20/02/2009: Breaching the Fed’s Maginot line

In 2004, calling it “a kind of balance of financial terror,” Lawrence Summers, President Obama’s Director of the National Economic Council, noted that “The incentive for Japan or China to dump Treasury bills is not very strong given the consequences it could have for their own economies.” Back then, China’s reserves were roughly 600 billion US dollars; by the end of 2008, they had crossed the 2-trillion threshold.

Most of China’s reserves are in US government bonds. If these bonds were sold on a large scale, their prices would tumble, triggering a sharp increase in US interest rates, surely the wrong medicine for frozen credit markets right now. Thus China’s vast currency hoard looms large as a threat to the US economy. But Summers spoke of a “balance of financial terror,” and there was indeed a counter-threat.

By selling its reserves, China would have lost money twice: the sale would have weakened the US dollar, thus undercutting the proceeds of the sale; and with higher US interest rates, China’s bond portfolio itself would have lost value.

Today, with the Fed saying it might buy US Treasuries to keep interest rates low, we argue that the balance of financial “terror” has started to tilt in favor of China. In buying Treasuries, the Fed presents China an opportunity that is too good to refuse: since the Fed aims to keep interest rates low, China’s portfolio would not be hurt by lower bond prices; the dollars from the sale would have no effect on China’s currency; and, not least, China could rebalance its rather poorly diversified reserve portfolio. Win-win-win, we would say, for China.

Of course, this dollar windfall would need to be reinvested somewhere. And this recalls another image of twentieth-century warfare, the Maginot Line, France’s supposed impenetrable defensive cordon built up along its border with Germany prior to World War II. It was, of course, anything but failsafe. The German army simply circumvented it, invading neighboring Belgium on its way to Paris.

So who, or what, might be the Belgium of America’s financial Maginot Line? The euro is one obvious candidate. The European Central Bank is far more reluctant to enter a currency devaluation contest than the Fed. By buying euro-denominated assets with its US dollars, China would drive up the euro and keep Eurozone interest rates low. Commodities are another route for China to avoid self-inflicted damage from a weakened dollar. Commodity prices are relatively low now, and building up inventories might appeal to China’s economic planners and voracious industrial base.

Clearly, the Fed is the loser in this scenario. “Don’t fight the Fed,” runs the old Wall Street truism. But two trillion dollars in currency reserves is a mighty big gun if China chooses to test it. This financial power play could lead to higher US interest rates despite Fed interventions, to lower European interest rates despite a more hawkish European Central Bank, and to a far weaker dollar versus the euro and other currencies and against commodities, with a corrosive effect on the dollar’s status as the world’s reserve currency of choice.

06/02/2009: Europe’s midlife crisis

Europe’s self-image is taking a beating: ratings downgrades to the sovereign debt of Spain, Greece and Portugal; Ireland on the “watch” list; and, at least according to the British tabloids, the UK on the brink of bankruptcy, replaying its 1976 humiliation, when the International Monetary Fund came to the rescue. In the gloomier precincts of public opinion, the dominos are all in place: after the housing market and the financial sector swan-dived into despair, governments, especially in Europe, are next in line to leap into the abyss.

The trouble is, this view applies a very mistaken lens to today’s events. The ground rules for the sovereign debt of emerging market countries do not work for developed economies, as we will explain.

Most emerging market debt is issued in a major currency like the US dollar or the euro. If an emerging country lacks the foreign currency to repay or to service its debt, it faces the risk of defaulting and the likelihood of a steep devaluation in its currency.

But developed nations usually issue sovereign debt in their own currency. Thus, they can, if necessary, “monetize” the debt: they can print the money they need to manage it. Of course, if they print too much money, they also face currency devaluation. But default is not a danger.

Back to the UK, currently all its debt is in British pounds. Now, the UK enjoys one of the lowest government debt-to-GDP-ratios of all developed countries, 47.5% in 2008, compared with over 60% for the US and over 180% for Japan. This alone should soothe default fears. The cookie jar is not empty.

Granted, the foreign liabilities of the banking sector and its ongoing bailout add to the UK’s total liabilities. But the banking sector’s 4.5 trillion dollars in foreign liabilities is matched by its 4.6 trillion dollars in foreign assets. And these assets would also go to the UK government in a worst-case full nationalization of the banking sector. More cookies in the jar.

True, the pound may well depreciate, which would help reinflate the depressed UK economy, but default simply isn’t going to happen.

The members of the European Monetary Union issue debt in euro. And here is a critical difference: individual EMU countries have no control over the European Central Bank. Thus, they cannot monetize their debt and inflate themselves out of trouble. Moreover, EMU and EU institutions are prohibited by law from supporting a defaulting member country. But no law prevents one or more EMU members from aiding another country.

And there a good reasons to help: If an EMU country defaults on its debt, intra-government bond spreads would likely widen sharply. This would raise the financing costs for other EMU high-debt countries, pushing them towards insolvency and, in a true domino-effect, undermine the stability of the whole Union.

Therefore we see Europe’s default fears as overdone. While the default of an EMU member country cannot be ruled out, it is unlikely, and other scenarios will first be tested before it happens.