becomes large.
3. In that case, over time, even their bilateral exchange rate relative to the US $ may move as you cannot have a whole bunch of countries pegging to the dollar and dumping dollars without effects on their bilateral rate relative to the US $. Korea experienced that, in part, when last fall it tried to get out of BW2, it stopped intervening for a while and saw an excessive movement of the won relative to the US $ and was thus forced to start intervening and buying dollars again.
3. Suppose that a number of small BW2 periphery countries diversify out of US dollars into yen and euros and that leads to a weaker $ relative to Euro and yen. Then, the BOJ may start intervening again and the ECB may start to intervene altogether to avoid excessive appreciation. Then, the BW2 periphery would free ride on the ECB and BOJ: they would be able to dump their undesired $ assets and acquite Euros and Yen provided by the BOJ and ECB intervention at no cost to these free riders as the $ cross rate relative to euro and yen would be unaffected if such intervention occurs and at not cost in terms of bilateral currency value relative to the US $ as someone is absorbing the undesired hot potato of dollar assets. This way ECB and BOJ get the hot potatos of $ assets that small countries do not want and give Euros and Yens to the free riders in exchange. So, ECB and BOJ end up taking more of the risk of a $ fall. Would this intervention save BW2? No, as in addition to the stock of existing hot potatoes of dollar assets that the various central banks are trying to dump into each other, from BW2 periphery into Japan, Europe and China, someone has on net to hold the extra new $700 billion of new hot potatoes (by now rotten potatoes) deriving from the US current account deficit. So, the hot rotten potato musical chairs game becomes unstable over time as the US supply of lousy potatoes increaes by $700 billion dollars a year while no one want to increase its net ingestion of such a lousy and increasingly rotten meal. So, the end game becomes a hard landing for the US dollar and the US bond market, i.e. a nasty end game to this unsustainable attempt by the US to free ride on the world. For details see my new paper with Brad coming up next week….
And here is the interesting FT editorial:
Published: January 25 2005 02:00 | Last updated: January 25 2005 02:00
The fate of the dollar rests in the hands of a handful of central bankers in Asia. We have known this for some time. Since the foreign private sector shows insufficient appetite for US assets, the US relies on central bank purchases to fund its current account deficit and the acquisition of foreign assets by US residents. By absorbing the excess supply of dollars these central banks stop their own currencies appreciating against it. This Faustian bargain underpins today’s currency prices and trade patterns and sustains global imbalances. Any suggestion that foreign central banks may be losing their hunger for dollars is highly significant.
A new survey suggests that central bankers are beginning to ponder whether it is in their interest to carry on buying dollars. This does not signal a rush for the exits. Much of the rise in the share of reserves held in euros is a valuation effect. Two-thirds say they want to keep the proportion in dollars unchanged this year. Neither Japan nor China – which together hold 40 per cent of the world’s reserves – took part in the survey. Yet one-third of those polled did indicate a desire to increase the share of reserves held in euros. Eurozone capital markets are seen as liquid. Not a single respondent wants to hold a greater share in dollars.
It would be surprising if central bankers were not thinking very carefully about what they should be doing. The fall in the dollar has already resulted in big capital losses for those holding large dollar reserves. They risk far bigger losses if the so-far steady decline turns into a rout. The importance of capital loss increases as reserves rise relative to gross domestic product. For example, Malaysia’s reserves are now equal to 54 per cent of GDP, up from 34 per cent two years ago.
Could a country with a de facto dollar peg diversify its reserves without appreciating against the dollar? Many assume not. In fact the answer, as so often in international economics, depends on whether the country in question is “small” or “large” in this context. A “small country” with medium-sized reserves, such as Thailand, Malaysia or even India, could continue to absorb surplus dollars on the bilateral currency market, but sell its stock of dollars for euros. The effect would mainly be to push the euro up against the dollar. The central bank’s own currency could remain pegged.
A “large country” – Japan or China – could also embark on the same strategy. But the scale of the dollar sales would probably cause a generalised dollar collapse, with private buying disappearing altogether, demanding still greater central bank purchases. The central bank would lose control over domestic money supply, resulting in soaring inflation that would in turn push up the real exchange rate. In practical terms, Japan and China probably cannot diversify to a meaningful extent without letting their currencies rise. So keep an eye on the other Asians. Who will break ranks first?
5 Responses to “The FT on BW2 free-riding and capital losses on holdings of dollar reserves: A “Hot Rotten Potatoes” Musical Chair Game…”
Great stuff as always, Nouriel. I suspect, however, that a political-military angle needs to be inserted into this discussion. Korea and Taiwan are in my view not in the same category as other “small free riders”. If the top four reserve builders move in a bloc — and especially if they can force the ECB to join — then there won’t be nearly enough rotten potatoes to spoil the stew. Gen’l Glut
From Andy Xie’s commentary at http://www.morganstanley.com/GEFdata/digests/20050124-mon.html#anchor4 ”While virtually everyone at the MacroVision conference was bullish about the yen, one Japanese participant from a big insurance company stood up and begged to differ. ‘The spread between Treasury and JGB is 300 bps. That’s good enough for us to buy’, he said. No one reacted to his comment.” ”I checked the data afterwards. Sure enough, the average spread between 10Y Treasury and JGB was 299 bps in the past three years. While hedge funds borrow dollars at 2.25% to buy yen with zero yield, Japanese insurance companies are buying US Treasuries with 300 bps yield pickup. With 300 bps pickup, they are better off buying Treasuries against JGB if dollar-yen is higher than 80 ten years from today. Of course, if you listen to some hedge funds, dollar-yen should reach 60 or lower and soon. With dollar-yen at 60, Japan’s per capita income would be 60% higher than the US’s. Have you been to Japan lately?”
Events in the foreign exchange market during the last few days show how fickle orthological analyses of “economic fundamentals” can be. Now the dollar is rising again and should this continue (as indeed it appears) then nobody will be worried about the excessive US current account, etc. In fact, all those smaller central banks (and some of the bigger ones too) that were furiously buying Euros during the last 3 months of 2004 at rates close to 1.30 will probably be reprimanded by their governments for their lousy management skills. When I asked some FX dealers the question ” if everybody including many central banks are selling their dollars, then who is buying these dollars?” I received a dumbfounded gaze. Well it now seems clear (at least to me) that the US after talking the dollar down in unusually vocal terms, has now amased a sizable enough position to reverse its rhetoric and cause a “scramble”. This for as long as it lasts and after? Why not another war, etc. Anybody who doubts that the US still calls the shots has better get his head examined.
The url was not working?
I WANNA SEE A PICTURE